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Too Hot To Handle

Nestle’s stock is on a roll, but investors would be better off waiting for valuations to cool down…

I want to buy 10 shares of Nestlé India. What is the outlook and should I buy, given that the shares have run up quite a bit? Ajoy Ganguly

Nestlé India is currently one of the “hot” stocks in the market. It has had a fantastic run over the last one year. The stock is up 50 per cent while the Sensex is up only 11 per cent.

The company is on a roll too. Revenue has grown at a compounded annual growth rate (CAGR) of 21 per cent during the last three years while EPS growth has come in even higher at 25 per cent.

In the most recently concluded quarter (March 2011), the company has managed to sustain its growth momentum. Sales grew 22.3 per cent y-o-y. Domestic demand continued to remain strong. Domestic revenue grew 23 per cent y-o-y while exports lagged behind with only a 10.2 per cent growth y-o-y.

The company has done an exceptionally good job of managing costs. An improved product mix and lower promotional spending saw gross margin expand 100 basis points while Ebitda margin expanded 75 basis points (bps) to come in at 21.3 per cent. Higher other income saw PAT rise 33 per cent y-o-y. Maggi Noodles and chocolates, which were both under intense competitive stress, delivered for the company — both reported double-digit growth.

But not all is hunky dory in Nestlé’s world. An important change in its operating environment of late has been the entrance of serious competition — something the company did not have to contend with so far. In the noodles category, you now have three biggies — HUL (Knorr Soupy Noodles), GSKCHL (Horlicks Foodles) and ITC (Sunfeast Yipee). The long-term implications of the entry of these major players are yet to be seen, but they will surely nibble into Nestlé’s market share.

Many brokerages still have a buy rating on the stock — they set a higher price target after each quarterly result. However, valuations look stretched. The stock trades at 46 times its CY10 (its year ends in December) earnings. That is nearly twice the 25 per cent EPS growth the company has seen in the last three years. The current valuations are based on a number of presumptions that may or may not turn out right — that revenues can grow at current rates; that margins will sustain; and input price inflation will remain at current levels.

Though the company could be a fantastic investment, you need to watch out for the price you pay for Nestlé’s growth. At current prices there is simply no comfort in its valuations. To assume that the stock price will keep on growing sky-high is not common-sense investing. Wait for valuations to cool down before you venture in.

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