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February 14, 2020

Nestle punished by target pullback but positive undertones abound – key takeaways

Market reaction to Nestlé's annual results was less than positive after a key target was pushed back. Simon Harvey takes a look at the major talking points.

By Dean Best

Market reaction to Nestlé’s annual results on Thursday (13 February) was less than positive after a key target was pushed back. Simon Harvey takes a look at the major talking points.

It’s a fragile world in the packaged foods space when small market misses caused Nestlé’s share price to head into the red on Thursday despite progress made across key metrics, most notably the best annual performance in organic growth in four years.

The KitKat maker has been undergoing a rejig since chief executive Mark Schneider came on board three years ago, selling off a host of ill-fitting, low-margin assets, and investing in on-trend, high-growth areas such as plant-based foods, where he’s made two recent acquisitions – Sweet Earth and Terrafertil.

Other accomplishments last year by the world’s largest food manufacturer include the highest top-line sales and net profits in almost a decade, the fastest development in real internal growth, (which strips out pricing) in six years, and, according to Schneider, “record” underlying earnings per share.

And the Cheerios cereals maker also made inroads in accelerating the underlying trading operating profit margin (UTOP) introduced by Schneider in 2017 shortly after joining Nestlé. 

However, the share price was punished, not just because organic growth of 3.5% (3% in 2018) fell short of estimates. 

While UTOP climbed 60 basis points to 17.6% and inched above the lower-end of a previously stated target for the first time, it remains off the upper heights of 18.5% to be achieved by 2020, leaving much work to do in this financial period if Nestlé is to maintain the momentum.

“Too much of a stretch”

Markets were also nervy on the outlook. Schneider had set out to achieve a mid single-digit organic print by the end of this year but he now expects an “acceleration in 2021/2022 towards sustainable mid single-digit growth”. 

“2020 guidance implies modest consensus downgrades, to our eyes,” Martin Deboo, an analyst at Jefferies, says. “As we expected, this has proved to be too much of a stretch. To us, this implies 2020 growth somewhere in between consensus 3.9% and Jefferies’ 3.5% but amounts to a postponement of the MSD [mid single-digit] aspiration by one to two years.”  

He adds: “The implication is that Nestlé is not immune to the wider pressures bearing on the sector, in the context of a premium valuation. We continue to prefer Unilever, where despite more evident challenges, the headline metrics aren’t that different and the valuation is supportive.” 

Not surprisingly, Schneider was pressed on a follow-up conference call to provide more insight, and was met with a clear statement on the negative impact of its water business.

He responded: “I think you should see the positive side of what we are saying, and that is, we are expecting a further increase in our organic growth. Compared to the traditional two percentage-point bands where we have guided in the past, I think this is a strong statement. And all we are saying is, towards the top end it may not cross over towards 4% yet. And to me, one of the swing factors here is clearly the fact that our waters business is not in great shape.”

Market reaction aside, Schneider has had some successes, selling off Nestlé’s skin health and life-insurance businesses, and more recently, its US ice cream operations and a big stake in Herta meats, with the latter two disposals still to be reflected in the results. The transition away from direct-store-delivery (DSD) in the US to a warehouse model was also completed in 2019.

Schneider said the business transformation – disposals and asset purchases – since 2017 has amounted to 12% of Nestlé’s sales and he expects a similar ratio for the next three years, which in turn should provide a further boost to organic growth. Restructuring costs for the current year are envisaged at CHF500m (US$509.7m).

Jon Cox, an analyst at France-based Kepler Chevreux, says: “Schneider has made clear that there are no sacred cows and if businesses can’t be turned around they will be sold and faster-growing and more profitable businesses will be bought to replace them. In addition, there are parts of the business that are not firing on all cylinders, particularly water, where I would anticipate disposals of low-price point products that can’t be premiumised.” 

Schneider added sales of Nestlé’s vegetarian and plant-based food products reached almost CHF200m. It has two meat-free burgers under its wing – Sweet Earth’s Awesome Burger and the Incredible Burger from Garden Gourmet.

He describes the category as a “once in a generation opportunity” where the “story goes way beyond burgers”, with further innovation in the pipeline such as meatballs, and chicken and tuna products.

Talk about plant-based products led to a question on the frozen category, a sector where growth is mixed across the industry.

“Let me be very clear, the business [plant-based] in itself is super attractive,” Schneider said. “So when you have a CHF200m business growing strongly and accelerating at a double-digit rate, that’s nothing to reject. 

“That’s not the only reason to maintain that business – I think we’ve seen a turnaround in frozen as a category overall – and I think we are also seeing very promising work in our own frozen business when it comes to improving growth rates. But I think it’s one added opportunity here to breath new life into this category.”

