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Initiating Coverage Nigeria | Equity | FMCG | April 2014 www.gtlgroup.com Good Food, Good Life Strengthened to ride through the bumps

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  • Initiating Coverage

    Nigeria | Equity | FMCG | April 2014

    www.gtlgroup.com

    Good Food, Good Life

    Strengthened to ride through the bumps

  • 1

    CONTENTS

    INVESTMENT SUMMARY .......................................................................................... 2

    THE NIGERIAN CONSUMER GOODS SECTOR .................................................................. 3

    COMPANY PROFILE ............................................................................................... 7

    KEY GROWTH DRIVERS ..................................................................................... 10

    REVIEW OF NESTLE FULL YEAR 2013 RESULTS ........................................................... 16

    OUTLOOK FOR EARNINGS 2014 AND BEYOND ........................................................... 18

    VALUATION ..................................................................................................... 21

    DISCLAIMER AND IMPORTANT DISCLOSURES ............................................................... 24

    file://GTL-SADC02/G-Drive/GREENWICH%20RESEARCH/REPORTS/GREENWICH%20DAILY%20MARKET%20REPORT/2014/Nestle%20Final%20Final%20Review.docx%23_Toc385508042

  • 2

    Nestl Nigeria Plc

    The Nigerian consumer market is poised to continue to

    expand and a rapidly growing population as well as

    rising income levels will be key drivers of consumption

    growth, in our view. We believe that evolving consumer

    themes will play to Nestls strengths - robust capacity

    (on the back of high capex investment), unique

    approach to distribution channels and product

    innovation.

    Nestl has recorded double-digit revenue growth over

    the last decade, despite challenges within the Fast

    moving consumer goods (FMCG) sector. We hold a long

    term positive outlook for the sector and we believe the

    company has capabilities to sustain momentum, as

    pressure points in its FY-13 numbers are mostly

    transient.

    Over the past four years, the company has invested

    heavily in capacity expansion in its Nigerian business.

    We believe increased volumes from on-going expansion

    will be a key driver of future revenue. This has driven

    our expectations for double digit revenue and after-tax

    profits growth over our forecast horizon.

    While market sentiments on the counter over a five year

    period reveal a price uptrend of ~83% CAGR, suggesting

    the stock has been modestly over-bought, we still see

    some upside as we believe the stock is current trading at

    close to its intrinsic value, at current levels. At

    N1215.67, our 12 month Price target is ~9% above

    Nestls current trading price of N1111.00. We rate

    Nestle HOLD.

    Nestle Nigeria

    RECOMMENDATION

    Current Price, NGN 1,111.00

    Target Price, NGN 1210.92

    Rating HOLD

    Potential upside 9%

    FINANCIALS

    2013 2014e 2015F

    Sales 133.1 165.3 203.3

    EBIT 27.8 38.5 47.8

    PBT 26.0 37.2 60.8

    PAT 22.3 30.9 38.4

    EPS 28.1 39.0 48.5

    Div. Yield % 2.5 2.6 3.4

    SHARE SUMMARY

    Bloomberg Nestle NL

    Reuters Nestle LG

    Free float 36%

    Market Cap, (Nmn) 911,475

    Year Low (N) 958.80

    Year High (N) 1,195.00

    52 Week Low (N) 879.50

    52 Week High (N) 1,249.50

    RETURNS

    Year to Date -4.18%

    52 Week 27.40%

    Usoro Essien

    [email protected]

    Ade Alabi

    [email protected]

    Oluwaseun Dosunmu

    [email protected]

    Nelson Iziogba

    [email protected]

    INVESTMENT SUMMARY

  • 3

    THE NIGERIAN CONSUMER GOODS SECTOR

    The consumer goods sector can be broadly grouped into the following

    sub-sectors; white goods, brewers and bottlers, pharmaceuticals, household

    and personal care, beauty as well as food & nutrition. Although dominated by

    global brands such as Reckitt Benckiser, Procter and Gamble, Unilever, PZ

    Cussons, Cadbury and Nestle, which are active in the Nigerian market

    through their local subsidiaries, the sector remains fragmented. Other key

    players within the space include Kneipe, Promasidor and United African

    Company of Nigeria (UACN). Of the major players, only Unilever, Cadbury,

    PZ Cussons, Nestle, Nigerian Breweries, Guinness and UACN are listed on the

    Nigerian bourse.

