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,

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

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?

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

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

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. ‐ Suresh Narayanan; CEO Nestlé India

The next question one should ask is what is the primary driver of Nestlé India’s sales growth? In order to answer that question we need to understand a concept called as real internal growth. This is beautifully explained by the company in its 2012 presentation. Take a look at the table containing the sales data for an imaginary company.

The current year sales grew by 11.8 percent [163, 859 / 146, 570] compared to the previous year sales. This growth is called as organic growth, which captures both volume and price increases. To calculate real internal growth rate, we need to find out how much did the sales grow by had the price remained constant. The real internal growth rate is 6.5 percent [156, 088 / 146, 570].

To find how much did sales grow due to price increases, we need to subtract real internal growth from the organic growth rate. So the pricing impact comes to 5.3 percent [11.8 − 6.5]. This concept is very important as 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.

Take a look at the table showing Nestlé India’s real internal growth rate. From the table, we can clearly see that its volume driven growth has been decelerating from 2012. And most of its sales growth in the recent years came from price increases.

In the table given below, I have broken down the real internal growth (RIG) rates for each of its segments. Of the four segments the only segment which grow its volumes at a decent rate is Maggi. All the increase in value for its milk products segment came from price increases and volume remained flat. We already know that chocolate segment is losing market share to Mondelez and Ferrero. Finally, in the beverage segment the volume growth is moderate due to low acceptance of coffee as Indian consumers mostly prefer tea.

Moat and Management

If you are a value investor then most likely you would have come across the four filters of Buffett and Munger. All you need to do is follow it and compound your wealth at above average rates. I completely agree with their view. But I seriously doubt if an average investor, who can’t even identify their own moat, can identify if the business will be able to maintain its moat for over a decade. It is not the existence of a moat that is hard to identify but the longevity of it is damn hard to identify as a priori. This is beautifully explained by Fernando del Pino in one interview he gave to Manual Of Ideas. Read, reread, and reflect on what he wrote.

My investment style is disappointingly simple: I only buy cheap assets when I find them on a global basis, that’s all. I understand this is too short a statement to impress clients and increase AUM – but that’s not my case. If I had clients, perhaps I would feel impelled to add some bells and whistles to this description, such as saying that I only buy great businesses with durable competitive advantage, high ROIC, recurrent cash streams and management teams resembling Mother Theresa of Calcutta. But being as skeptical as I am about the ability of the average investor – even the average good pro – to spot this kind of businesses a priori, and skeptical as well of the usefulness of doing so, I am glad to stick to the shorter version. You know, outstanding companies do not always make outstanding investments – more often than not, they don’t, because of one single irritating factor: expensive prices. Very few investors can follow this path consistently and successfully – in a more Phil Fisher way, so to speak, but Buffett has, wrongly in my view, made this approach appear easier than it is and independent from his individual circumstances as an investor (the Berkshire business model). Now the wide‐moat idea has become a fad. ‐ Fernando del Pino

Having warned you enough about moats, I am going to identify the moats of Nestlé India and see if they are durable. Let us start with local economies of scale, one of the three sources of moats. This becomes a moat only when the scale is big enough relative to your competitors and absolute scale doesn’t matter much. The food and beverages market with 800 million customers is too big for other players to produce enough and achieve economies of scale. Clearly this is not a moat for the company.

Let us move on to the supply side advantages, the next source of a moat. Does access to 34 R&D centers give Nestlé India any advantage? I am not an expert in food science. But after talking to a few people in this industry I came to know that getting the nutrition and flavoring right is not an easy task and it gives Nestlé India some supply side advantages. Does having a panIndia distribution network give it an advantage? No, it doesn’t as anybody can distribute whatever he wants to. This concept is beautifully explained by the current CEO of Nestlé India.

My underlying principle of managing renovation, innovation is sell what differentiates, if there is no differentiation I think as an organization I do not have sustainable competitive advantage. In the old days when I started my life in the commercial areas or even later, access and distribution models were considered to be big barriers of entry, today that is gone, anybody can distribute whatever he wants to, wherever he wants to, however he wants to. So those kind of artificial barriers now which were real barriers then no longer exist. ‐ Suresh Narayanan; CEO Nestlé India

Let us move on to the demand side advantages, the last source of a moat. These advantages arise because of customer captivity that is based on habit, on the costs of switching, or on the difficulties and expenses of searching for a substitute provider. Products of Nestlé India are bought on a weeklytomonthly basis and are consumed daily. Who makes these purchase decisions? It is mostly done by the queen (wife & mother) of the house. And these decisions are made subconsciously without thinking too much thereby reducing the search costs.

