Rich valuations, competition limit upside

While June quarter could see volume-led growth, any reversal in softening of input costs could dent margins.

High inflation, a rising interest rate environment and risk to earnings of the broader indices have led investors to fall back on defensive sectors such as fast moving consumer goods (FMCG). The FMCG index has outperformed the Sensex in the past six to eight quarters, trading at peak valuations of 26.3 times 2011-12 earnings estimates (versus a historical average of 22.6 times). It commands a huge premium of 85 per cent over the Sensex versus 53 per cent historically.

Standard Chartered FMCG analysts Sanjay Singh and Pratik Biyani believe valuations in this space are high across the board and recommend stocks with potential earnings surprises (Titan, Hindustan Unilever, Britannia). While strong consumption boosted 2010-11 growth for the sector, continuing higher inflation could dampen the demand, believe analysts. Also, higher visibility on earnings of the broader markets could lead to a correction in valuations of the FMCG index over the next 12 months.

While the sector is expected to do well, driven by a mid-teens growth in consumption (including rural demand), rising income levels and low penetration levels, volatile input costs and growing competitive intensity are major risks. To boost revenue, FMCG companies are venturing into low-penetrated, high growth categories. HUL’s entry into the food segment and Colgate’s new launch in the oral care sensitive segment are examples. Companies are also stepping up presence abroad, to attain size and reduce dependency on domestic markets.

Competition is expected to intensify across categories in this sector. Niche segments like noodles and fruit juices could see more competition, thereby limiting pricing power of major players. ITC is most protected from competition in its cigarettes business, owing to high entry barriers and restrictions on advertising. Further, experts believe, low penetration categories like food and skin care have higher growth potential vis-a-vis more mature categories such as detergents, soaps and tea. Thus, players like Nestle (foods) and Marico (foods and personal care products) are better placed to capture these growth avenues. HUL and Colgate, on the other hand, are exposed to well-penetrated product categories.
 

RICH VALUATIONS
	P/E (x)	ROE (%)	Sales (Rs cr)	OPM (%)
Asian Paints	31.0	39.6	9,092	17.0
Britannia	31.0	37.8	5,014	5.8
Colgate	29.1	113.9	2,564	20.1
Dabur	26.9	46.7	5,268	19.1
GlaxoSmith Consumer*	29.7	32.6	2,723	16.4
Godrej Consumer	24.2	35.1	4,196	19.5
HUL	29.4	74.8	21,840	13.4
ITC	27.0	32.7	24,706	34.0
Marico	31.5	30.8	3,431	13.7
Nestle*	40.6	91.1	7,277	20.1
Figures are FY12 estimates;  * Dec yr-end                                       (x): Multiple  Source: Analyst reports

Colgate is likely to reel under the whammy of overall cost base, tax expenses and a potential price war in the oral care space due to the entry of FMCG giant Procter & Gamble in this segment. Though acquisitions will drive top line growth for Dabur and Jyothy Labs, the higher interest costs and losses of Henkel India will impact Jyothy Labs’ profitability. While top line is likely to be driven by volume growth, profitability will be decided by the movement of input costs.

INPUT RELIEF
After denting margins of major FMCG companies last year, the prices of key raw materials have started coming down. Softening palm oil prices and high inventory levels will address the supply concerns for this key input for soaps. Further, correction in crude oil prices and good supply of soy oil will likely push palm oil prices further down. HUL and Godrej Consumer Products will gain the most from this, as soaps form 20 per cent of their overall sales pie.

Further, lower prices of other agri-linked products (copra, tobacco) will enable FMCG players to reduce prices (and push up volume growth). Says Edelweiss Securities analyst Abneesh Roy, “FMCG companies will continue to focus on volume growth, rather than margins. However, recent softening of key raw materials will aid margin growth and provide head room for price reduction which should prop up volume growth.” The softening of raw material prices will also offset the impact of rising freight cost due to higher diesel prices. Also, any further fall in crude oil prices will likely benefit all FMCG players. While most companies have been taking calibrated price rises, they are also trimming advertising spends to combat input cost inflation.

For the quarter-ended June, FMCG companies are expected to post robust results, driven by volume growth. The revenue and net profit for the sector as a whole are expected to grow 19.8 per cent and 17 per cent, respectively, over the same quarter of 2010-11. Though input prices (crude oil-linked, palm oil, mentha oil) corrected in the June quarter, the full impact will be visible only in the September one. Going forward, the dual benefits of price rises and softening input prices would improve operating margins of most companies.