    Strong macro-fundamentals underpin positive outlook....

    A review of our basket of companies in the Nigerian consumer goods space

    show that revenues have grown by 15% over the past three years, while the

    Nigerian food market is estimated to be growing at an average of ~9% per

    annum. Major drivers include a positive shift in consumption patterns, the

    emergence of a significant middle class in a sizeable population of

    ~167million, growth in the non-oil sector of the Nigerian economy and

    annual per capita GDP growth of 3-5% for the past five years (which is

    comparable to the growth seen in other emerging markets over the same

    period).

    Furthermore, data from the National Bureau of Statistics (NBS) show that

    since 2006, the sector is the third largest recipient of foreign direct

    investment (FDI), behind the oil & gas and telecoms sectors.

    Our outlook for the sector is positive, underpinned by expected secular

    growth in consumer demand in the near to medium term. Sub-Saharan

    Africa (SSA) is now nearly as urbanized as China and also has a similar

    population to urban city ratio with Europe. In addition, Mckinsey estimates

    that Lagos, (together with Johannesburg and Cape Town) will generate

    ~$25bn in consumer spending annually by 2020, a figure comparable to its

    forecast for key cities in other emerging markets such as Delhi and Mumbai.

    The consumer goods

    sector is poised to

    continue to expand, to

    be driven by continued

    secular growth in

    consumer demand.

  • 4

    Mckinsey also expects Ibadan, located only some 150km from Lagos, will

    generate over $10bn within the same period.

    Key players within the consumer goods space such as Nestle, Unilever, UACN

    and PZ Cussons seem aware of these projections, and continue to invest

    heavily in capacity expansion. We view this as a significant initiative, and

    envisage that growth within the sector will likely be driven by these leading

    brands, despite competition from smaller domestic companies whose

    products have gained some prominence as cheaper substitutes, on the back

    of the domestic impact of events that stemmed from the 2008 global

    financial crisis. We hinge our perspective on three lines of reasoning:

    First, we consider Nigerias most developed cities - where the leading brands

    already have a strong hold - central to the growth of the fast moving

    consumer goods sector, given the growth of the middle class as well as rising

    urbanization.

    Furthermore, rapidly expanding distribution networks as well as innovation

    and versatility of the products offered by the leading FMCG companies,

    suggest that the rural communities across the country will likely see

    increased penetration from the leading brands in the near to medium term. A

    good example is Nigerian Breweries acquisition of five small brewers in

    October 2011, a move that has seen its mass market brands

    (Maltagold, Life, Climax and Goldberg) gain traction in the second and third

    tier states across Nigeria.

    45% 30% 40%

    73% 79% 82%

    55%

    70% 60% 27%

    21%

    18%

    0

    200

    400

    600

    800

    1000

    1200

    1400

    1600

    China India Africa Europe Latin

    America

    North

    America

    To

    tal

    Po

    pu

    lati

    on

    Urban Rural

    Growth within the FMCG

    sector will likely be

    driven by leading

    brands, despite

    competition from

    smaller domestic

    companies.

  • 5

    Finally, we see a major advantage of scale for the leading players, especially

    those with foreign parentage. These can benefit from access to cheap

    financing from their parent companies, through which they can better fund

    operations whilst also improving efficiency.

    Thus, despite some challenge from the less popular section of the FMCG

    segment, we view the leading brands as the prime beneficiaries of the

    expected growth in the Nigerian FMCG sector in the foreseeable future.

    Defensive players to remain strong, despite potential headwinds

    Despite a positive long term Outlook for the Nigerian consumer goods sector,

    we are conscious of potential headwinds that may arise from upcoming

    events in the next 24 months; notably the change in the central bank

    leadership and its potential impact on monetary policies, political events in

    the run-up to the 2015 elections, and plausible re-emergence of socio-

    political unrest in the Northern part of the country.

    Nevertheless, we expect companies in the consumer goods space with

    defensive characteristics (from exposure to non-cyclical goods, especially

    food) to outperform companies more involved in the production of cyclical

    goods, irrespective of the occurrence or otherwise of these risk factors. We

    believe that this view is corroborated by recent trends.

    During the last three years, the consumer goods sector has experienced a

    challenging environment due to a squeeze on consumer disposable income,

    stemming from the global financial crisis, as well as structural adjustments in

    the domestic economy.

