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Company update: Nestle India (Outperformer) - Strong underlying trends; CY17 annual report analysis

Nestle India’s (Nestle) CY17 annual report shows overall improvement in the company’s operational performance, led by a) 11% volume growth b) overhead cost control on improving EBITDA margin c) strong free cash flow (FCF) and higher return ratios. We have factored in 10% volume CAGR over CY17-20E, aided by recovery in market share and sustained new product/variant launches. Further, favourable input cost environment and benefits of operating leverage will improve EBITDA margin by 230bp over CY17-20E to 23.7% in CY20E. Although Nestle trades at expensive valuations of 51x/44x CY18/19E, a 10%/18% volume/earnings CAGR over CY17-20E and improving return metrics make the stock attractive. We maintain our Outperformer rating on the stock with a revised target price of Rs9,565; we have introduced CY20E earnings of Rs225.4.

Maggi drives 11% volume growth in CY17 – Nestle’s 11% volume growth in CY17 was led by 19% growth in prepared dishes segment. 2HCY17 volumes grew at 12% yoy versus 9.5% in 1HCY17. Nestle reported highest growth of 3.2% in last 3 years, if we exclude volumes from the prepared dishes segment. We expect healthy performance to continue and factor in 11% volume growth in CY18E.

Cost control led EBITDA margin expansion – Although gross margin contracted 70bp (inflation in milk, sugar, coffee) in CY17, EBITDA margin improved 20bps on overhead cost control (savings in A&P and other expenses). We estimate 160bp EBITDA margin expansion in CY18E.

Strong FCF and RoCE improvement – Low capex intensity (Rs2.6bn), improved working capital (reduction of 10 days) and higher profitability resulted in FCF increasing 23% yoy to Rs19bn. ROE/Pre-tax ROCE increased 320/430bps yoy to 38.3%/51.6% in CY17, respectively.

Earnings revised upwards by 5%/2% for CY18/19E – We have revised our earnings upwards by 5%/2% for CY18E/19E and introduced CY20E EPS of Rs225.4. Though the recent run up in the stock price (20% in the last two months) limits near term upsides, we believe margin tailwinds in the medium term and a structural improvement in volume growth prospects will drive 18% earnings CAGR over CY17-20E, ahead of peers. We value Nestle at 47x March 20E earnings, in line with Hindustan Unilever; maintain Outperformer. Increased competition or adverse movement in input cost is key risk to our earnings estimates.