Why do I see Nestlé (M) Bhd as a good company but not a good investment?

I believe many of you are familiar with Nestlé (M) Bhd and you have most likely consumed its products ever since you were born. Just a little background of the company. Nestlé (M) Bhd was public-listed on Bursa Malaysia on Dec. 13, 1989. As of the time writing this, it employs more than 5000 employees and serves the markets with more than 300 Halal products in Malaysia. Its brand names such as MILO®, NESCAFÉ®, MAGGI®, NESPRAY® and KIT KAT® have become trusted household names and existed for generations. According to the latest available financial report of the company, it is principally owned by Nestlé S.A. - approximately 72% interests.

It has a wide range of products and many of them are consumed day in day out. For some people, they would feel uncomfortable not having Nestum, Milo or Nescafe every morning. Most kids nowadays would fall in love with KoKo Krunch and Honey Stars. Busy or lazy to cook? Eat Maggi Noodles! In short, Nestlé's brands are so well-known and most importantly, they taste really good!

It's really undeniable that Nestlé (M) Bhd has many superb products which have quitely blended into our daily lives without some of us even knowing. Of note, Nestlé S.A. is the largest food company as of writing this. As such, have you ever considered investing in this company? Keep reading and I will show you why you should or shouldn't invest.

The first step of value investing is always study the company's business model and think like an owner or a potential acquirer. Put it simply, a business model is the way a company does its business. According to Investopedia, business model can be defined as "The plan implemented by a company to generate revenue and make a profit from operations. The model includes the components and functions of the business, as well as the revenues it generates and the expenses it incurs".

Nestlé (M) Bhd has a simple business model. Firstly, it spends money on Research & Development to innovate existing products or create new ones. New or existing products then go into the manufacturing process. Next, the company distributes the products to its distributing channels which ultimately reach the end consumers. As you may wonder, this kind of business model is just ordinary and many food companies have no problem replicating that.

So what makes Nestlé special, as compared to other food businesses? Firstly, its diverse range of products allows us to have multiple choices. Usually, the higher the number of product types offered, the lower the quality of the product. Not only that Nestlé (M) Bhd is able to keep its quality, their products taste really nice to me as well. Famous brands like MILO®, NESCAFÉ®, MAGGI®, and KIT KAT® have won the trust of its customers and the consumption level is extremely sustainable. I shall expect its products remain attractive to many Malaysians in the future.

Secondly, let me ask you a question. When did you start eating the first Nestlé product, be it MILO®, NESCAFÉ®, MAGGI®, and KIT KAT®? For me, ever since I was born, I have been eating and drinking three out of four brands above - MILO®, MAGGI®, and KIT KAT®. I am not a fan of coffee, which is why I seldom drink NESCAFÉ®. So, have you noticed that these four products still look the same to you as compared to many years back? In short, Nestlé has been selling you the same products for so many years and the demand is still there!

Don't you feel wonderful? The same products have been serving you for so many years and they are expected to remain favourable in the years ahead. I hope I have somehow convince you into thinking is Nestlé (M) Bhd is really a good company, but it's not the end of this writing yet. Let's take a look at Coca-Cola, a Warren Buffett invested company in the United States. Ask yourself again, has Coca-Cola undergone any major changes in its products for the past 10 or 20 years? Obviously no, it has been selling the same products for so many years which is the key to its success.

Why do I say so? Relatively unchanged products paves way for predictable revenues and earnings. In our examples of Nestlé and Coca-Cola, you can safely expect the people to continue buying and paying them. However, this is not applicable to the technology and fashion industry which requires adequate level of change. Kodak, which is engaged in imaging products was hit by a change in technology into the current digital world. Same goes to Abercrombie & Fitch, its relatively same style of clothings have finally ended its glory days.

