FMCG valuations may come off

High valuations are not pricing in risk of margin pressures and competitive intensity.

In good times and bad, private consumption has held strong. And, robust demand for consumer staples and durables revived investors’ interest in these stocks in the first quarter of FY12, despite mounting pressures on cost. As a result, stock prices of most consumer companies have rallied in recent months. Over the next two years, analysts expect the sector to clock a compounded annual growth rate (CAGR) of 15 per cent. However, this growth will mostly be volume-led and rising input costs will continue to put pressure on margins.

According to Credit Suisse, the sector has seen a re-rating (from 23x to 29x) over the last year, led by healthy consumption trends and, more important, led by continued weakness in investment sectors. However, revenue growth, margins and return on equity appear to be peaking. High valuations are not pricing in the risk of margin pressures, led by high input costs. Competitive intensity will also impact the pricing power of companies, as players will not be able to pass on the entire cost-push to consumers. In categories where the pass-through is complete, volumes could suffer.

While competitive pressures and high valuations are a concern to some, others believe growth in volumes will not be as high in FY12 as it has been over the last two years. Rural demand accounts for one-third of total FMCG volumes and rural sales this year have been growing 150-200 basis points higher than urban FMCG growth. A segment of analysts believe rural demand will not be as strong this year as farm income will be flattish, thanks to last year’s bumper crop and lower realisations this year. Also, flattening government spends on NREGA and other rural benefit schemes could impact rural demand to some extent.

What can one expect from the two big boys of the sector — Hindustan Unilever and ITC? Analysts don’t like the high market share that HUL has in most categories and its exposure to categories with high penetration levels. Also, the slow pace of innovation in the past has probably made it difficult for the company to outpace industry growth, claim analysts. On the other hand, ITC’s exposure to a fairly resilient cigarettes business is what the Street likes. Also in favour are FMCG players that have expanded their footprint, both organically and through acquisitions, into demographically similar markets as India. This would give these companies adequate diversification. As competition heats up in India, these companies could drive better margins from other markets.