Nestlé (OTCPK:NSRGY) (OTCPK:NSRGF) recently announced its Q3-2023 sales, which fell below expectations as the company continued to experience negative internal growth and a moderation in pricing. As a result, I am downgrading Nestlé to a Hold, awaiting more certainty surrounding its margins and volume acceleration.

Underperformance Year-To-Date

Since I began covering Nestlé in February, the stock has underperformed compared to the S&P 500 by 10 percentage points. This can be attributed to the overall disfavor towards the consumer staples sector, as the tech industry experiences a major rally and concerns arise about a potential decrease in global food consumption. However, some staples companies, including Nestlé, now offer more sensible valuations, creating potential investment opportunities.

Analyzing Nestlé’s third-quarter numbers, we can see that the company’s reported sales decreased by 4.4% to CHF 22.5 billion. On a constant currency basis, nine-month revenues grew by 7.0%, with organic growth at 7.8%. However, real internal growth (RIG) declined by 0.6%, offsetting the positive price contribution. The growth was broad-based across categories, with PetCare and Confectionary leading the way. However, there has been a notable deceleration in growth in these categories as Nestlé’s pricing actions moderate.

Mediocre 9M-2023 Highlights

While Nestlé’s results are lackluster, we cannot overlook the impact of foreign exchange headwinds and ongoing supply constraints. These factors contribute to the company’s inability to significantly improve its margins and reported sales, which ultimately drive stock performance.

Looking at Nestlé’s reported segments, Latin America continues to lead growth, while the worst currency impact was felt in Zone AOA and Zone Greater China. Although the company’s Health Science division only accounts for a small portion of total sales, there is potential for high single-digit growth and a significant margin improvement. Management has reaffirmed its 2023 guidance, but it should be taken with caution as there is a significant difference between reported and adjusted financials.

Evaluation and Conclusion

When evaluating Nestlé’s valuation, we find that the company is trading at a similar level to the staples index (XLP), with a P/E ratio of 22.0x over 2023 consensus GAAP EPS estimates. Considering Nestlé’s size and limited growth potential, it is challenging to identify an attractive investment opportunity. Based on my long-term financial model, I estimate a fair value of CHF 104 per share, reflecting a modest 5% upside.

While Nestlé’s steady and slow-growing operations provide stability and consistent dividend payments, they struggle to offset the drag of higher rates. Despite the company’s efforts to optimize its portfolio and address supply chain constraints, the improvements may not be enough to generate market-beating returns given the current valuation. Therefore, I am downgrading Nestlé to a Hold.

Please note that this article discusses securities that do not trade on a major U.S. exchange, and it is essential to be aware of the associated risks.