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Sales below our estimate; gross margin pressure evident

* Sales growth of 14% YoY in 2QCY21 was lower than our expectation (+17%), given the weak base in 2QCY20 (+1.7% YoY sales growth). Two-year average sales growth slipped to 7.8%, lower than the 9-10% range seen in the preceding three quarters. Rising palm oil and packaging costs led to lower than expected operating margin, resulting in a 5-6% miss to our EBITDA and PBT estimate.

* The company indicated in its press release that it has already invested INR10b of the INR26b capex program it had indicated earlier (planned over 3-4 years). Given the addition of only INR470m to fixed assets in its 1HCY21 Cash Flow Statement, a considerably higher investment is likely to have come through in Jul’21. While this will lead to higher depreciation in 2HCY21 and beyond, the substantial capex is indicative of the management’s confidence in NEST’s topline growth prospects.

* The structural opportunity in the Indian Food space is extremely attractive. While NEST’s ongoing investments are encouraging, valuations at 65.2x/56.2x CY22E/CY23E EPS lead us to maintain our Neutral rating.

Slight miss to our estimates

* Net sales grew 14% YoY to INR34.8b (est. INR35.7b) in 2QCY21. Domestic sales grew 13.7% YoY, led by double-digit volume and mix growth. Exports rose 17.7% due to the timing of exports to affiliates. We peg volume growth at ~11% in 2QCY21.

* EBITDA/PBT/adjusted PAT increased by 9.9%/8%/5.4% YoY in 2QCY21 to INR8.3b/INR7.2b/INR5.2b v/s our estimate of INR8.7b/INR7.6b/INR5.7b.

* Gross margin expanded by 70bp YoY to 57% due to better realizations and mix, offsetting higher commodity cost.

* As a percentage of sales, lower staff costs (-120bp YoY to 10.9%) and higher other expenses (+280bp YoY to 22.1%), led to a 90bp YoY contraction in EBITDA margin to 24% (est. 24.5%) in 2QCY21. Higher other expenses were mainly on account of rising fuel prices and comparison to a base quarter, impacted by restricted operations due to the lockdown.

* Other income decreased by 22.3% YoY in 2QCY21 due to lower yields and average liquidities.

* Sales/EBITDA/PAT increased by 11.2%/13.1%/9.4% YoY in 1HCY21 to INR70.9b/INR17.6b/INR11.3b.

* As of 30 Jun’21, NEST’s inventories/debtors/creditors were up 16.9%/12.8%/17.4% YoY. NWC was 14.1% higher YoY at INR5.4b.

Highlights from the management commentary

* NEST’s key products of Maggi noodles, KitKat, Nestlé Munch, Maggi sauces, and Maggi Masala-Ae-Magic posted strong double-digit growth.

* Recently, commodity prices have been rising across oils and packaging materials.

* The e-commerce channel posted a strong (105% YoY growth) performance and contributed 6.4% of domestic sales.

* Contribution of innovations to domestic sales grew 4.9% in 1HCY21.  It has invested INR10b of the INR26b capex plan announced earlier.

Valuation and view

* Changes to our model resulted in a 4-5% EPS reduction in CY21E and CY22E as a result of sales and margin miss in 2Q and higher than expected capex in CY21.

* While the management announced a capex plan of INR26b (spread over 3-4 years) towards the end of CY21, it has already invested ~INR10b as mentioned in its 1HCY21 press release, which showcases its high confidence on NEST’s medium-to-long-term growth prospects.

* The long-term narrative for NEST's revenue and earnings growth are highly attractive. The Packaged Foods segment in India offers immense growth opportunities. This is particularly true for a company like NEST, with a strong pedigree and distribution strength. Successful implementation of its volume-led growth strategy in recent years provides confidence on execution as well.

* As indicated in our annual report update note, the pace of new launches in CY20 (while lower than preceding years due to the management’s focus on the core business, amid the COVID-19 pandemic), was healthy compared to its peers. Since CY16, NEST has launched 80 (including nine in CY20) new products. In a recent analyst meet (Feb’21), the management said these products contributed a healthy 4.3% of sales in CY20 v/s 3.4% in CY19. With 40-50 products in the pipeline, the pace of new launches is likely to remain healthy going forward.

* Valuations at 65.2x/56.2x CY22E/CY23E EPS are expensive and offer limited upside from a one-year perspective. We value the company at 60x Sep'23E EPS to arrive at our TP of INR18,600. We maintain our Neutral stance.

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