We maintain ?sell? on Nestle with a target price of R4,430 as we foresee moderating growth in the near term, while stock valuations are coming off ? relative valuation to the sector average is at ~1.1x (versus peak of ~1.5-1.6x last year). Current valuations of ~31-32x one-year forward P/E are not still supportive, in our view.
We value Nestle India using a P/E based methodology, given its steady growth characteristics and non cyclical revenue streams. Our target price is based on a target P/E multiple to 30x FY14e. We peg the target multiple at the average of the stock?s long term historical trading band. The stock is trading at relative P/E of ~2.7x versus the broader market ? at the higher end of the last 10 years band. At current valuations of ~35x one-year forward, the stock is trading at a ~15% premium of its long-term P/E multiple, which we think is fairly rich especially considering the moderating growth outlook and heightened competitive intensity ? and leaves no room for disappointment, in our view.
Nestle India?s royalty payment is raised to 4.5% of net sales from 3.5% at present, beginning January 1, 2014. The royalty hike will be effected in a staggered manner ? 20 bps per year over the next five years. EPS impact is expected to be modest over CY14 ? a little over 1 percentage point, but given the cumulative
effect of the hike, by the fifth the cascading impact will be ~5% EPS cut. This hike is more modest (in % terms and EPS impact) than HUL?s recent royalty hike.
Nestle should be compensated for services rendered by it to Nestle India, which benefits from its access to Nestle?s group?s brands and technologies. Nestle India has a GLA (general license agreement) with Nestle, but the royalty rates were fixed two decades ago. A study by McKinsey (to Nestle) noted that IPRs provided by the GLA provide Nestle India with benefits that range from 5% to 7.6% of net sales. The fairness opinions tendered by Bansi S Mehta and KPMG (registered) to Nestle India suggested in turn that royalty could be applied at a rate of 5% to 9.1% of net sales ? depending on the various valuation methodologies used.
Over the next five years (till CY19), royalty will be capped at 4.5% of net sales, which when viewed in conjunction with Nestle?s PAT margin of ~12-13% makes for a fairly reasonable outcome.