By consuming these products on a daily basis people develop deep habit patterns and this results in structural changes in their brain. For items that you put inside your mouth the habit patterns are difficult to break (high switching costs). If you don’t believe me talk to someone who is a regular customer of Starbucks. An FMCG company operating in food and beverage industry has huge demand side advantages if it creates a brand and make customers addicted to that brand. This is the reason why a brand like Maggi or Cerelac can remain as a leader for well over 30 years. And you can see this pattern across FMCG companies throughout the globe.

The restriction placed by the government to not advertise baby food products turned out to be blessing in disguise for Nestlé India. Danone is among the world’s biggest food and beverage makers is facing a lot of challenges with its baby food, Farex brand, as it can’t promote the brand due to advertising restrictions. You can read more about it here. From all this we can conclude that the moat for the company comes from the demand side and a little bit comes from the supply side. Before analyzing the longevity of the moat let’s look at the Maggi fiasco.

I am sure that all of you would have read bits and pieces about the Maggi fiasco that unfolded on June 2015. If you want to get a comprehensive update on what happened right from the beginning, then I would encourage you to read this recent update given by the company. I won’t be repeating it here. Instead, I annotated the stock price chart with how the events unfolded.

The company started selling Maggi from November 9th. Even though the ban on manufacturing and sale of Maggi is lifted the case is not yet over. The company is defending a litigation filed against it by the Ministry of Consumer Affairs, which is asking for a compensation of around $100 million. Also Food Safety and Standards Authority of India (FSSAI) is appealing against a Bombay High Court order that allowed the relaunch of Maggi last November.

Only time will tell how this movie will unfold. You can read more about the latest developments here. This fiasco made Etienne Benet to step down and he was replaced by Suresh Narayanan as the managing director of Nestlé India. A lot of investors complained that the management of Nestlé India was inept handling this issue. These investors claim that the issue surfaced more than a year back in March 2014. Had the management acted on time, then the fiasco could have been avoided. Is their claim right? Those who claim that the fiasco can be avoided are talking with the benefit of hindsight bias. At that time the management couldn’t have known the severity of this issue. What is very clear in hindsight is not at all clear in foresight.

This fiasco resulted in sales declining by 16 percent in the first nine months of 2015. And the real internal growth rate declined by 19.6 percent. On top of this the company took a one time exceptional cost of Rs 476 crores. I am not worried about these temporary declines and losses. But what we need to see is that if Nestlé India can get its Maggi market share to 70+ percent once the dust settles down. This is a real test for the brand and it is not going to be easy as competitors [Yippee and Patanjali] are giving a tough fight.

Let’s spend some time to think about the longevity of Nestlé India moats. The world we live in today is very different today compared to the ones we saw until 2007. What do I mean by that? I was lucky to attend Charlie Munger’s DJCO meeting last year. In that he told about a woman in China by spending just $150,000 was able to change the policy in China.

One woman in China took $150,000 of her own money and a year of her life and created a documentary film. She ran the thing over the Internet. It was a film. She got 200 million views. What she did was a long thing about smog, how the people were dying in China, and how Los Angeles fixed its smog problem by taking sulfur out of the air when people burn coal and oil and so on. Terribly well done. This one woman is changing the policy of China. She isn’t on the newspapers. She isn’t on the television stations. Nobody had ever heard of her. One damn documentary. That is a new world. That’s a new source of power. I don’t know where a world like that is going to end up. I just know it’s different. It’s important. ‐ Charlie Munger

Ten years ago we interacted with brands like Nestlé through radio, television, newspapers, and daily consumption. Emergence of new products were low and shelf life for the existing brands were much higher. This resulted in customers sticking to their brands for lifetime. But the situation today is very different today.

With the emergence of the internet, mobile, and social networks customers are getting a lot of opportunity to interact with other brands. And there is a greater social acceptance for switching brands. Like the Chinese documentary film, this could result in black swan events and new brands getting viral acceptance in the marketplace is much higher. So there is no guarantee that customers will stick to Nestlé products for lifetime. And one need to access the moat of Nestlé on a periodic basis.

