Silver linings, some clouds for Nestle

The company follows a January-December financial year; so, the June quarter is its second. Total operating revenues in Q2 rose 16.1% year-on-year (y-o-y) to nearly ₹4,037 crore, primarily driven by domestic sales. Domestic revenues, which comprised 95% of its operating revenue, rose by 16.4% y-o-y. For perspective: domestic growth in Q1 was 10.2%. Its domestic sales growth in Q2 is broad-based with a healthy balance of pricing, and volume and mix.

“Management commentary towards broad-based growth across categories and uptick in rural market in Q2CY22, coupled with the announcement of entering into fast-growing, high-margin pet care category and introducing the Gerber brand in India was a surprise element, which led to increasing excitement," said Naveen Kulkarni, chief investment officer, Axis Securities.

Nestle India will acquire the pet food business from Purina Petcare India for ₹123.5 crore. Purina’s revenue for the year ended March was ₹36.08 crore. These levels are too small to move the needle in the near term, but the prospects are upbeat. The company estimates the size of the pet care category to be around ₹4,000 crore.

According to Nestle India, in the post-pandemic world, pet adoption is on the rise and pet food business is expected to post a compound annual growth rate (CAGR) of 50% over 2022-2026 versus 39.4% CAGR over 2018-2021.

Sachin Bobade, analyst at Dolat Capital Market, said, “The pet food business is a high-margin one and that is likely to work in favour of the overall margin improvement in the long run."

Separately, the launch of the Gerber brand in the toddler nutrition segment offers products to accelerate growth in the category. Kulkarni said, “Nestle India is lately witnessing increased competition from Abbott’s Similac and PediaSure. By introducing Gerber brand in India, Nestle can now protect its turf from other companies."

While these developments are encouraging, cost pressures have been relentless across industries and Nestle hasn’t been immune to this. The company said there have been unprecedented commodity headwinds and that inflation in 2022 has been five times the 3% CAGR seen over 2018-2020. Accordingly, Ebitda in Q2 contracted as much as 409 basis points (bps) to 20.3%, the lowest in the past 10 quarters, at least. This comes on the back of a 304bps drop in gross profit margin to 54% as raw material costs as a percentage of revenue rose. The increase in raw material costs can be attributed to higher inflation, particularly in edible oil, milk and its derivatives, and packaging materials. This was partly offset by better realizations.

Shares of Nestle India have fallen by 3% so far in 2022. What is heartening is that cost pressures are easing. “We are witnessing early signs of softening in a few of the commodities like edible oils and packaging materials. Fresh milk, fuels, grains and green coffee costs are expected to remain firm with continued increase in demand and volatility," said the company.

Needless to say, potentially steady or lower raw material prices will help its margin outlook. The expectation of a normal monsoon and higher crop realization should boost rural demand. However, considering that valuations are pricey, meaningful upsides may be capped in the near future. Based on Dolat Capital’s estimates, Nestle’s shares trade at 60.5 times 2023 EPS.