Confectionery under pressure for Nestle

Confectionery under pressure for Nestle

Delivering its first-half numbers yesterday (18 August), Nestle reported a stronger operating performance, with trading operating profit increasing by around 3% to CHF6.6bn (US$6.8bn). The growth – which beat analyst expectations by around ten basis points - was supported by "continuous cost discipline, active portfolio management, premiumisation and [an] input cost tailwind" the company noted. 

Organic sales growth of 3.1%, however, was below consensus expectations, with analysts looking for growth in the region of 3.5%. In particular, pricing – which contributed 0.7 points to growth – was particularly weak. Nestle said pricing had reached a "historically low level" due to "deflationary" environments in developed markets and low input costs. 

Nevertheless, Nestle reiterated its outlook for the full year, meaning that growth must accelerate in the second half. 

Here are the key points to take away from Nestle's first-half results. 

Pricing outlook brighter but remains a thorny issue

Nestle has felt negative pressure on pricing throughout the first six months of the year and the company has been constrained in its ability to increase prices in markets such as Brazil, where currency fluctuation has increased costs. However, CFO Francois-Xavier Roger revealed action has already been taken to address this issue in various markets. 

"As anticipated, the pricing environment remains challenging. We had deflation in developed markets and low commodity pricing overall," he noted in a conference call to discuss the group's performance. However, Roger continued: "We expect stronger pricing in H2 though. We started to take selective price increases in some categories and geographies."

Roger revealed prices were increased in Brazil late in the second quarter, with benefits expected moving into Q3. He also hinted at future hikes in Russia and the UK. The UK is a market that has seen the value of sterling fall in the wake of the country's decision to leave the EU.

"I am confident that we have hit the bottom [of low prices] in Q2 and that this is now going to increase. We have put some increases through [in select markets]," he elaborated. "There will be some pricing coming through in other markets... In the UK, with the 15% deflation of the currency... we import raw material in the UK we will have to pass through the cost of lower currency."

Roger did, however, seem to suggest increasing prices could dampen Nestle's real internal growth rate, an internal metric referring to organic growth stripping out the impact of pricing. "I am more concerned on the impact that pricing could have on RIG," he suggested. "When you increase prices consumers have a tendency to go down... consumers in the mainstream category could move to lower price [products]... there is always some elasticity."

If that were to happen, it could dampen the growth of Nestle's premium products. According to Euromonitor analyst Lianne van den Bos, growing sales of premium products is increasingly important in the low-  to no-growth packaged foods market. "With growth slowing, especially in developed markets, future profits will have to come from higher-margin foods, which is the intention behind the launches of Damak in the US and wider expansion of the Baci Perugina brand. Whilst Nestle's vision to become the world's leading health and nutrition company is one way of approaching growth through high margin (health) food, premiumisation is definitely another way. The trick is to be 'mass premium' so that Nestle can still use its scale and existing distribution network," van den Bos notes. 

Strengthening the product mix and selling higher value items has been a key strategy for Nestle and management will no doubt want to carefully balance the impact of pricing action on consumer purchasing patterns. 

Health science, nutrition growth slows

Nestle also believes developing its health science and nutritional food businesses will be an important lever for long-term growth. Indeed, the recent appointment of Ulf Mark Schneider, the CEO of healthcare company Fresenius, as Nestle's new chief executive has been taken by many as a sign of intent.

However, it emerged yesterday Nestle's health science and nutrition units have seen a significant reduction in growth rates. Nestle's nutrition arm generated CHF5.17bn in sales in the first half of 2016, an increase of 1.3%, while nutrition and health science revenues rose to CHF7.36bn, growth of 2.5%. This is a slowdown from the growth rates reported in the comparable period of last year when nutrition and health science grew by 4.3% and 7.7% respectively.

As Pablo Zuanic, an analyst at US investment and trading firm Susquehanna International Group, notes: "The company has a new CEO with a health science background, but in the meantime, our breakdown of the data shows that the much-vaunted health science [business] only grew 5% in 1H16 after mid/high-teens growth in 1H15." 

Roger attributed the slowdown at Nestle nutrition, the group's  nfant formula business, to issues in China and the US. "This is a softer level [of growth] than what we had in the past, which is largely the consequence of limited pricing. We see distinct dynamics between geographies with the US and China somewhat under pressure."