One recent example of a black swan event is the sudden emergence of Patanjali branded FMCG products. Last month IIFL Institutional Equities released a report on Patanjali and the first page of the report contained — Injurious to listed FMCG health. The report claims that Patanjali products has a potential to do sales worth of Rs 20,000 by 2020. The reason for Patanjali’s success is its unique business model of a single brand, a wide spread of categories, exclusive store network and close association of Baba Ramdev with the brand. These kinds of things were unimaginable a decade ago. But in today’s interconnected world these kinds of black swans are going to emerge from nowhere. You can read more about it here.

Last month, Baba Ramdev claimed that Patanjali brand of noodles would soon oust Maggi as the top brand in India. To which the new CEO Suresh Narayanan gave a fitting reply. You can read about it here. The key is to see if Maggi can regain the lost market share over time. Only time will answer that question for sure.

There are lots of noise around Nestlé in the last one year. But let us not miss the forest, longterm oriented management with world class brands, for trees, recent Maggi fiasco. The company thinks very long term to develop world class products by suffering a lot in the short term. One such example is Nespresso in which the company lost money for 25 years to develop this world class product. The chart shown above clearly tells this fact.

Valuation

How does an investor make money in a stock? Money is made through two sources — price appreciation and dividends. Stock price appreciates through growth in earnings, multiple expansion, and share buybacks. Let’s take a look at the experience of an investor who purchased the stock of Nestlé India in 2005 and held on to it until the end of 2014. The table given below shows that experience. Spend some time to deeply understand what’s inside the table.

During this period the investor made 23.77 percent from price appreciation. On top of that dividends generated an average return of 4.61 percent. At the end of 2014 he received a dividend yield of 6.73 percent, which is tax free and it is growing. The price appreciation of 23.77 percent resulted from earnings growth of 16.06 percent and the remaining 7.7 percent came from multiple expansion.

For the next ten years I am assuming that sales and earnings of Nestlé India are going to grow at 15 percent. Is my assumption too high? In 2014 the parent company generated revenues of 91.6 billion in Swiss Franc. The Indian subsidiary generated a revenue of 1.4 billion in Swiss Franc. Sales from India is 1.53 percent of its parent. This is miniscule as India represents 18 percent of the world’s population. The parent has a lot of products which are yet to be launched in India. And the new CEO hinted at introducing newer products in other categories like dairy, coffee and chocolates.

At the current stock price of Rs 5,200 and normalized earnings per share of Rs 140 an investor would be paying 37 times earnings. During his holding period the chances of earnings multiple contraction is very high. Let’s assume it to be 26 times earnings, which the stock experienced in 200809 financial crisis. This will result in price appreciation of around 11 percent and an average dividend yield of 2.75 percent, giving a total return between 13 to 14 percent. At the end of 2025 the dividend yield should come to 4.78 percent, which is tax free and it is growing. Here are few things to consider before you think about buying the stock.

1. If the company loses market share in Maggi and other segments, then it could result in permanent loss of capital. 2. New product launches need not be successful. Remember in FMCG business the first mover has a big advantage. And Nestlé India might not be able to take away the market share from the incumbents. 3. Paying up for quality comes with a lot of risk as the future is unknown. In today’s interconnected world a new Patanjali can come from anywhere and take away Nestlé’s market share. A better strategy would be to buy the parent’s stock NSRGY which is selling at a reasonable multiple. By doing this we can reduce the chances of multiple contraction and increase our margin of safety.

References

1. Nestlé India’s annual reports from 2010 to 2014. 2. Nestlé India’s analyst meeting presentations and transcripts https://goo.gl/jTbYh7 3. Parent company Nestlé’s annual reports. 4. Rajeev Thakkar’s thoughts on Indian consumer market https://goo.gl/f2AEyO 5. Read the book We Are Like That Only to understand the logic of consumer India. 6. Thomas Russo’s thought process on Nestlé https://goo.gl/4uxPwB 7. Bruce Greenwald’s thought process on Nestlé https://goo.gl/vCsBjs

Disclaimer: As of this writing, I own shares of Nestlé India. This is not a recommendation to buy, sell, or hold. I am not a SEBI registered analyst. I wrote this document to organize my thoughts and deepen my understanding about the company and industry. I am sharing it so that you can learn something from this.

Author : Jana Vembunarayanan Website : https://janav.wordpress.com Twitter : @jvembuna