CMP: INR6,183 TP: INR5,750 (-7%) Neutral Will a new Nestle emerge from the Maggi crisis?

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1 23 November 2015 Update Sector: Consumer Nestle India BSE SENSEX S&P CNX 25,868 7,857 Stock Info Bloomberg NEST IN Equity Shares (m) Week Range (INR) 7,500/5,499 1, 6, 12 Rel. Per (%) 0/-4/8 M.Cap. (INR b) M.Cap. (USD b) 9.1 Avg Val ( INRm) 70.9 Free float (%) 37.2 Financials Snapshot (INR b) Y/E Dec E 2016E Net Sales EBITDA PAT EPS (INR) Gr. (%) BV/Sh (INR) RoE (%) RoCE (%) P/E (x) P/BV (x) Shareholding pattern (%) As On Sep-15 Jun-15 Sep-14 Promoter DII FII Others FII Includes depository receipts Stock Performance (1-year) CMP: INR6,183 TP: INR5,750 (-7%) Neutral Will a new Nestle emerge from the Maggi crisis? Volume and innovation focus back; Challenging journey ahead We attended Nestle s analyst meet. Our key takeaways: The shift in focus to volume growth and bringing back double-digit revenue growth is refreshing. Innovation will be prioritized. Ten must win battles highlighted to revamp Nestle to make it fast, focused and flexible. Portfolio rationalization is over no subtraction without addition. Under the new MD, Nestle is finally pressing the right buttons, but results will be gradual, in our view. Retain Neutral on expensive valuations. Volume growth focus makes a comeback, finally: Nestle s new MD, Mr Suresh Narayanan outlined the shift in strategy, with unequivocal emphasis on volume growth. This will not be a short-term priority, led by rise in tactical promotions, but a long-term strategy in line with his mandate of delivering sustainable profitable growth. His enunciation of the belief in volume growth/market share gains ( what we sell are packets/cases, not rupees ) is a departure from earlier such meetings, where the articulation of volume growth focus was not as prominent, in our view. We like this change in strategy, as we believe disproportionate focus on margins/profitability (% margins even for recruiter SKUs) had impacted Nestle s topline performance over CY Portfolio rationalization behind: Nestle pursued a strategy of portfolio rationalization, wherein it exit certain products/channels earning less than threshold margins. This not only impacted volume growth but also put a question mark on its long-term market development efforts (Nestle is a leader in most of the categories it is present in). Mr Narayanan emphasized that he would not be continuing with this strategy and any portfolio exits will happen (if at all) only if accompanied with additions. He spearheaded the India Sales function a decade ago [during the heydays of 20% revenue growth Head of Sales ( )] and we believe his experience will help take Nestle out of the current crisis. The management also outlined Innovation as a key growth driver in the medium term. Investments for innovation and driving growth will depend on two factors (a) Nestle s right to win, and (b) size of the prize. Ten must win battles: Mr Narayanan highlighted 10 must win battles for Nestle, as it emerges from the current crisis. These essentially border around people aspects, as Nestle is nurtured back to its pre-crisis state. They are: (1) bringing back double-digit growth, (2) bringing Nestle India back to stability, (3) learning to manage volatility and adversity, (4) revamping Nestle to become fast, focused and flexible, (5) making people fit for battle by enabling, empowering, engaging and energizing, (6) zero tolerance for non-compliance, (7) nurturing key partners back to health, (8) priorities consumer service engagement, digital media engagement, media responsiveness, friendly face of Nestle, (9) teamwork for speedier responses, and (10) proud to be Nestle. Gautam Duggad (Gautam.Duggad@MotilalOswal.com); Manish Poddar (Manish.Poddar@MotilalOswal.com); ; Vishal Punmiya (Vishal.Punmiya@MotilalOswal.com) Investors are advised to refer through important disclosures made at the last page of the Research Report. Motilal Oswal research is available on Bloomberg, Thomson Reuters, Factset and S&P Capital.

