Issue: 2 | Report date: December 2009
There is no dearth of great companies. If only the prices
were right
It is a common perception that investing involves a
great deal of business insight, the ability to work
through complicated formulae and having the right
contacts. Very few would include the old virtues of
patience and independence in t he same list. But as
Warren Buffett has shown us time and time again,
they are perhaps the most important requirements in
becoming a value investor.
And now would be a good time to exercise those
traits. You see, we have been looking at several
companies in order to handpick the very best to form
a part of the V alue Pro port folio. Truth be told, there
are several we like. Tak e Castrol for example it has
such a strong brand name that it is able to increase
prices at will even though volumes hardly move and
generates extraordinary returns for investors. Or take
Hero Honda it is able to achieve amazing volume
growth by making very efficient use of capital. Or take
3M India its ability to innovat e products is the stuff of
legends. Now, these companies would sail through
Warren Buffetts investment principles that we have
identified and apply. All but one principle. The price.
Try as we might, we find it difficult to find a margin of
safety in the valuations for t hese companies. The
current markets are just too expensive to permit
such gem s to be reasonably priced. In this issue,
we present to you one of our very best picks. It does
exceeding well on the investment principles that
Warren Buffett discusses and applies. But it is not
the right time for us to recommend it to you just
yet.
A basket of mouthwatering brands
Imagine the food section of your local supermarket. It
is highly likely you will see the ubiquitous yellow
packets of instant noodles stacked all around. Youll
also see bottles of instant coffee, tea whiteners and
milk cartons in tetra packs. Now, walk up to the chilled
foods section. Among the prominent displays youll
find the packaged dahi. As you are checking out,
youll find packets of wafer chocolates.
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Most likely, you will find about 2-3 brands in each of
these items. One of them will be from a great foods
company called Nestle India (Nestle). One of Warren
Buffetts most important investment principles is that
the business must be easy to understand. It does not
take a genius to decipher that Nestle definit ely
qualifies on that count. Coming up are a number of
reasons why Nestle is almost a cinch to be a part of
every value investors portfolio provided the valuations
are right. Let us keep the discussion on valuations for
later. Let us first go through the companys strengths
and that too how Warren Buffett would view them.
Track record of high returns on capital
Here's what we're look ing forbusinesses earning
good returns on equity while employing little or no
debt. Warren Buffetts letter to shareholders, 1987
Nestle has been consistently generating ret urns on
equity well above 25% since the past 10 years. Over
the past 5 years, the company has posted returns of
around 90% on an average. Importantly, the rapid
increase in return on equity has not been fuelled by
debt. In fact, from CY03 onwards, the company has
utilised very little debt.
Nestle: Reaping the benefits of a strong franchise
120%
Return on equity
90%
60%
30%
0%
CY96 CY98 CY00 CY02 CY04 CY06 CY08
Note: CY = Calendar Year, being the accounting period for Nestle
Source: Company
The Nestle franchi se
There's not a lot new to report about these
businesses and that 's good, not bad. Severe
change and exceptional returns usually don't
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Issue : 2
mixE xperience indicat es that the best business
returns are usually achieved by companies that are
doing somet hing quite similar today to what they were
doing five or t en years ago. That is no argument for
managerial complacency. Businesses always have
opportunities to improve service, product lines,
manufacturing techniques, and the lik e, and obviously
these opportunities should be seized. But a business
that constantly encounters major change also
encounters many c hances for major error.
Furthermore, economic terrain that is forever shifting
violently is ground on which it is difficult to build a
fortress-lik e business franchise. Such a franchise is
usually the k ey to sustained high returns. Warren
Buffetts letter to shareholders, 1987.
The packaged food industry in India is highly
competitive with some very strong players in the fray.
However, you wont find any eart h shattering shifts in
the industry over the years that would disrupt the
pecking order a great deal. In such an industry
landscape, Nestle has gone about launching new
categories, line extensions, variants and stock
keeping units. It weeds out the unsuccessful ones and
concentrates on building the promising ones. In its
recently held analyst meet, Nestles management
said that a product i s launched only when at least
60% of the customers who participate in the test
marketing like the product.
As a result, the company has been able to build some
extraordinarily strong brands which have thrived over
the years. Nestle Indias parent, Nestle S.A. is the
worlds largest food company. Nestle India benefits