    As we would expect, the impact of these events was less evident on the

    earnings of companies within the consumer goods space with exposure to

    non-discretionary goods, as demand for these classes of products remained

    relatively strong. For instance, while both Unilever and PZ Cussons, which

    are major players in the non-food segment, easily delivered high teen sales

    growth prior to 2009, both companies have endured single digit growth in

    revenue over the past three years.

    We favor companies in

    the non-discretionary

    FMCG segment as these

    have a track record of

    resilience in a

    challenging business

    environment.

  • 6

    On the other hand, Nestle, which is a major player in the food segment,

    constantly delivered double digit growth prior to and over the corresponding

    period (average of ~20% per annum).

    With the ability to benefit from long-term growth in consumer demand while

    also demonstrating resilience in the face of a more challenging environment,

    we are naturally inclined to favor companies in the non-discretionary section

    of the market, such as Nestle and UACN.

    0

    5000

    10000

    15000

    20000

    25000

    30000

    35000

    40000

    Q1 - 12 Q2 - 12 Q3 - 12 Q4 - 12 Q1 - 13 Q2 - 13 Q3 - 13 Q4 - 13

    Trend in Revenue Growth (Q1-12) - (Q4-13)

    Unilever Cadbury Nestle RHS

  • 7

    COMPANY PROFILE

    Nestle Nigeria, a member of the Switzerland based multinational Nestle

    Group, began trading operations in Nigeria in 1961 and was listed on the

    Nigerian Stock Exchange (NSE) in 1979. The company is presently the

    largest food and beverage company in Nigeria (ex-brewers), both in terms of

    sales and market capitalization. Nestle Nigeria is part of the Central and

    West Africa division of the Nestle Group, managed by Nestle Central & West

    Africa based in Accra, Ghana. This entity is also the largest shareholder in

    the Nigerian subsidiary.

    The company has two manufacturing plants in Ogun state; the Agbara and

    Flowergate plants. With an initial outlay of ~N30 million, the Agbara factory

    came into existence ~30 years ago, and remains one of Nestls largest

    factories in Asia and Africa. The factory has been subject to extensive

    capital expenditure over the years, as Nestle grew volumes and increased its

    product portfolio in response to evolving consumer demand.

    The Flowergate plant was commissioned in 2011 at an estimated cost of

    ~N12 billion, and has since been dedicated solely to the manufacture of

    popularly positioned products (such as the Maggi brand) in order to ease

    Part of the Central and

    West Africa division of

    Nestle Group

    Two Manufacturing

    plants in Ogun

    state - Flower gate and

    Agbara.

    59.59%

    3.89%

    36.52%

    Nestle Nigeria - Shareholer Structure

    Nestle CWA Ghana

    Nestle SA Switzerland

    Others

    Source: Company Filings, Greenwich Research

  • 8

    pressure and free up space at the Agbara plant for other product lines.

    The company has also revealed plans to build a third factory in Abuja in the

    near term, as it seeks to grow its presence in the Northern region.

    Nestle operates a centralized distribution system with its distribution centre

    in Ota, in Ogun state. The centralized distribution centre supplies a total of

    74 distributors (as at Q3-13), spread across key regions in Nigeria.

    Brands manufactured by Nestle Nigeria fall under eight categories as shown

    below:

    Table 1: Nestle Nigeria Major Product Lines

    Product Line Products

    Infant Cereals Nestle Nutrient, Cerelac, Lactogen

    Family Cereals Golden Morn

    Beverages Milo

    Confectionary Chocomilo

    Bouillon Maggi - Cube/Chicken/Crayfish/Mixpy

    Table Water Nestle Pure Life

    Coffee Nestle Classic/3-in-1/Nescafe Breakfast

    Milk Nido

    The products are produced by two main strategic business units (SBUs),

    namely Food and Beverages, which are defined by differing marketing

    strategies and technology requirements.

    Food Maggi, Cerelac, Nutrend, Lactogen

    and Golden Morn.

    Beverages Milo, Milo ready to drink, Chocomilo, Nido, Nescafe and Nestle Pure Life.

  • 9

    Over the last five years, revenues for the two strategic business units have

    grown in double digits, with the Food SBU accounting for ~61% of sales.

