Nestlé India

1 Nestlé India Cerelac is a brand of instant cereal made by Nestlé. The cereal is promoted for infants 6 months and older as a supplement to breast milk when it is no longer the sole item in an infant's diet. I got introduced to the Cerelac brand in the early 80’s when my mother was feeding it to my younger brother. After 20+ years the same brand came into my life once again when my wife was feeding it our elder son. Had I been smart then I would have bought the stock of Nestlé, along with Cerelac. Along with our son, our wealth would have compounded at 19 percent. But I am not smart and I convince myself by telling that hindsight is always twentytwenty. Business Nestlé is the world's leading nutrition, health and wellness company. It was founded in 1866 by Henri Nestlé in Vevey, Switzerland, where it is headquartered even today. Its relationship with India dates back to 1912 when it started selling imported products in the Indian markets. Nestlé India set up its first manufacturing facility in 1961 at Moga, Punjab. After spending more than a century in the Indian soil, Nestlé India has presence across India with 8 manufacturing facilities. It generates sales from four different segments and their details are given below. Segment Description Brands Milk Products & Nutrition Around 47 percent of sales Lactogen, Cerelac, comes from this segment. It has EveryDay, Milkmaid, the highest market share by Nestum, and Slim Milk. value in Baby Foods, Dairy Whitener, and Sweetened Condensed Milk. In the Baby Foods segment it is a leader with 70 percent market share. Prepared Dishes & Cooking Aids Around 32 percent of sales Maggi with several comes from this segment. It has variants. the highest market share by value in Instant Noodles, 2 Sauces, and Pasta. At its peak Maggi controlled 80 percent market share. Chocolate & Confectionery Around 12 percent of sales KitKat, Munch, comes from this segment. It has Milkybar, and Polo. the highest market share by value in Wafers and Whites segment. Beverages Around 9 percent of sales Nescafe, Nestea, and comes from this segment. It has Sunrise. the highest market share by value in the Instant Coffee segment. Take a look at the table given below. What do you see? We can see that the Maggi brand has grown much faster than the other segments. Chocolate and Beverages segment total contribution to sales came down over the years. In the later section we will see that Chocolate segment is losing market share to other players. Also, we will learn more about the legal challenges faced by its flagship brand Maggi. The company sells its products to middle, uppermiddle, and high class customers. This is the reason why the company focuses mostly in urban India, and it doesn’t have a strong presence in rural India. From the table shown below, we can conclude that the company has a long runway left for growing its sales and profits. In order to manufacture the above mentioned products it needs a lot of raw materials, including milk, wheat, coffee beans, sugar, etc. The company works with 100,000 milk farmers and collects over 300 million kilograms of high quality milk every year. Also, it works with 397,000 3 wheat farmers and 15,000 spice farmers. It distributes its finished products through 1,357 distributors who in turn sends it to 3.9 million retailers. As the company deals with a lot of small vendors and distributors it has a lot of control over them. This enables it to operate on an average cash conversion cycle of negative four days. Take a look at the table given below. What do you see? A curious reader should ask why did the ROIC drop from 163 percent to 48 percent? In order to answer this question, let us focus on the components of ROIC — Profitability and Efficiency. From 2005 to 2014 its profitability has been super stable between 17 to 18 percent. But the asset turnover came down from 9 to 2.8 times. This is the reason why the ROIC came down. Should we worry about it? 4 From the above chart, we can conclude that low asset turnover is not a concern. And generating a ROIC of 48 percent is phenomenal. The next question one should ask is why did the sales growth slowdown? There is a strong correlation between India’s nominal GDP and Nestlé’s domestic sales growth. What is a nominal GDP? It is the economic output produced by a country without adjusting for inflation. As domestic sales of Nestlé India includes price increases we need to compare it with nominal instead of real GDP. From the chart given below, we can see that from 2011 India’s nominal GDP growth started going down. Along with that the sales growth of the company went down. Only in textbook sales and profits always go up year after year. But in real life, it ebbsandflows along with the economy it is operating in. Let’s look at the major expenses incurred by the company. In the last ten years the company on average made a gross profit of 46 percent. It didn’t get affected by high inflation as it passed on the increase in raw material prices to the consumers. Its gross margin is very consistent with a low standard deviation of 1.9 percent. The same trend can be seen in pretax operating margins with a ten year average of 17 percent with a low standard deviation of less than 1 percent. There are three kinds of asset classes that you can own. You have real assets, like natural resources, companies that are competitive, and real estate. These assets do really well in the inflationary environment and do poorly in the deflationary environment. The second category is fixed income. They do very well in the deflationary environment and do very badly in the inflationary environment. And then there are the Nestlé’s of the world, franchise businesses. And they do well in both inflationary and deflationary environment. ‐ Bruce Greenwald 5 One major expense item incurred by all the FMCG companies is advertising and promotions. FMCG companies buy commodities and sell brands. So they need to spend a lot on this item to convince consumers to buy their products. Take a look at the chart given below which compares Nestlé India’s A&P spending with other players in the FMCG industry. The company on average spends 4.8 percent, which is much lower than the other players in the industry. I wouldn’t worry much about it if Nestlé gained market share. But this is not the case with Nestlé India. In the Chocolates segment it used to have a market share of around 30 percent in 2007. But currently it only has a market share of around 16 percent. Mondelez with its Cadbury brand continues to dominate the market. And new players like Ferrero with its Kinder Joy brand has ramped up nicely to challenge Nestlé for the second position. One reason for Nestlé’s low A&P spending is because of the restriction placed by the government to not advertise baby food products. Excluding the baby food segment, Nestlé’s A&P spend comes to 7 percent, which is lower than Britannia’s 8 percent. Nestlé’s India has access to 34 R&D centers of its parent through general licensing agreement. By tapping into this expertise it can come up with innovative products that are tasty and healthy. There is no such thing as a free lunch. For providing this facility the parent charges Nestlé’s India with a fee which is called as royalty. You will find the royalty fee charged by a lot of MNCs to its foreign subsidiary. How much is the royalty charge? This is what I found in its 2014 annual report. The Company has reviewed the General License Agreement in 2013, the Board of Directors of the Company negotiated and Nestlé S.A. accepted an increase in royalty from 3.5% to 4.5% of domestic sales in a staggered manner by making an increase of 0.20% per annum over five 6 years effective January 1, 2014. The royalty rate on exports will now be aligned to 4.5% of sales. A company can grow its sales in three different ways (1) volume growth; selling more units at the same price (2) price growth; selling the same number of units at higher prices (3) volume and price growth; selling more units at higher prices. Which is better? All else being equal I would prefer both volume and price growth. If that doesn’t happen then I would prefer volume growth. As always there are some exceptions to my rule. Few companies that are selling cigarettes (Philip Morris) and candies (See’s) have managed to grow their sales by increasing prices even though the volumes didn’t grow by that much. Look, I am old school salesmen and the old school salesmen has always been taught that what you sell are cases and packets, you do not sell rupees. So my grounding has been on volume growth, I am a great believer in volume growth, obviously volume growth, means consumption growth means penetration growth, means distribution growth, means various growths that are linked directly to volume. I would be privileging volume growth, to me the game is that unless you get volume and market shares you do not get sustainable growth models, that is the way at least these markets work, you can skirt the advantage of value growth for a time but unless you start getting in volume growth you are not going to be able to sustain that over a longer period of time.

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