from the centralized research & development efforts of
its parent. Hence, it has a steady flow of new
products. Nestle India just concentrates on
localization of the product offering and the marketing
aspects. Its extraordinary return on equity is explained
by its franchise.
Generates a lot of capital
Almost by definition, a really good business
generates far more money (at least after its early
years) than it can use internally. -Warren Buffetts
letter to shareholders, 1994
During the decade from 1999 to 2008, Nestle
generated cash flows from operations to the tune of
Rs 39 bn. Thats Rs 3. 9 bn per year on an average.
The company has purchased fixed assets of only Rs
11 bn from 1999 to 2008. Hence, it would not be out
of place to say that the funds that the company
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Report date: December 2009
requires for capex for a decade are generated by
the company from internal accruals of just three
years! Contrast this with some capital intensive
industry where exactly opposite is the case. In such
industries, int ernal accruals for the entire decade
could go towards incurring capex for 2-3 years.
Nestle: Very little cash goes in, a lot comes out
8
6
Rs billion
Capex Operating cash flow
4
2
0
CY96 CY98 CY00 CY02 CY04 CY06 CY08
Source: Company
Either employ incremental amounts of capital
The best business to own is one that over an
extended period can employ large amounts of
incremental capital at very high rates of return. The
worst business to own is one that must, or will, do the
opposite - that is, consistently employ ever-greater
amounts of capital at very low rates of return.
Unfortunately, the first type of business is very hard to
find. Warren Buffetts letter to shareholders, 1992
Closely related to the fact that Nestle generates a high
return on capital, is the question of how much
incremental capital it is able to employ? The answer
is: not much. In CY96, the company had employed Rs
0.9 bn in the business. 11 years later, it employed a
higher capit al of Rs 1.7 bn in CY07 and Rs 2.5 bn in
CY08. And how have the profits done during the same
period? Spectacularly well, we believe. They have
witnessed a jump of 10 times. Now, here is a
company that ha s not only utilized more and more
capital but has also generated even greater
returns on it.
What has helped make this t rans formation possible is
the remarkable change in the companys working
capital, which has swung from Rs 2 bn in 1996 to a
negative Rs 4 bn in 2008. The company i s now in a
position to fund a portion of its operations from
current liabilities.
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Issue : 2
Nestle : Turning the table on working capital
12
Current Assets Current Liabilities
9 2.0
Rs billion
6 1.5
3 1.0
0
CY96 CY98 CY00 CY02
Source: Company
Overall, it is evident that Nestle has been extremely
productive on the incremental capital that it has used.
However, in its recently held analyst meet, Nestles
management has indicated that a large capital
expenditure is expected shortly in the processed
foods segment. But they have not revealed any further
details.
else pay it back to shareholders
Most high-return businesses need relatively little
capital. Shareholders of such a business usually will
benefit if it pays out most of its earnings in dividends
or mak es significant stock repurchas es. Warren
Buffetts letter to shareholders, 1992
While the capital employ ed by the company has
increased steadily over the years, it is still a small
portion of what the company is able to generate
internally. Good business sense suggests that the
company s hould ideally pay out what ever it is
generating in excess of its needs. It is doing just what
the doctor ordered. Of the Rs 30 bn free cash flow
that the company ha s generated from 1996 and
2008, it ha s paid out Rs 24 bn a s dividends. A
further example of Nestles shareholder friendly
dividend policy is the special dividend it paid in CY08.
The company decided to return the extra cash
rather than the same sitting idle on its books and
adding little value.
Low risk
the might of their brand names, the attributes of
their products, and t he strength of their distribution
systems give them an enormous competitive
advantage. - Warren Buffetts letter to shareholders,
1993
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Report date: December 2009
Nestle: Maintaining its brands over the years
Selling & distribution expenses
Rs billion
0.5
CY04 CY06 CY08
0.0
CY96 CY98 CY00 CY02 CY04 CY06 CY08
Source: Company
Nestle has several strong brand names. Many of them
are household names Cerelac, Everyday, Milkmaid,
Maggi, Nescafe, Munch, Polo, Kitkat, Milkybar etc.
And it works at maintaining it through advertising and
sales promotions. From 1996 to 2008, the company
has spent Rs 17 bn on adverti sing and sales
promotion activity. In its recently held analyst meet,
Nestles management indicated that the benefits of
the advertisement campaign during 2009 will spill over
Sto next year as it has tied to engage the consumer at
an emotion level.
The company also has a strong distribution system.
Its sales organization is structured on the lines of
mother sales branc hes with multiple regional sales
offices within each branch. This allows the company a
