With Nestlé’s North American waters business kicked out the door, chief executive Mark Schneider has openly admitted China is a market that now needs fixing as he charts a course to potentially reach the threshold of the group’s organic-growth target this year.
Nestlé will pocket US$4.2bn from the waters sale and Schneider suggested last week, after reporting annual organic growth of 3.6%, the fastest pace in five years, that he’s almost done with reshaping the portfolio toward high-growth categories. He said there are still adjustments to be made but not in the same league as waters.
Having parted with the troublesome Yinlu peanut milk and rice porridge operations in China, Nestlé gave no hint of any further divestments in its second-largest market where growth has slowed, with infant formula a drag.
Combined with the earlier disposals of US confectionery, skin health, Herta meats and Buitoni pasta, as well as the closure of 27 factories to boost efficiencies, the CEO expects organic growth to be on the edge of the mid-single-digit target he introduced in 2017 amid pressure from activist investors.
“We are seeing an opportunity to potentially cross over the 4% mark, which is important because that defines the entry point to the mid-single-digit rate,” he informed analysts on a call to discuss the results on Thursday (18 February). “This is a possibility but we can’t firmly promise it yet because we don’t know how exactly the pandemic is going to shape this year but definitely we see an opportunity to be above the 3.6%.”
Schneider gave an inkling of what assets he still considers as central, flagging a commitment to the rest of the confectionery portfolio, to infant nutrition, to Nestlé Health Science, which has been pushed aggressively through acquisitions, plant-based products and pet care, the company’s second-largest category.
The CEO suggested he’s now more open to M&A, with the potential of further activity in e-commerce having recently bought Freshly, the US direct-to-consumer meals firm, taken a majority stake in another D2C company, London-based Mindful Chef, and a UK confectionery partnership with Deliveroo. He isn’t completely done with water either, voicing an interest in functional waters, or “healthy hydration”
"We are very interested in advancing our waters business," Schneider says.
China infant formula in focus
M&A and disposals aside, Schneider's attention is now turning to China. As Alain Oberhuber, an analyst at financial services firm Stifel, argues: "China becomes a larger focus for Nestlé's valuation".
Organic sales in China declined at a "high-single-digit" rate in 2020, compared to "slightly positive" the previous year, and a mid-single-digit increase in 2018. While Nestlé's chief put the losses down to the timing of Chinese New Year, limited festivity spending linked to Covid-19, the disposal of Yinlu and a relatively high exposure to the out-of-home sector, Schneider was not happy. "We share your disappointment around the performance in China."
Infant nutrition sales in China were "slightly negative" due to a contraction in the Wyeth brand, slowing from "slightly positive" in 2019, partly linked to what Schneider says are declining birth rates and more mothers choosing to breast feed, an issue Nestlé is trying to fix with premium products geared to weaning toddlers.
More broadly, despite the problems in China, Schneider said infant nutrition remains a "core business of ours" and one which Nestlé "considers in the mid to long term to be a clear growth driver". Excluding China, the category grew low single digits. On a call with analysts, JPMorgan's Céline Pannuti asked whether Schneider had changed his mind "in terms of this being one of the growth engines, as you had talked about three years ago?"
"Over the past few years, the fundamentals of infant nutrition have certainly not improved," he told analysts. "I'm still a big fan of the benefits I've seen from moving this business from a globally managed business to one that is handled by our Zones [geographic regions]. The Zones are clearly the better operators of these businesses. We're dealing with issues so much sooner. But around the world, what you have seen is a certain downdraft from declining birth rates, increasing breastfeeding rates, which, of course, we strongly salute. So, the fundamentals have not been great when it comes to the more narrow definition of infant formula. I think all the more for us, the piece of homework we have to do is to take a slightly wider definition around what we call the first 1,000 days from conception into the first few years of life of a newborn and then see what we can offer to both mother and child as the optimal nutritional solutions."
He added: "So, this is a core business of ours that we consider in the mid and long-term to be a clear growth driver. Everyone is interested in giving their children the best possible start in life. There is strong scientific evidence that if you get that right, both from a physical and mental development, you're doing the best possible thing for your child. So this to me is company DNA and certainly not something we're giving up on."
It was not all bad in the area of baby nutrition, with positive growth for the Nan and Cerelac brands, "strong double-digit" growth for Gerber's infant cereals.
In China, Nestlé is seeking to address the issues in infant formula through innovation and a planned expansion beyond the major Chinese cities into tier three and four cities.
The company has expanded its "super premium" offering for Illuma with the addition of A2 milk and a hypoallergenic formulation as well, while an organic version of the S-26 brand was rolled out last August.
While Stifel's Oberhuber says a "gradual improvement" is expected in China, he remains cautious. "Despite some confidence due to favourable base effects in China, the jury is still out for a strong recovery in infant formula," Oberhuber wrote in a research note. "As a backdrop, birth rates in China are declining and local players are gaining market share. Both of these trends are a threat for the international players."
"M&A value destruction"
Plant-based products are "growing very significantly" for Nestlé, an area described by Schneider as "a once in a generation opportunity to reinvigorate our CHF12bn (US$13.4bn) food category", with options currently available in alternatives to seafood, burgers and dairy.