    Nido , 3%

    Nescafe , 4%

    Pure Life, 9%

    Golden Morn, 12%

    Baby Food, 14%

    Milo, 22%

    Maggi, 36%

    2013 - Product Contribution to Revenue

    Revenues from Nestle

    Nigerias 2SBUs - Food

    and Beverages - have

    grown double digits in

    the past five years.

  • 10

    KEY GROWTH DRIVERS

    Over the last five years, Nestle has consistently recorded double digit growth

    in profitability, with revenue and net income growing at an average of ~23%

    and ~26% y/y respectively. At 21%, growth in EPS lagged the bottom line

    rate, owing to adjustments made to outstanding shares in FY-10,

    when a bonus of one share was issued for every five held.

    Portion sizes expand mass market appeal: Nestls production of key

    products such as Milo, Nescafe and Golden Morn in small single-use sachets

    has been a major driver of volumes and market share in the last 3-4 years.

    These products are designed for and appeal to low-income consumers who

    constitute a large proportion of the Nigerian population, and in our view, play

    a significant role in the overall consumption value chain. We observe this

    strategy is being adopted industry wide, with products from Procter &

    Gamble, Cadbury, Unilever and Promasidor providing competition.

    Exports gaining traction: The Company commenced exporting some of its

    products to neighbouring African countries such as Ghana, Togo, Mali and

    Benin in 2011. We believe the move was designed to improve capacity

    utilisation following the recent significant investment in capex. Although the

    contribution of export sales to revenue is still minimal (two year average of

    ~1.5%), we envisage a steady improvement in the near term, as further

    expansion plans are completed (mainly the construction of the Abuja

    factory). The companys export strategy also benefits from the Federal

    Governments favourable stance to exports in the form of subsidies.

  • 11

    Efficiency gains from improved distribution network: In our view, the

    company has benefitted from changes to its distribution process that saw it

    shift from wholesale to a retail driven distribution model. The retail model

    relies heavily on secondary sales forces to push products through distribution

    channels, resulting in a rationalization of the companys distributors from a

    total of about 170 to 74. This rationalization coincided with the companys

    move to a more centralized warehouse in Agbara, Ogun State.

    .

    As a result, Nestle now has a more structured distribution network, which

    has given the company more grip over its distribution chain, while giving its

    distributors more responsibility and ensuring deeper penetration across

    different regions of the country.

    We observe that Nestls footprint continues to grow across secondary and

    tertiary cities, especially locations within the northern region not rocked by

    socio-political unrest, as it seeks to diversify away from those areas where

    the local economy has been hit.

    0

    5

    10

    15

    20

    25

    30

    35

    40

    45

    50

    2008 2009 2010 2011 2012 9M - 13

    Percen

    t

    Source: Company Filings, Greenwich Research

    Nestle - Gross margin vs. competitors

    Nestle Unilever Cadbury

    Nestls footprint

    continues to grow in

    secondary and tertiary

    cities, especially areas

    in the northern region

    not rocked by

    socio-political unrest.

  • 12

    0%

    10%

    20%

    30%

    40%

    50%

    60%

    70%

    2008 2009 2010 2011 2012 2013

    Cost to Sales Opex to Sales

    Change in dynamics for raw material procurement: The company has

    vastly improved its ability to manage typically volatile raw material costs

    (which are affected by global commodity prices and exchange rates) by

    ensuring a large proportion of its agricultural raw materials and packaging

    materials are sourced from the domestic market. Figures from the FY-12

    annual report show that ~75% of agricultural raw materials, which constitute

    ~60% of COGS by our estimates, are sourced locally. Key raw materials

    obtained locally include cocoa, sorghum, cassava, maize and soybeans.

    Furthermore, for imported raw materials, the company operates three levels

    of procurement to drive supply chain efficiency: Nestle SA (at the global

    level), Nestle Central and West Africa (at the regional level) and Nestle

    Nigeria (at the local level). Thus, while the company is now exposed to

    volatilities in domestic agricultural production, its exposure to exchange rate

    volatility, which we consider the greater risk, has been significantly reduced.

    We expect the trend to persist in the near term, with favourable Government

    policies towards the agriculture sector providing support. Overall, this has

    helped to moderate the rise in COGS and SDA expense over the last five

    years, both of which have grown at a lower rate than revenues.