wide reach and coverage enabling it t o launch new
products efficiently. Over the years, Nestle has
introduced numerous new categories, line extensions
& variants and stock keeping units. It monitors their
progress for a few years, reviews the performance
and takes the decision of continuing, modifying or
discontinuing with them.
Stability in market share
A fast-changing industry environment may offer the
chance for huge wins, but it precludes the certainty we
seek . Warren Buffetts letter to shareholders, 1996
Many of Nestles products have dominated market
shares on a sustained basis. In terms of market share
by value, it is the No.1 in baby foods & infant formula,
dairy whitener, instant noodles, sauces, instant coffee,
wafers and white chocolates. It is the No. 2 in healthy
soups and clairs. It has a strong presence in
sweetened condensed milk and in out-of-home
beverages vending. It also has a good presence in
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Issue : 2
fresh dairy. Despite the strong competition in the
foods segment of the Indian FMCG sector, Nestle has
successfully defended its market shares over many
years.
Pricing power
Favored business must have t wo characteristics: (1)
an ability to increase prices rat her easily (even when
product demand is flat and capacity is not fully
utilized) without fear of significant loss of either mark et
share or unit volume - Warren Buffetts letter to
shareholders, 1981
An economic franchise arises from a product or
service that: (1) is needed or desired; (2) is thought by
its customers to have no close substitute and; (3) is
not subject to price regulation. The existence of all
three conditions will be demonstrated b y a company's
ability to regularly price its product or service
aggressively. - Warren B uffetts letter to
shareholders, 1991
Increase in realisations over the years
CY00 to CY08 CAGR
Milk products - Licenced 5%
Milk products - Others 4%
Beverages 4%
Prepared dishes 2%
Confectionery 2%
Note: CAGR Compounded annual growth rate
Source: Equitymaster Research
Nestle has a mixed track record in terms of pricing
power. It is able to increase prices over a period of
time as shown in the table. But the pricing power is
not spectacular. The company has introduced low
priced packs over the years in beverages, wafer
based c hocolat es, instant noodles and s oups making
it evident that the Indian foods market is highly price
sensitive. It was also one of the key takeaways from
the companys recent analyst meeting. The
management mentioned how Nestle raised the price
of a chocolate bar from Rs 2 to Rs 3 resulting in a
slowdown in volumes. It then had to bring down the
price point to the original price. Of lat e, the company
has been reducing package size to maintain price
points. However, once the package reduces to a
particular size Nestle may be forced to increase
prices. The company has not studied this scenario as
yet.
Hone st and able management
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Report date: December 2009
The certaint y with which management can be
evaluated, both as to its ability to realize the full
potential of the business and to wisely employ its cash
flowsThe certainty wit h which management c an be
counted on to channel the rewards from the business
to the shareholders rather than to itself Warren
Buffetts letter to shareholders, 1993
Switzerland based Nestle S.A. holds 62% in Nestle
India. The S wiss giant is the largest food company in
the world. The parent actively helps Nestle India to
realize the full potential of the business. Firstly, the
parent company can chose the top management for
Nestle India from its talent pool around the globe. For
example, the current chairman & managing director
Mr. Martial Gildas Rolland was appointed by Nestle
S.A. in 2004 after varied int ernational experience
including an earlier three years posting in India. His
predecessor, Mr. Carlo M. V. Donati joined the
executive board of Nestle S.A. after six years in India.
Secondly, Nestle India has access to the parents food
technology through a general licenc e agreement. The
Nestle group s pends close to 2 bn S wiss Francs
worldwide on research & development. Nestle India
needs to only concentrate on testing and modifying
products for Indian conditions. This explains why the
company is able to introduce products at such a rapid
pace. Finally, Nestle S.A. also helps in setting up
plants, improving processes in technical operations,
sales & marketing and product launches.
Amount in millions CY06 CY07
Nestle S.A. (Swiss Francs) 1,700 1,900
Nestle India (Rs) 124 134
Source: Company
There is also a great deal of certainty that the
management rewards its shareholders and not itself.
This is evident from the companys shareholder
friendly dividend policy referred to earlier.
And now, the valuations...
Having ascertained that Nestle India is really every
investors dream come true and one of the top
contenders for becoming a part of a portfolio that
Warren Buffett would love to own, let us have a look
whet her there is sufficient margin of s afety in the
companys current stock price and whether one
should invest in the stock at the current levels.
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Issue : 2 Report date: December 2009