In China, Roger said demand is "clearly slowing" but added that growth in super-premium remains strong. "The market itself in China used to enjoy a double-digit growth and is now into low single digits. In our premium and mainstream ranges where we have NAN and S-26 Gold, we clearly see a softer demand with much more price competition, and the situation is certainly little bit more complicated there, while on the other hand in the super-premium segment where we are represented with ILLUMA, we are growing north of 30%. Overall in China for nutrition, we are slightly gaining market share."

In the US, Roger said nutrition sales were dented by the group's decision to exit low-profit regional contracts. He continued: "We had a little bit of difficulties in the transition to new packaging from glass to plastic, and we had some temporary supply constraints to produce pouches which are now being sorted out. So, we are more optimistic for the later part of the year."

Roger stressed Nestle continues to believe in the long-term potential of its health science businesses and the group is investing in further expansion.

"We are investing in R&D, we are investing in innovation, we are investing in terms of geographic expansion as well. I mentioned, for example, we entered [South] Korea with some products; we entered Europe as well. The success we have with products like Boost into the US - it's so successful, I mean, we grew by 15% in the first half of the year. So, why don't we do the same in Europe? Which is actually what we are doing here as well," he noted. 

Questions over China outlook 

Beyond infant nutrition, Nestle also found itself grappling with a broader slowdown in China's food and beverage market, which, Roger said, saw growth decelerating "to basically zero growth". 

He suggested the company's confectionery brands such as Shark wafer delivered a solid performance "in that context" thanks to "product renovation" and "good retail execution". However, the performance of Nestle's joint venture businesses in the market - Hsu Fu Chi and Yinlu – remained subdued. 

"Hsu Fu Chi has been soft in the period but we expect an improvement in the later part of the year. And Yinlu is clearly under pressure," Roger said. "We are currently executing a plan in order to address the entire needs of the mix. It will take some time to stabilise, though."

MainFirst analyst Alain Oberhuber said China remained a "main focus and concern" given Nestle generates 8% of its revenue in the country. However, he noted Nestle did gain share in the market and flags e-commerce represented a bright spot for Nestle in the country. "In China, e-commerce experienced a strong growth rate as in FY-15 e-commerce was more than 5% and more than doubled. In H1-16 e-commerce is now at around 8% as it grew by more than 80% year-to-date," the analyst suggested. 

Confectionery proving a challenge

Nestle's confectionery business, which boasts the KitKat brand, also faced some first-half challenges and volumes came under pressure. 

As Kepler Cheuvreux analyst Jon Cox notes: "Confectionery was under pressure in the Americas due to a competitive market for mid-tier products."

Roger described confectionery as a "challenging" category and noted the company is experiencing "tough trading conditions, both in the US and in some emerging markets, Brazil is one of them". 

The finance chief said overall the confectionery business was able to post positive pricing, driven by Latin America and eastern Europe. 

SIG's Zuanic suggests that could signal Nestle is becoming less aggressive on price competition at its confectionery operations. "Pricing in confectionery, after a phase of disinflation (-2.8% in 4Q15, +2.5% in 1Q16), improved to +4.7% in 2Q16, which was remarkable given the +9.3% comp. While timing of promotions and regional mix shifts may explain part of this, we think Nestle is becoming less price aggressive in confectionery."

Building margin momentum in the medium term

Looking beyond the top line, Nestle has made solid progress in developing its margins. The company reported a 30 basis point increase in trading operating margin in the half, while gross margins were up by 130 basis points. Executives chalked improvements up to mix gains, active portfolio management and efficiency initiatives. 

The company has implemented the first steps of its cost saving programme. According to Roger, this consists of eight "key initiatives", four of which the company has already got off the ground. 

Roger said "the largest ones" are "the asset intensity increase and the manufacturing side where we're reviewing our footprint". He continued: "We expect significant savings as well to come from our consolidation of procurement activities above markets. We are increasing our shared services. We are working in terms of workplace solution, real estate optimisation, delayering, and there are some country-specific projects".  

He said Nestle is "entering the execution phase" and suggested that these projects have a "horizon of three years", cautioning not to expect saving initiatives to have a "significant impact" in the second half of this year. "Even next year, the impact will be relatively limited but it will scale up as we move over time."