Nestle (M) Bhd
(Feb 2, RM76.04)
Maintain neutral call with a lower target price (TP) of RM82.68: Revenue growth for Nestle Malaysia Bhd has been quite stable with the first quarter ended March 31, 2016 (1QFY16) to 3QFY16 recorded a sequential growth of 2.8%, 8.2% and 3.7% respectively.

The significant increase of 8.2% in 2QFY16 was due to a lower base in 2QFY15 pursuant to the goods and services tax implementation.

The stable revenue growth was achieved on the back of product innovation, and strong growth from both domestic and export segments.

Product innovation is one of the key pillars to sustain revenue growth for Nestle Malaysia. In FY15, approximately RM400 million was generated from new product launches which account for roughly 10% of the group’s total revenue.

We expect that product innovation will continue to fuel revenue growth as management guided that more than 50% of the revenue growth of 9MFY16 was attributed to new product launches.

The domestic segment has delivered growth due to aggressive advertising and promotional along with new product innovation. As a result, Nestle Malaysia’s domestic market share rose from 14.5% (FY14) to 15.8% in FY15.

In the meantime, the export segment has continued to perform well since its turnaround in 3QFY15. Currently, exports make up 20% of the group’s total revenue.

The growth momentum is expected to continue as Malaysia is the halal hub for Nestle worldwide and it ships out high quality locally produced halal products to over 50 countries worldwide.

Agricultural commodities such as sugar, milk and coffee have reverted to pre-FY15 price levels. Along with the depreciating ringgit, we expect that the gross profit (GP) margin to come under pressure and hit FY17 earnings as the commodities are imported from overseas and priced in US dollar.

However, the shrinkage in GP margin might not be too significant as the management claimed that the group is hedged for most of FY17.

In 3QFY16, the group recorded a fall in GP margin of 3.7 percentage points (ppts) quarter-on-quarter to 38.9%.

Prior to the decline, quarterly GP margin for FY16 experienced year-on-year growth ranging between 0.9 ppts to 3.6 ppts. Due to this, we expect that the GP margin will maintain at around 38% to 39% levels.

As Nestle Malaysia remains committed not to increase product prices, it has introduced efficiency programmes along its supply chain to combat rising costs.

At least RM188 million additional income was generated in FY15 through this initiative. While operating profit margin recorded for 1QFY16 was 21.7%, it has been on a downward trend ever since, which might suggest its existing cost saving initiatives might have reached its limit.

Nevertheless, Nestle is in a continued effort to manage its expenditure with a global procurement hub expected to be launched in Malaysia in the first half of FY17 which is one of three global procurement hubs in the world along with Switzerland and Panama.

These hubs will provide a range of services, including the management of procurement for specific raw materials, packaging, indirect materials and other services.

We are revising our forecast FY16 (FY16F) and FY17F earnings by 5.42% and 13.34% lower respectively to be more in line with management guidance. The revision is due to the increase in commodity prices such as sugar, milk and coffee which will impact earnings in FY17.

However, in the long term, the increase in raw material prices would be mitigated by the efficiency and cost management programmes undertaken by the group.

Our TP is based on dividend discount model using the assumption that required return on equity of 5.70% and sustainable dividend growth rate of 2.11%. — MIDF Research, Feb 2