The value investing framework

However, if a company has constantly growing

Mr. Market's quote Margin of safety earnings like Nestle does, the value of firm assuming
Stock price its earnings grow is:

Intrinsic value
Earnings Value
Book
power value Capital at the start X (Return on capital growth rate)
value from -----------------------------------------------------------------------
growth
(Cost of capital growth rate)

Source: Equitymaster Research

It is import ant to note three points. First, growth

Book value
creates value only when the additional returns
generated (return on incremental capital, ROC) is
The book value of Nestle as per its last available
greater than the cost of creating the growth (cost of
balance sheet as on 31st December, 2008 is Rs 4.7
capital, R). As long as the return on capital is greater
bn. With 96.4 m shares outstanding, the book
the cost of capital (ROC > R), any increase in growth
value per share is Rs 49. However, for a company
rate (G) makes the business more valuable. Secondly,
which earns such superb returns on capital, its
as the growth rate (G) approaches the cost of capital
intrinsic value is dri ven by its earning power. In
(R), mathematically the result becomes absurd.
other words, its ability to generate net profits.
Henc e, we can only take a growth rate which is lower
than the cost of capital (G<R). Thirdly, by
Earnings power value (EPV)
substituting numbers for ROC, R and G we find
that an investor can pay a maximum of 3X the EPV
Nestle posted a profit aft er tax of Rs 5.3 bn in CY 08. If
if the first two points are met.
Nestles earnings were to stagnate and remain at Rs
5.3 bn going forward, the most we would have been
Nestles return on capital is substantially higher than
willing to pay for the company is an earnings multiple
its cost of capital. It is also highly likely to post strong
of 12.5x. The reason we chose this number is
growth. Hence, we can pay the highest multiple i.e. 3X
because this would take the earnings yield to 8%
its EPV for Nestle. Hence, we would be willing to pay
(inverse of 12.5), similar to what one would expect
Rs 66.3 bn X 3 = Rs 199 bn. At the current stock price
from a 10-year Indian government bond. Hence,
of Rs 2,628, the c ompany is currently trading at Rs
applying a multiple of 12.5 to the companys
2,628*96. 4 = Rs 253s bn. Thus, at the current share
earnings, we get an earnings power value (EPV) of
price, there isnt sufficient margin of safety.
66.3 bn for the company.
John Burr Williams set forth the equation for value,
Value from growth
which we condense here: The value of any business
today is determined by the cash inflows and outflows -
It is evident from the earlier part of the report that
discounted at an appropriate interest rate - that can be
Nestle has a sustainable competitive advantage due
expected to occur during the remaining life of the
to which earnings growt h is almost certain. Hence the
asset. - Warren Buffetts letter to shareholders, 1992.
companys true value is definitely more than the one
that we got from the EPV method above. But by how
From CY 96 to CY 08, Nestle has paid out cash
much? We can derive a multiple of earning power with
dividends totaling Rs 24 bn. While the dividend paid in
growth/ earning power without growth (EPV) from the
the recent years is higher, it works out in the region of
following formulae:
Rs 2 bn per year on an average. We can use the
dividend discount formula for valuing Nestles future
The value of a firm based solely on the fact that its
dividends. The two variables are a) t he future growth
earnings stagnate or the current earning power (EPV)
in dividends and b) the appropriate interest rate.
is:
We feel confident in estimating intrinsic value
Capital at the start X (Return on capital / cost of capital) only when we employ a range of values, rather than

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Issue : 2 Report date: December 2009

some pseudo-precise figure. - Warren B uffetts letter are just too expensive to permit such gems to be
to shareholders, 1999 reasonably priced. Ne stle doe s exceeding well in
the investment principles that Warren Buffett
We have used a range of growth and interest rate discusse s and applies. But the price is not right at
figures to estimate the intrinsic value of Nestle based thi s time.
on the dividend discount formula. As can be seen
under a range of figures, the higher end of valuation is
reached at Rs 200 bn.
Value of business Share price
(Rs bn) (Rs)
Nestle: The range of intrinsic values (Rs bn)
Current 252 2,609
Cost of capital Fair Valuation 200 2,075
10 11 12
5% 6% 7% 8% 9% Buy at 2.25 X EPV 150 1,556
% % %
2% 67 50 40 33 29 25 22 20
3% 100 67 50 40 33 29 25 22 Performance of the previous recommendation
Growth

