We came away from NESTLE’s 3Q17 results’ briefing feeling NEUTRAL on its short-term outlook. Sales growth is sustained by strong product development, but earnings may still be clouded by a slower-than-expected recovery of input costs. We believe this is due to untimely hedging positions. Maintain MARKET PERFORM but we raise our TP to RM86.90 (from RM81.10) on a higher valuation following the stock’s inclusion into the MSCI Malaysia Index.

Stubbornly high production costs. In the recent 9M17 results, group revenue grew by 4% to RM4.0b backed by growth in both domestic and export demand. However, gross profits dipped by 5% from a lower gross margin of 36.9% (-3.5ppt). We believe this is due to the continuing impact of the group being locked in unfavourable hedging positions on key commodities, being sugar, cocoa, coffee and milk powders. This could also been further aggravated by high forex positions as c.50% of the group’s raw materials is imported. Management believes a lagging easing of production costs may be realised within 1H18, as our local currency is recovering.

A review at supply chain initiatives. Management presented various initiatives tasked to improve the efficiency of its logistics systems. This includes revamping the palleting system, streamlining warehouse storage, refurbishing older facilities and relocation to a new distribution centre (to be operational by 2Q18). Collectively, the above rationalisations are expected to improve the fluidity of its supply chain, provide more efficient storage use and introduce better economies of scale with regards to logistics costs. While we are upbeat on any efforts for continuous improvement, we are neutral on the overall financial impact of these exercises as they have been implemented progressively since 2015 and do not present a complete overhaul in the group’s operating structure. However, the resulting increase in storage capacity should resolve any present issues to ramp up production in anticipation for higher near-term demand.

Minimal increases in selling prices. In supporting its profit margins, management indicated that price increases in selected products have been in effect. However, the rate of the increase is minimal and is directed towards products, which are stickier in demand. We agree with this strategy as substantial price increases would be detrimental to overall sales, given the sensitive spending habits of consumers.

Still a heavyweight to be reckoned with. The relevancy of NESTLE brands to customers is still intact with consumers. Even so, the group has been consistent with further developing its brand equity through the introduction of new products and revamping existing brands to continually expand its market share. While near-term prospects could still be clouded by ongoing cost concerns, the group is weathering these challenges well.

Reiterate MARKET PERFORM with a higher TP of RM86.90 (from RM81.10, previously). Post briefing, we made no changes to our FY17E/FY18E net earnings estimates. However, we raise our ascribed valuation of NESTLE to 30.0x (from 28.0x) FY18E PER, as we apply a +1.0 SD over its 5-year mean PER (from no SD, previously). We believe its recent inclusion into the MSCI Malaysia Index has generated higher interest on the stock.

Source: Kenanga Research - 24 Nov 2017