EUR 850.00 For Business Accounts Only

Morningstar | Trends Unchanged for Nestle in 2Q; Shares Fairly Valued

Nestle remains on track to meet our full-year forecast of almost 2% reported sales growth after a second quarter in which trends remained unchanged from the first quarter. We are unlikely to alter our CHF 79 fair value estimate by more than the impact of the time value of money, and we currently consider Nestle to be fairly valued. Although Nestle appears to be suffering from the low-growth environment more than most of its peers, the company's wide economic moat is based on its supply-chain entrenchment, rather than brand equity. Thus, while the weak pricing that was again evident in the second quarter is not surprising, we are reiterating our wide moat rating.

Second-quarter organic growth of 2.8% was in line with our forecast and the same as the first quarter, with volumes again driving the bulk of that growth rate and real internal growth up 2.5%. However, this remains well below the roughly 4% being achieved by many other large-cap consumer staples multinationals, primarily reflecting Nestle's soft price/mix, which improved sequentially in the quarter, but only to 0.2%. It is somewhat encouraging, however, that all regions except Europe, the Middle East, and North Africa, or Zone EMENA, posted flat or positive price/mix. Anemic global inflationary pressures are weighing on price/mix across consumer staples, but we think Nestle is also feeling the pressure from price competition in its commoditized packaged food and water businesses.

Geographically, there were few surprises in Nestle's report. Investors will be relieved that the U.S. was flat year over year, but with core inflation running close to the Federal Reserve's 2% rate, the U.S. is an example of Nestle's recent inability to price in line with broader inflation. As inflation returns, however, we would expect the pendulum to swing a bit more to price/mix. In the meantime, Nestle's volume growth is a good indication that its ability to defend shelf space is intact.

The key question for investors, however, is how much investment will be required to defend that shelf space. Our valuation is dependent upon some margin improvement at a time when we believe the customer acquisition cost is increasing. In the second quarter, Nestle's profitability improvement was again limited, with 20 basis points being added to the underlying EBIT margin from the year-ago period. Operating leverage is not likely to contribute to margin expansion in a slow-growth environment, at least in the short term, and any margin gains are likely to come from cost savings and synergies from acquisitions. At its current pace, Nestle will struggle to meet our 18% medium-term EBIT margin assumption by 2021, but it was negatively affected in the second quarter by unfavourable cyclical factors, including higher commodity, packaging, and distribution costs.