    -5% 0% 5% 10% 15% 20% 25% 30% 35% 40% 45%

    2008

    2009

    2010

    2011

    2012

    9M - 13

    Cadbury Unilever Nestle

    Opex to Cost of Sales & EBIT Margins vs. Peers

    ~75% of agricultural

    raw materials, which

    constitute ~60% of

    COGS by our estimates,

    are sourced locally, thus

    reducing significantly

    exposure to exchange

    rate risk.

  • 13

    0

    5,000

    10,000

    15,000

    20,000

    2008 2009 2010 2011 2012 2013

    Mil

    lio

    n

    Source: Company Filings, Greenwich Trust

    CAPEX Investment - Nestle Vs Peers

    NESTLE CADBURY UNILEVER

    Tax incentives: As a result of the pioneer tax status granted by the Federal

    Governments Nigerian Investment Promotion Council (NIPC), Nestle has

    enjoyed a significant moderation in its tax rate, which has fallen to ~13% in

    the last two years (vs. an average of ~30% prior to 2011). This follows the

    expansion and completion of the companys Agbara and Flowergate factories

    in FY 2011. The lower tax rate has boosted net margin within the period.

    Trend in Net Margin and Effective Tax rate

    Investment in capacity expansion: In the last decade, Nestle has

    invested over N100 billion in capacity expansion, well ahead of peers, in its

    bid to meet growing demand. Major completed investments include new

    production lines (to increase capacity across the companys flagship

    products), the commissioning of the Flowergate factory, the completion of a

    malt plant as well as an independent tri-generation power plant in the

    companys Agbara factory, which cost N3.6 billion.

    0.00%

    5.00%

    10.00%

    15.00%

    20.00%

    25.00%

    30.00%

    35.00%

    0.00%

    2.00%

    4.00%

    6.00%

    8.00%

    10.00%

    12.00%

    14.00%

    16.00%

    18.00%

    20.00%

    2008 2009 2010 2011 2012 2013

    Net Margin Effective Tax rate (RHS)

    In the last decade,

    Nestle has invested

    over N100 billion in

    capacity expansion,

    well ahead of peers

  • 14

    In our view, investment in the new power plant is especially important as it

    reduced the companys dependence on energy from the national grid,

    thereby increasing overall energy efficiency and reliability. The recent surge

    in capital expenditure commenced in 2009 (with a total investment spend

    ~3x that of 2008) and increased further over the following two years.

    Consequently, operating free cash flow (OFCF) was negative in 2009 and

    2010. However, operating cash-flows remained strong, leading to a reversal

    in OFCF in 2011 and 2012, despite an additional total capex outflow of ~N30

    billion in both years. We expect OFCF to remain strong going forward.

    We believe that the company will be close to the end of its major spending

    programme, once the Abuja factory is completed. Nevertheless, we do not

    expect capex to fall to pre-2009 levels (of ~N4 billion annually) as we

    believe that management will continue to invest in strategic ventures to keep

    the business at the forefront in the sector.

    94,300

    -1,120

    1,721 2,101

    19,047 28,186

    0.00

    2.00

    4.00

    6.00

    8.00

    10.00

    12.00

    14.00

    16.00

    18.00

    20.00

    -30,000

    -10,000

    10,000

    30,000

    50,000

    70,000

    90,000

    110,000

    2008 2009 2010 2011 2012 2013

    Th

    ou

    san

    ds

    Trend in OFCF and CAPEX

    OFCF CAPEX (RHS)

  • 15

    100% 93%

    102%

    67%

    85%

    66%

    50% 47%

    85%

    0%

    20%

    40%

    60%

    80%

    100%

    120%

    2005 2006 2007 2008 2009 2010 2011 2012 2013

    Source: Company Filings, Greenwich Research

    Trend in Dividend Payout Ratio

    Net Income Dividend Pay Out Ratio

    Expansion plans drive debt and lower dividends

    Nestl's balance sheet shows that, prior to 2008, the company was fully

    equity financed. Since then, Nestls debt to total capital has hovered

    between 40% - 60%, with bulk of the debt financing (> 75%) obtained from

    the parent Nestle SA.

    Nestle maintained close to 100% dividend pay-out policy until 2008, where a

    change in strategy engendered investments in capacity expansion. Over the

    last four years, the dividend pay-out ratio has averaged 62%. We expect the

    company to increase pay-out in the near term, as the construction of Abuja

    factory nears its completion.

