Nestlé Is One Stock You Should Own Forever

| About: Nestle S.A. (NSRGY)

Summary

In a recent article on L'Oréal, I made the case that it was a perfect buy-and-hold candidate. Nestlé is firmly in that category alongside it.

Nestlé's brands span the globe, and give it a fortress like moat around the underlying business.

Currency fluctuations continue to have an effect on the accounting numbers, but operationally, the company remains solid.

As I commented in a recent piece on L'Oréal, the European 'aristocrat' stocks understandably tend to get slightly less coverage on Seeking Alpha compared to analogous peers based in the U.S. Okay, unlike L'Oréal, technically, Nestlé (OTCPK:NSRGY) isn't actually an aristocrat (it did have a dividend freeze back in 1994); however, given its general history of superb dividend growth, it almost certainly qualifies for honorary membership. Leaving aside the respective differences in dividend history and it's clear that Nestlé, like L'Oréal, is very much a SWAN-type stock. For me, they are both core portfolio positions, and though Nestlé will certainly get less coverage than consumer staples like Procter & Gamble (NYSE: PG) and Unilever (NYSE: UL), the buy-and-hold case for the company today is arguably just as strong.

Nestlé: The global moat

On a revenue basis, Nestlé is the largest food and beverage company on the planet. To put that into some context, its sales are somewhere in the region of 2x Coca-Cola (NYSE: KO) or 1.4x Procter & Gamble. In other words, it is absolutely huge. And when you combine that with how stable the underlying business is (doesn't get much more stable than food and drink), then it's already well on the way to moat territory.

One of the key points though regarding this industry is the branding. I mentioned in this piece on Hershey (NYSE: HSY) that establishing and maintaining market share ultimately comes down to branding power (see here). It's one of the reasons why Hershey will dominate the U.S. chocolate market (in terms of revenues and profits), but will find it hard to get a toe into other markets and generate the same levels of profitability. The great thing about Nestlé is that it has an enormous stable of brands, and one which puts the company on a truly global scale.

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(Source: Nestlé Annual Report 2015)

This is just a narrow selection of brands, although it showcases the point quite well. Nestea, for example, is extremely common in mainland Europe. Anyone in the U.K. over the age of about five will recognize the iconic KitKat chocolate bar. Perrier is a well-known sparkling water internationally. Nescafé I'd imagine is also pretty much universally recognised, and so on. I'm actually sitting next to a bottle of Nestlé-branded still water as I type. The company's products are literally everywhere.

The point about having a stable of brands that span a global level means that the wide moat aspect of the company also applies on a global basis. You can see this very clearly when you delve into the company's financial reports, and thankfully, the company is pretty detailed when it comes to breaking down its figures. The regional breakdown of operating margins is particularly revealing in this sense.

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(Source: Nestlé Annual Report 2015)

Note that operating margins are very stable, not to mention quite high, across all the major geographic zones (which the company divide into three huge groups). Likewise, if you compare the figures to 2010, for example, the trend is pretty much exactly the same. This is down to the fact, and it's a great thing about the food and beverage sector in general, that disruption is incredibly difficult to achieve. Any new entrant wanting to muscle in on market share has to compete with the big two competitive advantages: branding power and economies of scale. As I said in the Hershey article, this is why the U.S. confectionery market is dominated by companies that are, in corporate terms, very old. Apply that on a global scale across multiple product markets and you have Nestlé.

In other words, the underlying business is extremely secure, diversified, and more importantly, very profitable on a global level. It doesn't get a whole lot safer than that really. Operating margins across a five-year period have barely moved - again, rock-like stability in terms of how profitable the underlying business is.

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It looks like a silly graph, but as a stock that many investors (hopefully me included) will never sell, shareholders will appreciate how predictable the profitability is here.

Nestlé: A story of dividends

If there is a graph that captures just how shareholder friendly and profitable this company is, then it's the long-term graph of its distributions. Luckily, the company provide all of the dividend data going back to the late 1950s. For those who enjoy its dividends, needless to say that the record at Nestlé is truly outstanding.