2 Update on Maggi: After following the required regulatory norms and processes, and clearing all court mandated tests, Maggi sales have restarted from 9 th November It is presently manufacturing Maggi noodles at three locations Nanjangud (Karnataka), Moga (Punjab) and Bicholim (Goa). Two more plants in Himachal Pradesh and Uttarakhand, (where Maggi is still banned) are yet to start. The company is engaging with authorities there to start production at those two units. Relaunch has seen overwhelming response, according to the management. After the relaunch, Maggi has reached 350 towns and covered 120k outlets through 724 distributors. It has sold 33m packs. Nestle will be launching the new commercial emphasizing the trust and quality attributes it has opted for non-celebrity endorser. We note that competitors have used the past six months to ramp up presence in the Instant Noodles segment. It will not be easy for Nestle to regain its lost share even as its recall and equity remains unchallenged. We expect Nestle to disproportionately invest behind Maggi relaunch in CY16. Financials bore the brunt of Maggi crisis: The Maggi crisis had a deleterious impact on Nestle s financials. Exception cost attributed to Maggi withdrawal was INR4.8b (23,649 tons of sales reversal and 34,663 tons destroyed). Nestle s domestic volumes declined 36.7% in 9MCY15 while revenue declined 16.3%. Ex-Maggi and portfolio optimization initiatives, volumes declined 6.8% while revenue grew 1.7%. Comparable revenue growth for 2Q and 3Q was 1.6% and -4.5%, respectively. Fixed costs were up 665bp to 24.2% in 2Q and up 980bp to 27.1% in 3Q. Consequently, rest of the metrics operating profit margin, net profit margin, cash generation, RoE, payout, etc also deteriorated. The silver lining for Nestle was the decline in commodity cost index after six years it went down from 137 in CY14 to 129 in YTDCY15 (CY10 as base = 100). Most of the commodity costs declined milk, MSK, wheat flour, sugar, palm oil. In our view, issues pertaining to Maggi spilled over to other segments (management bandwidth, fixed cost absorption, etc), with the impact not being restricted to just financials but pervading the ecosystem (suppliers, vendors, distributors, employees, factory workers). Maintain Neutral: The Maggi crisis can eventually prove to be a blessing in disguise for Nestle and help shake things up under the new MD, who we believe is pressing the right buttons. Though we like his focus areas, we believe the task ahead for the new MD is herculean reviving the portfolio in a challenged consumption environment after coming out of a serious crisis. Focus on volume growth, innovation and newfound vigor in the management are key positives. Nonetheless, it will be a while before the fruits of new strategy are realized. Valuations remain rich and prevent us from getting more constructive at this stage (51x CY16E EPS). Maintain Neutral. 23 November

3 Key analyst meet charts Exhibit 1: Market value growth (%) in recent period Jan-Sept 2014 Jan-Sept FMCG F&B F&B (Nestle Categories) Exhibit 2: Domestic Sales and volumes down 16% and 37% resp. in Jan-Sep 2015 Exhibit 3: While Exports sales and volumes down 1.1% and 10.6% resp Jan-Sept 2014 Jan-Sept 2015 Jan-Sept 2014 Jan-Sept Volume ('000s tons) Value (INR b) Volume ('000s tons) Value (INR b) Exhibit 4: Ex-Maggi and portfolio optimization initiatives, volumes declined 6.8% while revenue grew 1.7%. Volume ('000s) (%) Effective (%) Reported in Tons (36.7) Noodles (29.0) (-) PPO (-) Ghee (1.0) Value (INR b) Reported in Tons (16.3) Noodles (16.9) (-) PPO (-) Ghee (1.0) (6.8) 1.7 Exhibit 5: Comparable revenue growth for 2Q and 3Q was 1.6% and -4.5%, respectively Q1CY14 Q2CY14 Q3CY14 Q4CY14 Q1CY15 Q2CY15 Q3CY15 Reported Sales (in INR b) Reported YoY growth (%) (20.6) (33.8) Comparable Growth (%) (4.5) Comparable RIG (%) 0.7 (3.0) (5.5) 23 November

4 Exhibit 6: Maggi - Results from 3,566 tests, only two samples with Lead content>0.5ppm vs. permissible limit of 2.5ppm Exhibit 7: Maggi withdrawal - Reverse logistics involved in the product recall Exhibit 8: Exceptional Cost (INR m) incurred due to Maggi Noodles withdrawal Exhibit 9: Stepped up Ad Spends to combat the issue Incremental Cost due to Maggi Noodles withdrawal, 1,614 Cost of FG, Obsolescen ce of RM, Duties and Taxes, 3,148 % of Domestic Sales YoY Movement (in bps) +320bps +210bps +140bps Q1CY15 Q2CY15 Q3CY15 Exhibit 10: Current footprint of Manufacturing and Sales of Maggi Noodles 23 November

5 Exhibit 11: Nestle India commodity index falls after many years Nestle India's Commodity Basket CY10 CY11 CY12 CY13 CY14 9MCY15 Exhibit 12: Sugar prices deflationary Exhibit 13: Milk prices down in high single digits YoY Exhibit 14: MSK prices continue to be soft Exhibit 15: Green Coffee prices up high single digits YoY Exhibit 16: Wheat Flour flattish YoY Exhibit 17:...as is Palm Oil prices Source: MOSL, Company Source: MOSL, Company 23 November