    0

    20

    40

    60

    80

    100

    120

    140

    160

    180

    200

    -

    500

    1,000

    1,500

    2,000

    2,500

    3,000

    3,500

    4,000

    2008 2009 2010 2011 2012 2013

    Source: Company Filings, Greenwich Research

    Nestle - Debt Coverage

    Interest Cover (x) RHS Interest Expense

  • 16

    REVIEW OF NESTLE FULL YEAR 2013 RESULTS

    Revenue growth slows

    Nestle Nigeria recently released its FY-13 results, reporting revenue and net

    profit of N133.1 billion and N22.3 billion respectively, representing a 14.0%

    and 5.3% rise from the comparable period in 2012. Q4-13 revenue rose by

    ~14% q/q (19% y/y) to N37.7 billion. Management proposed a final dividend

    of N24.00, which brings the total dividend for FY-13 to N25.50, a rise of

    ~28% from the prior year.

    Further analysis revealed that input cost pressures weighed on the Q4-13

    cost of sales, which surged 32% y/y (24% q/q) to N22.6billion. The impact

    was however lower on the full year figures with the FY-13 COGS rising 15%

    y/y to N76.3 billion, ~300 bps below the 3-year trailing average.

    At 42.7%, the FY-13 gross margin was 30 bps lower than the previous year

    and 200 bps below Nestls five year historical average. In our view, this was

    partly due to the slower than expected top-line growth, which expanded at

    its weakest pace in four years. We believe the slow growth in top-line was

    due to negative consumer reaction to a price increase in Nestls Maggi line

    in H1-13.

    Nevertheless, top-line performance improved somewhat in H2-13, as the

    company rolled back some of its pricing decisions and also benefited from

    stronger volume sales in its Milo line, following more aggressive pricing of its

    main rival Bournvita by Cadbury during the same period.

    As Higher Operating Expenses Crimp FY-13 Earnings

    Higher operating expenses y/y (admin costs up 13% to N6 billion, selling and

    distribution costs up ~22% to N19 billion), were driven by an increase in

    staff wages, a trend seen industry-wide in FY-13, as well as higher

    distribution spending stemming from the companys expansion into 2nd and

    3rd tier states under its new retail distributorship model (designed to protect

    market share, especially in the north).

    FY-13 and Q4-13

    revenues both rose

    ~14% to N133.1 billion

    and N37.7 billion

    respectively.

    Net profit for FY-13 was

    N22.3 billion, equating

    to a 5.3% increase y/y

    and resulting in an EPS

    of N28.10k

    (vs. N26.7 in FY-12).

    Slower than expected

    top-line growth and

    input cost pressures in

    Q4-13 drove FY-13

    gross margin to 47.2%,

    30bps lower than FY-12

  • 17

    As a result, the opex to sales ratio rose 100pbs to 21.8% (vs. 20.7% in

    FY-12) with the EBIT margin falling by a similar proportion to 20.9%. FY-13

    profit before tax came in at N26.0 billion, up ~4% y/y. For Q4-13 PBT

    declined 16% y/y (21% q/q) to N5.7 billion, despite a steep ~71% fall in

    finance costs to N185.5 million. Net profit for the year was N22.3 billion,

    equating to a 5.3% y/y increase and resulting in FY-13 EPS of N28.10k (vs.

    N26.7 in FY-12).

  • 18

    OUTLOOK FOR EARNINGS 2014 AND BEYOND

    Nestle Global has made a firm commitment to expansion in emerging

    markets which has been reflected in its Nigerian operations. Approximately

    20% revenue CAGR over the past six years, effectively doubling revenues

    once every three years, has been driven by continued investment in capacity

    expansion. Based on the high capex outlay in the last 3-4 years, together

    with the strengthening of the companys distribution network (designed to

    cater for increased market penetration), we believe the company still sees

    opportunities for volume expansion in Nigeria in the near to medium term, to

    be driven by expected strong consumer demand and favorable

    demographics.

    Nevertheless, as seen in the recent results, some pressure points have

    emerged. These include a slowdown in revenue growth, a sharp rise in

    operating expenses (driven predominantly by a rise in distribution spending),

    as well as the impact of a weakening domestic currency on input costs and

    interest payments on the companys long-term borrowings, a significant

    portion of which are dollar denominated.