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(Data source: Nestlé)

It doesn't quite boast the perfect record of a few of the aristocrats such as Johnson & Johnson (NYSE: JNJ), Procter & Gamble or Coca-Cola, but it's one notch below perfection for income investors or those who like investing in dividend growth stocks. Recently, the company has been increasing its distribution in line with the historical average, which, given some of the issues facing the company (such as the strong Swiss franc), has resulted in the current pay-out ratio expanding up towards the 70% mark on an EPS basis (based on underlying earnings per share).

On any reasonable timeframe though, the company has been, and will continue to be, a dividend champion. The nature of the underlying business means that plenty of cash gets returned to shareholders via distributions and stock buybacks. Consider the investor buying the stock a decade ago when the split-adjusted share price at the time was around 40 CHF. Now, ten years later, he or she would have already collected 17.71 CHF in dividends and a princely return on the capital of 75%. In addition, the share count has been reduced by approximately 20% during that time frame, which of course means a greater percentage of the underlying business going into long-term shareholders' hands.

Note: Withholding Taxes

Whilst the current yield is above the 3% mark, foreign-based investors (which will represent the majority since the company is based in Switzerland) will also face the Swiss withholding rate of 35%. Many jurisdictions (including the U.S.) have tax treaties in place which will lower this rate down to 15%, which obviously makes a huge difference. The effect of the withholding tax really depends on where you are based and in what manner you hold your shares.

U.S.-based investors will mostly hold shares via the ADRs, either directly or, more likely, via a nominated broker. In the latter case, getting the correct paperwork and being marked for the reduced rate really depends on which broker you are using (in some cases, they may not be able to handle it at all). For those with shares directly registered with the custodian, obtaining the reduced rate is a matter of filling in and sending off the correct form. As a U.K.-based investor with shares held from the primary listing on the Swiss Market Index, I can fully sympathize with the situation! Unfortunately, though, the process for getting that tax rate down will really depend on each investor's situation, and may even depend entirely on your broker.

Nestlé: Current Performance, Outlook and Value

Turning to the here and now, and it's impossible to really look at Nestlé's recent performance without taking into account the massive effect of currency fluctuations. Usually, I think it pays to be agnostic about exchange rate changes, and with Nestlé, it certainly doesn't change the operational performance of the business. It does, however, have a monstrous effect on an accounting basis. To get a feel for that, here are Nestlé's sales by country for FY 2015 compared to FY 2014:

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(Source: Nestlé Annual Report 2015)

The cumulative effect was a currency headwind that amounted to -7.4% in CHF terms. That is to say that organic growth was still positive, coming in at 4.2% for 2015, but the currency issue continues to have a big impact on the accounting numbers. Underlying EPS was actually up 6.5% on a constant currency basis, and after taking into account various one-offs, such as the sale of part of the L'Oréal holdings in 2014 - which partly explains why basic earnings per share were down around 35% on 2014 (2.90 CHF in 2015 against 4.54 CHF in 2014).

This is why I mentioned Nestlé in the same terms as L'Oréal at the beginning. The two companies have a very close working relationship, which is partly why I see both of them as very attractive long-term investments. The two companies will remain long-term partners (Nestlé still owns a huge chunk of L'Oréal after all) which means Nestlé will continue to benefit from owning a large part of one of the best businesses on the planet; one that will continue to grow in value. The move to sell a portion of the stake in return for Galderma (a producer of skin treatments) also signifies Nestlé moving more towards health type products. As a long-term catalyst, this can only be viewed as attractive, especially with management's excellent track record of allocating capital. Combine that with the obvious bread and butter food business and the future looks the same as it always has been: solid.

Going back to the accounting headwinds - what should investors take away from the obvious foreign exchange effects? Ultimately, if you're long-term orientated, I think the key point here is that, although the effects on an accounting basis can't be avoided, the underlying business remains exceptionally strong on an operational basis. In the long-run, that's the most important thing.

Currently, the shares are trading at about 24 times reported earnings, and 21 times underlying earnings once you factor in the one-off items mentioned above. That's certainly at the high end of the five-year average valuation in terms of earnings, but if you're looking long term, then not many stocks will come better than this. For income investors a 3% yield in a world of stagnant, low interest rates is quite attractive too. Ultimately though, and just like L'Oréal, Nestlé is very much a buy the dips and hold forever type stock.

Disclosure: I am/we are long NSRGY.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Editor's Note: This article discusses one or more securities that do not trade on a major U.S. exchange. Please be aware of the risks associated with these stocks.