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Food stocks - Are high PEs justified?

Sep 17, 2012

This is the first of a series of articles that analyzes some expensive stocks in specific sectors to understand if the valuations are justified.

There are two ways in which one can make money from investing in stocks. One is by way of dividends earned, and the other is appreciation of share prices. Stocks are valued on the basis of price to earnings multiples (PE or price to earnings ratio). Stocks with a higher PE are said to be relatively more expensive than their peers.

Why do stock prices go up? One reason of course is the fundamentals of the company - but this is not the only reason. At times, speculation and other factors also contribute to changes in stock prices.

We examine whether these high PE stocks deserve such high valuations based on their fundamentals, or have speculation or one off events driven these valuations up.

Specifically, in this article, we focus on consumer goods food companies. We shortlisted companies with a 10 year track record of profitability, and a return on equity of 10% in each of the past 10 years.

The companies with the highest PEs, (in descending PE order) are Sanwaria Agro Oils Ltd., Nestle India Limited and Glaxosmithkline Consumer Healthcare Ltd.

Key financial parameters for 3 highest PE companies
 Sanwaria Agro Oils Ltd.Nestle India LimitedGSK Consumer
TTM PE55.243.531.5
Average Profit Margins (in %)   
Operating Profit5.019.019.0
Net Profit2.712.011.0
RoE (in%)32.496.124.3
Average debt to equity (x)1.60.10.0
Average dividend payout (%)13.074.040.0
Average PE (x)22.032.020.0
Note: Numbers are for last 10 years except TTM PE.
TTM: Trailing Twelve Month

Let's look more closely at the reasons for the strong PEs for these companies.

Sanwaria Agro Oils is in the business of edible oils produced from soyabean and other minor oil seeds, and sold under the brand names of Sulabh, Narmada and Sanwaria. The company also produces soya lecithin and soyabean meals for cattle feed. Soyabean has many health benefits because of its ability to lower cholesterol levels, and prevent heart diseases, diabetes, osteoporosis and other illnesses. With these many benefits, soybean's global demand is also increasing.

This has helped Sanwaria post an average sales growth of 20% over ten years. However, sales and net profits have been very volatile, including showing a drop in one year. The company has very low operating margins ranging from 3% to 8%, and net profit margins have been even lower. The dividend payout ratio has also been disappointing at 10-13%. As a result, RoE has also been inconsistent over the years.

All this makes us wonder if the company's high multiple is based on fundamentals, and if yes, is the high PE justified?

Nestle India has the second highest PE.

We know that FMCG companies are considered to be relatively safer investment bets since their earnings do not fluctuate too much with changes in the economy. Of late, with a rise in disposable incomes of rural Indians, the FMCG companies have been doing very well.

This gives Nestle a distinct advantage because of its brand equity, wide range of products from milk and milk products to coffee to noodles, and wide distribution network. The company's earnings have increased during the past few years. Operating margins and net profit margins have been consistent at 19% and 12% over the same period. Further, the company's average dividend payout of has been around 74% in the last decade. Continuously rising net profits have increased shareholder wealth with RoE averaging more than 95%. These fundamentals and results have improved investor confidence and thus the hike in stock prices and high PE multiples.

Glaxosmithkline is in the fast growing segment of malt beverages with a 70% share in volume terms. Its products include Horlicks, Boost, Viva and Maltova. There has been increased awareness of healthcare in the country, and this has higher sales of health drinks which now contribute to 85% of the company's total revenues. Net sales have grown robustly by12-15% over last 10 years and dividend payout has been 40% on an average. Operating and net profit margins are averaging 19% and 11% respectively. In terms of other financials, the company's debt levels have always remained at comfortable levels. Despite stiff competition from other players such as Bournvita (Cadbury), Complan (Heinz) and Milo (Nestle), GSK Consumer has been able to maintain its leadership position. The company's high PE seems to be because of the scope of malted beverages in a growing Indian economy, and the company's proven sound fundamental performance over the years.

Conclusion

We believe that, based on the company's fundamentals, Sanwaria Agro Oils's high PE of 55 is not justified. For the other two companies, Nestle and GSK Consumer, even though the fundamentals are good, their current PE multiples of 43 times and 32 times are far higher than their historical (10 year average ) PE of 32 times and 20 times respectively. It is possible that due to uncertain economic conditions, investors have in fear moved to these two "defensive" stocks and so raised their PE multiples to unreasonable levels.

Investors should dig deeper to understand the causes for company valuations being high, and carefully evaluate whether the PEs warrant investing in or not.

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