    While we anticipate stiffer competition across our forecast horizon, on the

    back of a growing influx of packaged food manufacturers such as Tiger

    Brands and forward integration of existing food businesses by companies

    such as Flour Mills of Nigeria (all of which we expect to wield the same

    supply chain control that has proven an effective competitive advantage for

    Nestle) we believe that Nestls scale, pricing power and its better

    understanding of the domestic terrain will ensure that it maintains a leading

    market position.

    Based on the negative consumer reaction to product price increases by FMCG

    players in H1-13, which adversely impacted Nestls FY-13 revenues, our

    view is that the players that will deliver the most impressive top-line

    performance in the near to medium term are those able to adopt innovative

    strategies that will ensure higher volumes sales with minimal price

    increments.

    ~20% revenue CAGR

    over the past six years,

    effectively doubling

    revenues once every

    three years, has been

    driven by continued

    investment in capacity

    expansion.

    Slowdown in revenue

    growth, sharp rise in

    opex and impact of

    weakening currency on

    input costs are key

    pressure points from

    FY-13 results

    Despite stiffer

    competition on the

    horizon, we believe

    Nestls scale, pricing

    power and its better

    understanding of the

    domestic terrain will

    ensure it maintains a

    leading market position

  • 19

    We believe the ability to push volumes and achieve scale is strongly

    dependent on three main factors, namely; available capacity, depth and

    efficiency of distribution and appeal to diverse consumer classes.

    In our view, the themes that will likely unfold in the medium-term play to

    Nestls strengths, and drive our expectation of strong top-line growth across

    our forecast horizon. Furthermore, we expect recent pressure on consumer

    spending to ease after Nigerias 2015 elections, with the expected

    subsequent pick-up in spending supporting growth in Nestls top line. On

    this basis, we expect only a mild recovery in 2014 and expect revenues to

    grow ~15% (similar to FY-13 run rate), we however forecast 18% growth in

    revenue (CAGR) through to 2016, largely in line the companys five-year

    trailing average (pre FY-13).

    On the cost side, we expect to still see higher distribution spending, albeit at

    a lower rate than the FY-13 level. We therefore anticipate a mild progressive

    uptrend in operating expenses of ~100bps annually over the next 3-5 years,

    as a rise in administration and marketing expenses will mask savings from

    lower distribution spending relative to FY-13.

    We see scope for pressure on the domestic currency to persist in the near

    term. Nevertheless, barring domestic shocks to agricultural outputs relevant

    to Nestls business, we do not foresee that volatility in global commodity

    prices and the value of the domestic currency will materially affect the

    companys input costs going forward, as Nestle now sources ~75% of its

    input requirements locally.

    In addition, while a significant portion of Nestl's long-term debt is dollar

    denominated, we expect to see a reduction in the face value of its total long-

    term exposure over the next 2-3 years, as the company enters the final

    phase of its capacity expansion programme which in our opinion - is the

    reason for the inclusion of debt in its capital structure. Overall, the impact of

    a depreciating naira on Nestls numbers will likely not be as severe as it has

    been in the past and interest expense will likely continue to decline across

    our forecast horizon.

    The themes that will

    likely unfold in the

    medium-term play to

    Nestls strengths, and

    drive our expectation of

    strong top-line growth

    across our forecast

    horizon.

  • 20

    We expect operating free cashflow to increase significantly going forward, as

    the companys capex spend declines from the levels seen over the last four

    years. We deem it unlikely that a large and growing cash position will be left

    sitting on the companys books, and expect any surplus will be put to use by

    means of one or both of the following means:

    Repayment of long-term debt, ~75% of which was obtained from Nestle SA

    for the latest capacity expansion. Although significantly below domestic

    rates, we believe this borrowing exposes the company to a depreciating

    naira.

    The dividend payout ratio (currently at ~90% in FY-13) may also increase as

    it benefits from the increase in OFCF mostly from decline in capex.

  • 21

    VALUATION

    In valuing Nestle, we have employed a combination of discounted cash flow

    (DCF), dividend discount model (DDM) and relative valuation methodology

    (P/E).

