1H16 core earnings of RM409.5m (+31.3% YoY) was broadly within our expectation (59.6%) but beat market’s (64.0%). 1H16 DPS of 70.0 sen was within expectation. No changes to our earnings forecasts. We view the high margin to be unsustainable from a high base in view of the uptick in key commodities prices, which point to more modest earnings growth moving forward. We downgrade NESTLE to MARKET PERFORM with unchanged TP of RM82.10 as we believe the positives have been priced and the stock is fairly valued.

Broadly within our expectation. 1H16 net profit of RM409.5m (+31.3% YoY) matched 59.6% of our full-year forecast and 64.0% of the consensus’ estimate. We consider the result as broadly within our expectation but above the streets’ as historically 1H accounted for 55.6% of full-year earnings based on past 5 years’ average and we think that the strong margin may not be sustainable moving forward due to the recent uptick in commodities prices. 1st interim DPS of 70.0 sen was declared (vs. 1H15: 65sen) which is within expectations.

YoY, 1H16 revenue grew by 5.4% to RM2.6b thanks to healthy growth in both domestic and export markets. The domestic demand was supported by effective marketing campaigns and innovative new product launches. 1H16 gross profit jumped 11.1% to RM1.0b driven by favourable raw material prices and greater operating efficiency, which expanded gross margin by 2.1ppt to 41.1%. Moderate increase in operating expenses (+1.3%) and lower effective tax rates of 18.1% (vs. 1H15: 22.8%) catapulted net profit by 31.3% to RM409.5m.

QoQ, 2Q16 revenue declined by 5.8% to RM1.2b on seasonality, in line with the group’s planning and selling cycle. However, 2Q16 gross profit margin expanded by 2.9ppt to 42.6%, which mitigated the softer sales and pushed gross profit higher by 1.1% to RM527.1m. Meanwhile, swing in marketing expenses between the quarters inflated operating expenses by 25.3% and in turn dragged down operating profit by 19.0% to RM230.7m. The drop in 2Q16 net profit of 14.4% to RM188.8m was relatively milder thanks to lower effective tax rate of 15.7% as compared to 20.0% in 1Q16.

Production efficiency to mitigate higher costs. While we think that the margin expansion on both YoY and QoQ basis was impressive, the company may find difficulties in further improving the margins from the high base considering the price uptrend of key commodities, including milk powder, coffee, and sugar. Direct cost pass-through is less likely in view of the weak consumer sentiment, but improvement in production efficiency might be the more relevant option to mitigate the impact. Thus, we remained confident in the group’s ability to achieve our targeted earnings growth thanks to its strong brand names and effective cost management.

Earnings estimates kept unchanged. We made no changes to our earnings forecasts.

Downgrade to MARKET PERFORM from OUTPERFORM with unchanged Target Price of RM82.10. Our TP is based on unchanged 27.1x FY17E EPS, in line with +0.5 SD over 5-year mean. Its share price has reacted positively to the encouraging results with YTD gain of 7.6%, which narrowed the upside potential from our TP to a mere 4.2%. We do not foresee favourable raw material prices or other catalyst to improve earnings margin and absolute earnings from the high base to prompt an earnings upgrade. At this juncture, we believe the positives have been priced in and the stock is fairly valued. Risk to reward ratio is less appealing as the dividend yield is unattractive at <4%. As such we downgrade our rating to MARKET PERFORM.

Source: Kenanga Research - 23 Aug 2016