Products potentially on the table include confectionery and ice cream as Nestlé seeks to grow the sector from CHF200m, with meat-less lasagne and plant-based pizza about to be served up, and a vegan KitKat in the pipeline.
Schneider says the category is worth around CHF700m and is increasing at a double-digit rate when "downstream opportunities" are taken into account, where plant-based ingredients are used in frozen foods and prepared dishes. And the dairy-free segment is now worth CHF100m, growing in 2020 at a double-digit rate, while the alternative to tuna launched last year – Vuna – has "seen great success".
He made no reference to planned acquisitions in the category but was clear M&A will form a bigger part of Nestlé's group strategy, with "caution and prudence" prevailing.
The Swiss giant will also be selective in conducting any deals, with last year's 240 basis-point increase in the return on invested capital evidence that the strategy employed by the CEO is working. ROIC came in at 14.7% in 2020, compared to 11.4% in 2017 and 10.8% three years earlier.
But any large-scale deal-making could eat into that.
"We are confident that bar any significant acquisition, we should be able to maintain our ROIC, and possibly improve it, but it can vary from one year to the other depending on what happens on the M&A front," Schneider explained.
He continued with respect to potential investments: "We do believe that in 2021 as well, we will see some good additions to our business. It will not be a repeat of 2019, and of course having gone through waters now, once that is closed, there will be in the mid-term other portfolio adjustments."
Martin Deboo, an analyst at Jefferies, says there are risks behind stretching too far in acquisitions, noting "M&A value destruction" is the principal risk.
"Schneider spoke with trademark wisdom and caution on the call around the risks from too-precipitate big M&A. But the temptation to deploy the balance sheet might become acute, if the top line won't accelerate. This in the context of big M&A being a traditional pitfall for later-tenure CEOs," he says.
Schneider took the helm at Nestlé in 2017.
A "giant awakened" in e-commerce
E-commerce could feature in his M&A plans as it becomes a key component of food manufacturer's operations in light of the pandemic, and where demand patterns are expected to stick to some degree beyond the pandemic.
Nestlé's sales through e-commerce exceeded CHF10bn last year, growing 48.4% to account for 12.8% of group sales.
"This is now a giant that has awakened," Schneider referred to it, but he went to some length to explain the criteria for any future deals in an area where he says there's "much more now to be done and we want to go and capture it".
"In terms of acquisitions, when it comes to just digital enablers, I feel more often this is about partnerships and it's about licensing. When it comes to business models, take as an example our investment in Freshly, where you have a business model and there's a strong digital component to it...This is where we'll see the sweet spot, so you have a digital model with a business model combined."
Direct-to-consumer could also play a part, as Schneider revealed plans to expand in D2C, along with efforts to build Nestlé Health Science into a "nutritional powerhouse" and fix underperforming businesses in China and Lean Cuisine, the US brand that falls into a frozen-foods business where sales grew in the high single digits last year.
In 2020, divestitures had a 4.6% negative impact on sales, bringing down the reported component of that metric to CHF84.3bn, a decline of 8.9%.
Elsewhere, the underlying trading operating profit margin, a key metric, rose 10 basis points to 17.7%, above the 17.5% to 18.5% target put in place by Schneider in 2017. It was up 20 points in constant-currency terms.
The trading operating margin climbed 210 points to 16.9%.
What Nestlé calls RIG – or "real internal growth", which excludes prices and M&A, was the highest in nine years at 3.2%, with pricing contributing 0.4%.
Net profit and free cash flow were the only real disappointments, with the former falling 3% to CHF12.2bn. Cash flow dropped to CHF10.2bn from CHF11.9bn.
Deboo at Jefferies explained his historical take on Nestlé's transformation: "On the 2018 first-half call, and with activists breathing down his neck, Schneider said that 'the logic and the direction of the strategy will evolve at appropriate speed and will only become visible over time'".
And further: "Close to 20% of the portfolio has been churned, with a 60 basis-point benefit to growth, which has accelerated by 120 points to 3.6%. Margins have risen by 120 points to 17.7%, within the 17.5% to 18.5% target. A challenging year has been navigated, with guidance maintained and no damage to the top line in aggregate."
Results should get better as Nestlé puts its resources behind high-growth category areas and premiumisation, which the CEO says "is a key component of our portfolio transformation". But there a bound to be pitfalls along the way.
Premium products now make up 30% of the company's sales versus 11% back in 2012.
It would be an impressive performance if Nestlé can get to 4% organic growth in the current fiscal year and even more impressive if it can reach the mid single-digit target of 5%, perhaps in the following 12 months. Based on the latest set of results, it has the legs to get there but much will depend on the portfolio choices Schneider makes.
Oberhuber's Stifel envisages organic growth will by just shy of 4% in 2021, although it has raised its estimate from 2.4% to 3.9%, with an outlook for 4.3% in 2022.
In summation, Schneider says: "We are not quite there yet when its comes to our mid single-digit organic growth. It's about advancing the high-growth categories and channels, ongoing portfolio management and gearing that portfolio towards higher growth, and also fixing underperforming businesses."