6 Financials and valuations Income Statement 20.9% (INR Million) Y/E December E 2016E Net Sales 51,294 62,547 74,908 83,023 90,619 98,063 81,902 96,896 Change (%) Total Expenditure 40,949 50,051 59,381 64,766 70,815 77,450 65,713 78,104 EBITDA 10,345 12,497 15,528 18,257 19,804 20,612 16,190 18,792 Change (%) Margin (%) Depreciation 1,113 1,278 1,533 2,772 3,300 3, ,496 Int. and Fin. Ch Other Inc.- Rec ,222 1,359 1,590 1,861 PBT 9,596 11,635 14,452 15,852 17,362 18,454 14,324 17,096 Change (%) Margin (%) Tax 2,620 3,264 4,264 4,847 5,609 5,897 4,655 5,556 Tax 2,669 3,252 4,161 3,728 5,075 5,824 4,516 5,390 Deferred Tax , Tax Rate (%) Adjusted PAT 6,976 8,370 10,189 11,006 11,753 12,557 9,669 11,540 Change (%) Margin (%) Non-rec. (Exp)/Inc Reported PAT 6,550 8,187 9,616 10,679 11,171 11,847 8,905 10,699 Balance Sheet (INR Million) Y/E December E 2016E Share Capital Reserves 4,848 7,590 11,775 17,020 22,723 27,408 24,855 21,851 Net Worth 5,813 8,554 12,740 17,984 23,687 28,372 25,820 22,815 Loans 6 0 9,709 10,502 11, Capital Employed 5,819 8,554 22,448 28,486 35,559 28,413 26,420 23,315 Gross Block 16,408 18,547 25,522 44,276 49,032 50,090 47,630 49,484 Less: Accum. Depn. 7,446 8,420 9,765 12,233 15,339 18,323 21,744 25,240 Net Fixed Assets 8,962 10,127 15,758 32,043 33,693 31,766 25,886 24,244 Capital WIP 796 3,489 13,718 3,441 2,947 2,448 2,448 2,448 Investments 2,033 1,507 1,344 3,649 8,511 8,118 10,056 12,459 Current 2,033 1,507 1,344 3,649 6,270 5,074 6,342 7,928 Non-current ,241 3,045 3,714 4,532 Curr. Assets, L&A 8,566 10,460 13,199 12,507 17,992 15,863 21,326 22,953 Inventory 4,987 5,760 7,340 7,456 7,359 8,441 7,129 8,578 Account Receivables , ,047 1,375 Cash and Bank Balance 1,556 2,553 2,272 2,370 7,494 4,458 11,198 10,392 Others 1,380 1,514 2,432 1,806 2,296 1,972 1,953 2,609 Curr. Liab. and Prov. 14,218 16,696 21,067 21,532 25,429 27,555 30,930 36,256 Account Payables 5,817 7,454 4,808 5,394 6,330 7,287 5,748 6,994 Other Liabilities ,287 5,580 5,026 4,250 3,396 4,014 Provisions 8,348 9,075 10,972 10,558 14,073 16,017 21,786 25,248 Net Curr. Assets -5,652-6,236-7,869-9,025-7,437-11,692-9,604-13,303 Def. Tax Liability ,621-2,155-2,227-2,367-2,534 Appl. of Funds 5,819 8,554 22,448 28,486 35,559 28,413 26,420 23,315 E: MOSL Estimates 23 November

7 Financials and valuations Ratios Y/E December E 2016E Basic (INR) EPS Cash EPS BV/Share DPS Payout (%) Valuation (x) P/E Cash P/E EV/Sales EV/EBITDA P/BV Dividend Yield (%) Return Ratios (%) RoE RoCE Working Capital Ratios Debtor (Days) Asset Turnover (x) Leverage Ratio Debt/Equity (x) Cash Flow Statement (INR Million) Y/E December E 2016E OP/(loss) before Tax 9,232 11,219 13,994 15,485 16,505 17,237 12,770 15,296 Int./Div. Received ,222 1,359 1,590 1,861 Depn. and Amort ,345 2,468 3,106 2,985 3,420 3,496 Interest Paid Direct Taxes Paid 2,669 3,252 4,161 3,728 5,075 5,824 4,516 5,390 Incr in WC -1,088-1, , ,887-2,052 CF from Operations 8,943 10,754 12,518 15,588 18,308 16,220 17,116 17,255 Extraordinary Items Incr in FA 2,064 4,832 17,204 8,476 4, ,460 1,854 Free Cash Flow 6,879 5,922-4,686 7,112 14,046 15,661 19,576 15,401 Pur of Investments 1, ,305 4, ,938 2,403 CF from Invest. -3,748-4,306-17,041-10,781-9, ,257 Issue of Shares Incr in Debt , ,370-11, Dividend Paid 5,471 5,448 5,435 5,435 5,471 7,106 11,457 13,704 Others CF from Fin. Activity -5,576-5,451 4,242-4,710-4,059-19,089-10,898-13,804 Incr/Decr of Cash ,124-3,035 6, Add: Opening Balance 1,937 1,556 2,553 2,272 2,370 7,494 4,458 11,198 Closing Balance 1,556 2,553 2,272 2,369 7,494 4,458 11,198 10,392 E: MOSL Estimates 23 November

8 NEST NESTLE GALLERY COMPANIES SECTOR UPDATES

9 N O T E S 23 November

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