We left Nestle’s analyst briefing yesterday feeling neutral about FY17 prospects on the back of i) selective price increase ii) concern for sugar price impact iii) increasing selling and distribution expenses. We increase our earnings forecast slightly by 2.1% - 3.2% for FY17 – FY19 with a revised target price to RM88.66/share based on DDM valuation. We downgrade our call from Buy to HOLD.

Selective Price Increase

Despite weakening consumer sentiment, Nestle’s 1QFY17 revenue increased to RM1.3bn (+9.8% QoQ, +4.4% YoY) due to stronger domestic and export sales. The positive momentum continued due to i) new domestic customer base generated from introduction of new products, ii) strong marketing support and iii) continuation of export sales growth which benefited from the weakening of Ringgit. Note that 10% of the 1QFY17 turnover comes from the launch of new products. This has resulted in improvement in net margin by 1.6%-pts YoY for the current quarter.

To sustain this momentum, management has guided that Nestle will protect its margin by selective price increase by single digit level of less than 5% for some of Maggi products, which are non-noodle range. For the beverage segment, however, management has guided that no price increase domestically for its flagship products like Milo. Management believed that the consumer sentiment is expected to recover by 3Q17.

However, we are cautious of the weakening consumer sentiment on the back of rising inflation and ringgit weakness. As such, we reduce our revenue estimates slightly by 2.6% and 1.1% for FY17 and FY18 respectively.

Mitigating Rise in Costs of Sales

Nestle’s 1QFY17 costs of sales increased by 4.1% QoQ and YoY to RM824mn. We attribute the rise to increase in sugar price. Sugar is sourced locally for manufacturers in Malaysian and the price was raised to RM2,780/tonne as compared to RM2,500/tonne last Nov-2016.

Management guided that one of the ways that Nestle could achieve cost efficiency is through the support of a global procurement team whereby raw materials are sourced at economies of scale either globally (e.g. milk based products), regionally (e.g. plastic packaging) or locally (e.g. sugar). Other than that, Nestle also looks at the efficiency of operations on a day-to-day basis.

Pressure on Selling and Distribution Expenses

YoY, Nestle’s operating expenses increased by 5.1% to RM248.7mn which includes structural costs and marketing spend. Management guided that Nestle plans to build a distribution centre that would also support its eCommerce businesses, which it has recently ventured into. Other than that, management shared that Nestle is continuously introducing new variants of products within its existing brands e.g. Kit Kat Bars and Kit Kat Minis.

We are concerned about the increase in cost over the short term as this affect the group’s margin. However, we are positive over the long term as the gestation period of new product launches and new distribution centre would start contributing to the bottom line. Currently, we are projecting that Nestle’s selling and distribution expenses to increase by 8.7% for FY17.

Outlook

We are neutral at this juncture as we believe that Nestle will be able to continue operating efficiently to be in line with the group’s FIT strategy. The globalised procurement support should allow Nestle to mitigate any rise in raw materials costs. Moreover, given that Nestle’s products are mainly low-ticket items, we view that the sales will continue to grow sustainably at the expense of introduction of new products and high marketing costs.

Valuation

All in, we increase Nestle’s earnings estimates marginally by 2.1% - 3.2% for FY17 – FY19. We also increase our forecasted GDPS to be in line with increase in earnings. Hence, our target price for Nestle has been adjusted to RM88.66/share (previously RM83.60/share). We downgrade our call from Buy to HOLD. Note that Nestle’s share price has increased by 5.5% YTD.

Source: TA Research - 27 Apr 2017