    Table 3:DDM Summary 2014e 2015F 2016F 2017F

    Dividend Per Share 29.28 38.76 44.68 55.42

    Terminal Value 1455.51

    Present Value 29.28 38.76 44.68 55.42

    Implied Value per Share 939.83

    Table 2: DCF Valuation Parameters

    Risk Free Rate 13.8%

    Return on the Market 14.0%

    Beta 0.6

    Average Tax Rate 16%

    Terminal Growth Rate 10.3%

    Cost of Equity 14.52%

    Table 4: Peer Comparables

    Domestic Market Emerging Market

    2013 EPS FWRD EPS TRLN PE(x) FWRD PE(x) 2013 EPS FWRD EPS TRLN PE(x) FWRD PE(x)

    Nestle 28.10 30.96 36.70 33.60 Nestle 28.10 30.96 36.70 33.60

    Unilever 1.48 1.54 42.10 39.70 T.Brands 16.24 17.59 16.83 15.66

    Cadbury 1.10 1.58 36.50 36.00 Spar 6.97 7.17 16.73 15.86

    PZ 1.23 1.23 21.40 32.10 Savola 3.37 3.68 19.86 18.22

    Guinness 9.95 6.76 28.20 36.40 AVI 3.41 3.67 15.55 15.45

    NB 5.03 5.81 26.40 29.60 Almarai 2.50 2.94 25.06 21.33

    Flour mills 2.91 6.09 28.80 13.70

    Peer AVG. 30.57 31.25 Peer AVG. 30.57 31.25

  • 22

    For the DCF and DDM valuation methodologies, details of the relevant

    parameters are given in Tables 2 and 3 above, which results in a 12 month

    target (TP) of N1,355.45 and N1272.40 per share respectively. Our DDM

    assumptions factor in expectations of dividend payout from 2014 forward.

    While the payout has declined from historical levels, especially during a

    period of high capex outlays (FY-09 till FY-12), we anticipate dividend payout

    will return to near historical levels as the company is set to complete its

    capex investment cycle in the near term.

    The average trailing and forward P/E for local food producers (excluding

    Nestle) is 30.6x and 31.3x respectively. At 36.7x, Nestle currently trades at

    a premium to its local peers, a premium we however believe is justified. Our

    P/E relative valuation (based on a domestic peer simple average) implies a

    12 month TP of N822.68 per share for Nestle.

    A blend of our three valuation methodologies result in a final 12 month TP of

    N1,215.67, just ~9% above the current trading price of N1,111.00.

    Consequently, we place a HOLD rating on Nestle Nigeria.

    Conclusion

    In our view, Nestls valuation reflects its commitment to product quality and

    innovation, the benefits from recent capacity expansion and deeper country

    coverage through its powerful distribution, our expectations of a rise in

    consumer disposable income post 2015 elections and Nestls marketing

    capabilities. While competition will likely be more intense going forward, we

    believe the company is well positioned to take advantage of growth

    opportunities that will emerge in the near to medium term, as the Nigerian

    growth story continues to unfold.

  • 23

    P&L (Mn) 2013 2014e 2015F 2016F

    Turnover 133,084 151,716 179,025 211,249

    COGS (76,298) (83,444) (98,464) (116,187)

    Gross Profit 56,786 68,272 80,561 110,737

    Operating Costs (28,953) (32,138) (35,673) (39,597)

    Operating Profit 27,833 36,134 44,888 71,140

    Profit Before Taxation 26,048 34,016 42,303 68,080

    Taxation (3,789) (6,293) (7,811) (13,667)

    Profit After Taxation 22,259 27,723 34,492 54,413

    Bal Sheet(Mn)

    Fixed Assets 70,621 78,227 84,344 92,807

    Stocks 9,854 11,319 13,922 15,403

    Trade Debtors 17,885 18,110 22,276 24,528

    Total Assets 108,207 122,852 142,337 177,579

    Trade Creditors 16,256 13,863 17,174 20,907

    Total Liabilities 67,613 138,306 144,900 144,067

    Net Assets 40,595 51,133 58,815 72,817

    Key Ratios

    Gross Margin 42.67% 45.00% 45.00% 52.42%

    Operating Margin 20.91% 23.82% 23.07% 33.68%

    Net Margin 16.73% 18.27% 19.27% 25.76%

    Return on Assets 13.62% 14.02% 15.13% 13.99%

    Return on Equity 33.53% 33.69% 36.61% 36.13%

    Capex/depreciation (x) 0.83 0.98 1.18 1.03

    Current ratio (x) 1.44 1.68 1.81 1.85

    Quick ratio (x) 1.14 1.37 1.50 1.55

    Cash Convetrsatino Cycle 31.37 27.79 26.98 26.52

  • 24

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    least 20 percent;

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