We came away from NESTLE’s FY18 results briefing feeling cautious of its near-term prospect. Domestic and export sales should see favourable traction from ongoing product innovations. However, we tone down our margins expectations in anticipation of limited expansion in lieu of commodity trends while raising tax rates. This translated to lower FY19E/FY20E earnings by 7.8%/6.5%. Maintain MP with a lower TP of RM138.50 (from RM146.50).

Healthy market demand. FY18 sales registered a 5% growth, attributed to better performance in both domestic and export markets. Management attributed new product innovations to be a key driver in stimulating demand, which we believe plays a role in keeping market interest fresh; most of which are extensions of flagship brands product portfolio.

Production costs at its most optimal? In terms of input costs, we gathered that FY18 gross profit margin was at 38.7% (+1.6ppt) with 39.1% in 4Q18 being the highest reported since 1Q17 when it hit 39.9%. Based on recent readings of key commodities (i.e. coffee, dairy, wheat) which indicate a stable market but with slight increments, we reckon that there may be limited room for improvement arising from cheaper raw material costs. In lieu of the group’s practice of hedging commodities, any potential upside from an increase in global prices may only kick in at the medium term, which is to its benefit.

Operationally speaking, FY18 could have seen higher expenses owing to: (i) moving costs and downtime during the transition/migration to the group’s new national distribution centre, and ii) skewed marketing spend on earlier CNY celebrations ahead of 2019. Management expects the former to translate positively in terms of supply-chain management. Further, the ongoing disposal of the group’s Chilled Dairy business should lead the way for a consolidated and expanded Milo production capability in Chembong. However, this may only materialise in the long term, with the disposal being earmarked for completion by 1H19. Further on the Chembong plant, management hopes that investments into the project could see the added benefit of further tax incentives. However, at this juncture, we believe that there are no ongoing incentives given that the group attributes its high effective tax rate of 31.2% to this reason. This brought FY18 effective tax rate to c.25%, whereas the average rate from FY13-FY17 stood at c.20% from consistent capex on plants.

Post-briefing, we cut our FY19E/FY20E earnings by 7.8%/6.5% mainly as we narrow our gross margins assumptions while also incorporating a higher expected tax rate in FY19/FY20, given the limited visibility of future tax incentive.

Maintain MARKET PERFORM but with a lower TP of RM138.50 (from RM146.50, previously). Our call is based on a rolled over valuation base year to FY20E while ascribing the same 42.0x PER, closely in line with the stock’s +1.5SD over its 3-year mean. The persistently steep valuation is largely attributed to the defensiveness of its business model and positioning as one of the very few large cap F&B stock, as well as being a FBMKLCI index member, warranting abovemean valuations for now. However, the low dividend yields of 2.2%/2.3% may appear unappealing to certain investors. Additionally, lower margin outlook and tepid growth expectations may caution growth-seeking investors to look elsewhere.

Risks to our call include: (i) stronger-than-expected sales, (ii) more favourable commodity prices, and (iii) lower-than-expected operating costs.

Source: Kenanga Research - 28 Feb 2019