NOMD - Nomad Foods Continues To Trade At Fair Value

2023-12-14 17:43:44 ET

Summary

• Sales are increasing due to price increases, and gross margins are not falling anymore.
• SG&A expenses as a percentage of revenue are rising again to recover market share. This is important to recover the brand.
• Operating income is still following revenue trends, while net interest income was higher than expected.
• I believe the company shows its resiliency and the quality of its brands, but continues to trade at a low multiple of current earnings.
• NOMD is a fair value bet between a regular and a recessionary mid-term future in Europe.

Nomad Foods ( NOMD ) is one of the leaders in frozen food products in the European Union and the UK.

The company's brands command an upper 30% market share in several European markets in the fish and vegetables category, and its products are premium priced as much as 20%.

Last year in October, I recommended NOMD on the idea that the company was selling at a relatively fair multiple of earnings, given the quality of its brand portfolio. The article contains a more detailed explanation of the business, and its history.

This year, NOMD has performed according to expectations. Margins have been recovered, although volumes have suffered, and the company's interest expenses have climbed.

I believe the situation is similar to last year regarding macro risks (Europe could enter a recession) but now offset by a clearer and more positive financing picture.

NOMD's management has stated that it plans to deploy capital into share buybacks and dividends. I believe this is conservative for a company in a mature market.

With a current P/E of 11x and an EV/NOPAT multiple of 14x, I believe the company's shares remain fairly valued (considering both positive and negative mid-term scenarios). The company's brands provide security to its operations, and the buybacks + dividends strategy can provide a return to shareholders.

I believe NOMD is a similar investment to Andina ( AKO.B ) of a mature, quality business trading at a relatively low valuation.

Operationally in line with expectations

Last year, I considered that if things went well for NOMD, the company would generate above EUR 200 million in net income in FY23. Well meant some form of revenue and margins recovery, or at least not a deterioration.

During 9M23, NOMD managed to grow revenues around 8/9% YoY, driven mainly by price increases, offset by a decrease in volumes. In this sense, the company follows the European Union market, which shows a 4/5% decrease in real food and beverages consumption and a 6/9% increase in turnover (prices * quantities) . This is a 'positive' scenario from last year's perspective when a deleveraging in the US and the EU was expected to lead to a sudden decrease in consumption.

The main effect of raising prices and growing revenues is to arrest the fall in gross profit margins that had started in 2021 after many global commodities exploded in price. The company originally absorbed some of those cost increases but then decided to be more aggressive, mostly fueled by price increases from its private label competitors.

Promotions and brand

NOMD decided to increase promotional expenses by 1.5% of sales to 5% of sales. This explains an increase in total operating expenses as a percentage of revenues, and a consequent fall in operating margins.

I believe this responds to a 'post-stabilization' strategy by management. Prices were raised to keep gross margins from falling further and because private labels were not competitive.

But whereas input prices can fall, retail prices tend not to. This means there is now an opportunity to recover margins via lower input prices, while at the same time regaining market share via more aggressive promotions.

Investing in promotions is not necessarily more leveraged to a European recovery. On the contrary, it has to be done either in a recession or boom, and I would argue that even more so in the former than in the latter. To protect the brands, market shares have to be recovered. Otherwise, consumers can form different habits (like buying private labels). Last year, NOMD protected its share via lower gross margins, now, it is doing so more traditionally via promotions.

Higher but more visible financial costs

My forecast from last year was mistaken in one respect: interest costs. I extrapolated the then-current expenses into the future without considering the EUR 800M that would have matured in 2024, yielding a rock bottom 2.5%.

The company had to refinance that debt at much higher rates. The principal was rolled over but now yields SOFR + 3% ($700 million) and EURIBOR + 2.25% (EUR 130 million). This greatly increased the company's interest expenses.

On the positive, the company's debt maturities have been mostly pushed to 2028 and 2029, and rates seem to have peaked. This allows us to be more confident about the (potentially) ceiling interest expenses that the company will face in the future. Based on a SOFR of 5% and an EURIBOR of 4%, plus the remaining of NOMD's debt paying 2.5% fixed (EUR 800 million) and EURIBOR + 2.25% (EUR 500 million), we can expect interest expenses of about EUR 110 million.

Further, whereas last year we could expect higher rates in the future, we can now expect either similar rates if the economy continues to perform or lower rates if there is a recession. This means interest expenses now work as an offset to a deteriorating operational environment.

Quality and capital allocation

NOMD's brands are quality brands, and that can be seen through the company's adjusted ROCE. The unadjusted ROCE (operating income over assets below) is relatively low at less than 7%. It doesn't show brand power. However, 70% of the company's assets are goodwill and intangibles from its acquisitions, that is, brand and market power. If we adjusted assets to remove these (as would happen if NOMD's brands were organic), the ROCE would be 4 times higher, or above 25%.

The company acquired those assets at a 20x valuation, so ROCE was closer to 5% before 2021. As the acquisitions mature (and thanks, among other things, to inflation), the brand's value becomes more prominent on capital return metrics.

One way the company can use that brand power and higher ROCE is by returning capital to shareholders. A company with low returns on capital cannot do that because it has to continue reinvesting to keep growing. This is not true for NOMD because its capital requirements are low.

So NOMD has been repurchasing shares, has announced an authorization to purchase another EUR 500 million until 2026 (20% of its current market cap) and possibly establishing dividends next year (at an undisclosed yield or payout ratio).

Prospects and multiples

Back to the drawing board, the company generated, as of 3Q23, EUR 400 million in operating income. From these, we must remove EUR 110 million in interest and apply an average income tax rate of 25%.

If things stayed the same, we could expect a net income of EUR 217 million and NOPAT of EUR 300 million. This is compared with a market cap of EUR 2.5 billion and an EV of EUR 4.3 billion, yielding multiples of P/E 11x and EV/NOPAT of 14x.

These are the multiples today for a company that has a very high consistent adjusted ROCE, therefore very high earnings quality, generated by brand power, and with a financial future that is more stable than last year.

On the negative side of outcomes, Europe could have a deep recession next year. This leads to lower operating profits via lower sales or margins to protect market share.

However, we know that if there was a recession, rates would probably decline, and so would NOMD's interest expenses. Also, households could trade down from other forms of food (takeaway, eat-out, organic) into the more value category of frozen foods. Further, NOMD's operating income today almost quadruples its interest expenses, so the outcome of insolvency or a similar situation is very remote.

On the positive side, the economy could continue as is or even improve. In that case, NOMD could recover volumes and potentially even margins. Its brands provide space for organic growth in the frozen category via expansion to other food types (the company has mentioned pizza and poultry).

In my opinion, this represents fair value, and I am happy to own NOMD.

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