How often do you see Nestlé products being displayed in supermarkets, convenience stores, traditional grocery stores etc.? My third point is, Nestlé has extremely vast distribution networks in Malaysia. This is clearly a hard-to-destroy competitive advantage possessed by Nestlé. Such an 'economic moat' enables the company to market its products to each and everyone of us, putting them in front of our eyes, which ultimately leads to higher revenues and profits earned. From what I observe, it is extremely difficult for mediocre food brands to achieve this. You need know why does a convenience store choose to let Nestlé occupy a space in its shelf? With such diverse range of products, Nestlé definitely takes up a larger space as compared to its competitors. So what's left for the other brands, not counting there are so many mediocre brands out there. The store owner is highly unlikely to exclude Nestlé products due to its high demands and preference from customers.

Also, Nestlé has invested in its IT systems so as to replenish the inventory at a fast pace. Store owners need not worry too much about inventory shortages.

I think its enough for Nestlé's business model. Below I will show you how did Nestlé perform financially for the past 5 years.

Revenues and net profits have experienced upward trends. It is noteworthy that Nestlé has been facing headwinds in growing its revenues and net profits. However, one should bear in mind that as long as a company is able to generate long term upward trends in sales and profits, it is considered to have performed well. It is advisable not to put too much focus on sales and profits growth, instead, you should emphasize how efficient the company is, financially.

Operating cash flows and free cash flows are healthy as well. If you look further, Nestlé's operating cash flows are higher than its net profits, indicating its cash generating businesses. If you don't know what free cash flow is, it is a measure of how much cash a business generates after accounting for capital expenditures such as buildings or equipment. Positive and high free cash flows allow Nestlé to pay more dividends, executive share buybacks, expansions and other initiatives which are in favour of the shareholders.

What attracts me the most is Nestlé's historical return on equity. Return on equity has been surging continuously. However, one needs to check if return on equity is boosted by leveraging. Fortunately, Nestlé's debt-to-equity ratio was low as of Dec. 31, 2014.

On the other hand, net profit margins have stayed relatively stable in the range of 10-12%. Also, the management has been pretty generous in paying out dividends. On average, Nestlé has been paying out RM0.90 for each dollar earned. You can rarely find such consistent and high dividend payout company in Malaysia.

In reality, even the best companies could fail if not managed properly, despite having a wonderful track record. In the case of Nestlé, I can't seem to identify any substantial risks associated with it. However, there is one potential risk which I am quite concerned - directors' ownership in the company. Directors don't seem to have a substantial stake in Nestlé (M) Bhd. This might lead to the directors not maximizing their capabilities to enlarge the company's potentials since they only own negligible stake.

Nevertheless, Nestlé (M) Bhd is still a very good company for me. The final step, as a value investor, is to determine the intrinsic value of the company and compare it to the current market share price. If the intrinsic value is above the market price, a value investor calls it undervalued and vice versa. There are many ways to arrive at an intrinsic value estimation, nobody in this world, even Warren Buffett, could say that his estimation is completely accurate. Based on my valuation, Nestlé (M) Bhd is overvalued now.

You wouldn't want to invest when a company is overvalued because it will diminish your potential return. For instance, if you valued Nestlé (M) Bhd at RM60 but the current price is RM72, investing in this company will make you an imaginary loss of RM12 outright. On the other hand, if you valued Nestlé (M) Bhd to be at RM100, you know that you have picked up a bargain and you just need to wait patiently for the market to realize its value.

All in all, Nestlé (M) Bhd is a very good company for me, but not a good investment at the time of writing this article as I valued it to be lower than RM72. I, thereby, end this post with a quote from Warren Buffett - "Price is what you pay, value is what you get". Thanks for reading.

Source: Bloomberg

Note: This value pyramid only shows what I think about a company’s valuation as at the time of writing this particular article. Do bear in mind that when a stock is undervalued, it doesn’t mean it can’t go any lower and vice versa. Please exercise your own judgment and do not treat this as a recommendation to buy or sell.

If you wish to learn, in a more detailed manner, how do I analyze a company using my 5R Model and how do I calculate the intrinsic value of a company, please click here.

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