4% 200 100 67 50 40 33 29 25 In the inaugural issue of ValuePro, we had

5% NA 200 100 67 50 40 33 29 recommended NIIT Tech as our first stock of the
6% NA NA 200 100 67 50 40 33 ValuePro portfolio at Rs 136 per share. The stock is
currently trading at Rs 172, implying a return of 26%
7% NA NA NA 200 100 67 50 40
since our rec ommendation. During this period, there
8% NA NA NA NA 200 100 67 50 were a couple of news items on the company -
Source: Equitymaster Research pledging of share s by promoters, and the company
entering into a deal with Hitachi to offer cloud-
It should be noted t hat the value from growth computing services. While we had updated you on the
analysis that we performed on the companys first, we see the Hitachi deal as a long -term positive
earnings and t he dividend discount model are very for the company. We maintain our positive view on
similar to a DCF approach and hence, violates none the stock.
of the Warren Buffetts criteria of valuing a company.
Also, as promised to you while offering the V alueP ro
Conclusion service, we invested Rs 100,000 in NIIT Tech 10
An analyst can easily go wrong in estimating future trading sessions after our recommendation. Our cost
coupons. We insist on a margin of safet y in our price stands at Rs 144.5 per share.
purchase pric e. If we calculate the value of a
common stock to be only slightly higher than its price,
we're not interested in buying. - Warren Buffetts
letter to shareholders, 1992

A too-high purchase price for the stock of an

excellent company can undo the effects of a
subsequent decade of favorable business
developments. - Warren Buffetts letter to
shareholders, 1982

From both the valuation perspectives, the upper limit

of Nestles value is around Rs 200 bn, i.e. Rs 2,075
per share. However, a value investment must allow for
a margin of safety. As such we recommend you to
buy Ne stle within a range of Rs 1,550 per share to
Rs 1,600 per share. To reiterate, the current markets

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Issue : 2 Report date: December 2009

Annexure:

Shareholding(% ,Sep-09) Market Data

Category (%) Price on reco. date (Rs) 2,628
Promoters 61.9 52 week H/L 2,739 /1,335
Banks, FIs and MFs 10.2 NSE symbol NA
FIIs 9.7 BSE code 500790
Public 17.8 No. of shares (m) 96.4
Others 0.4 Face value (Rs) 10
Total 100.0 FY09 dividend/share (Rs) 42.5
Free float (%) 38.2%
Market cap (Rs m) 251,508
Avg. 52-week liquidity (No.of shares) 34,994
Price to sales* (times) 5.2
Price to earnings* (times) 37.9
*Based on trailing 12-month numbers

Financials at a glance
CY03 CY04 CY05 CY06 CY07 CY08
Key growth parameters
Sales (Rs m) 21,406 22,276 24,769 28,161 35,044 43,243
Sales growth NA 4.1% 11.2% 13.7% 24.4% 23.4%
Operating profit margin 20.8% 20.2% 21.1% 19.1% 19.9% 20.0%
Net profit (Rs m) 2,631 2,519 3,096 3,151 4,139 5,341
Net profit margin 12.3% 11.3% 12.5% 11.2% 11.8% 12.4%
Key qualitative ratios
Sales per share (Rs) 222.1 231.1 256.9 292.1 363.5 448.6
Earnings per share (Rs) 27.3 26.1 32.1 32.7 42.9 55.4
Debt/Equity ratio (Times) 0.0 0.0 0.0 0.0 0.0 0.0
Return on equity 78.5% 78.9% 87.4% 81.0% 98.9% 112.9%
Return on invested capital 52.7% 53.1% 52.9% 48.5% 50.9% 56.5%
Dividend payout 66.9% 93.8% 77.9% 78.0% 76.9% 76.7%
Source: Company, Equitymaster

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Issue : 2 Report date: December 2009

Important Notice: Equitymaster Agora Research Private Limited is an Independent Equity Research Company.

Disclosure: The author of this article does not hold shares in the recommended company. As on date of release of this
article, Equitymaster does not hold shares in the recommended company.

Equitymaster will invest Rs 1,00,000 in the recommended company 10 trading sessions after date of the recommendation in
line with the commitment made at the time of launching the ValuePro service.

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