“Eager” to acquire in “attractive” categories

Acquisitions were absent at Nestlé last year, leading to a question on M&A. Schneider was clear he favours further deals in a strategy geared to small- to mid-sized companies, which are “the surest and best way to create value”, but is open to larger transactions.

Schneider continued: “I think everyone will understand that with portfolio transformation, ideally you do it on both sides of the ledger – the buying side and the selling side. We want to position the portfolio towards higher growth but we don’t want to deleverage the company when it comes to the size and operating leverage that we have. 

“We are also eager to build the business and to buy where we can strengthen attractive categories and market positions going forward. That’s my hope for 2020, that we’ll come to a more balanced picture in that regard.”

One analyst suggested his comments imply Nestlé will only dispose of assets if there’s a potential M&A deal on the table.

“If we come to the conclusion on a business that has to be sold, we will not slow that down just to wait for something to be bought,” Schneider clarified. “And I think you saw us in 2019 do exactly the right thing for shareholders on these three businesses – Nestlé skin health, US ice cream and Herta – so I think that’s proof that even in a year when there was almost no acquisition we did exactly the right thing for shareholders at exactly the right time.

“You should never assume that we are slowing down anything that has to happen simply because there’s a lack of buying opportunities.”

What impact will coronavirus have on Nestlé?

Like Nestlé’s peers, emerging markets are a valuable and growing source of income, but China, the Zurich-listed firm’s second-largest market by sales after the US, could see a protracted slowdown as a result of the coronavirus outbreak.

China accounted for 8% of revenues last year, up about one percentage point. A company spokesperson told just-food last week staff had been prohibited from travelling to China, where Nestlé’s factory operations were interrupted as the authorities extended the Chinese New Year holiday period to contain the virus.

Cox writes: “Nestlé has pushed back its medium-term sales target by a year or so which is a reflection of some of the portfolio adjustments it has made. Coronavirus also adds another element of uncertainty and is certainly going to weigh in the first quarter.”

Schneider was asked to quantify the situation with inventories in China.

“We do have inventory of course and infantry sits at various levels – raw materials, work in process, finished goods, and then there’s a lot in the supply chain towards the retailers – so I think whether that’s sufficient or not will all depend on what the next few weeks will look like, and to what extent transportation, distribution capacity will be constrained, and what the future of this outbreak is looking like. I think it is too early to give a precise estimate of where we stand.”

Last year, the Buitoni Italian sauces owner saw organic growth in emerging-markets of a flat 4.7% (CHF38.9bn), outpacing the developed world, which grew 2.6% to CHF53.7bn. Nestlé said North America witnessed its fastest growth in a decade of 2.6%.

In context, the Americas region posted sales of CHF42.3bn, representing organic growth of 4%. Sales on an organic basis from Nestlé’s operations in Europe, the Middle East and north Africa was up 2.3% at CHF26.5bn. In Nestlé’s operations in Asia, Oceania and sub-Saharan Africa, growth was 3.8% to CHF23.8bn. 

Nestlé was already facing challenges in China with its Yinlu and Hsu Fu Chi businesses, leading to speculation those assets could be sold even before coronavirus emerged, and that could perhaps happen soon.

“We have a number of specific issues to address…one is for example in China. We have been slowed down by Yinlu, where we felt in 2018 we would stabilise the situation but we saw in 2019 that that was not the case,” Schneider says. “So we are working on the strategy and will be back to you later this year on how to address that.”

The impact from China was felt in a 30 basis-point drop in another key metric – the trading operating profit margin, to 14.8%, and also a decline in sales in Yinlu peanut milk and congee, a rice porridge.

The earnings statement noted: “Restructuring expenses and net other trading items increased by CHF854m to CHF2.6bn, largely reflecting increased impairments of assets related to the Yinlu business.”

Deboo adds: “We continue to view Nestlé as a well-led, and well-strategised, business. But the struggle to deliver on growth aspirations relative to a close-to-peak valuation is beginning to weigh on the equity story, reflected in a flat lining share price since the summer and the modest negative reaction to today’s news.”  

Schneider says the “key message to point out is consistency across all metrics”. And looking ahead, further innovation is in store, along with the prospect of more asset disposals, and potentially other acquisitions too. But eyes will be on how organic growth pans out and the performance of key markets.

Schneider says: “Mid-term, I fully expect AOA to be the growth engine of the group, which rightly it should be given Asia’s importance for the world economy and the growth rates we are seeing. This is what our clear ambition is.”  

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