FMCG stocks get a boost from improving prospects; analysts are bullish

Despite high valuations, analysts are bullish and upgrading targets on the back of volume and margin gains for companies

The FMCG sector is generally considered to be a safe haven during difficult times as people never stop buying soap and toothpaste. However, weak rural and semi-urban demand has been a factor since the lockdowns of 2020-21 while rising inflation has also impacted margins. While the FMCG majors have survived on the basis of price hikes and good management practices, they have seen growth slowdowns and experienced margins being squeezed as raw materials and transport costs rose.

The FMCG sector witnessed positive volume growth in the fourth quarter of the 2022-23 financial year (Q4FY23) after five consecutive quarters of decline, and the rebound in demand was led by urban markets.

However, analysts feel rural softness has likely bottomed out, and lower input costs and softer inflation should sustain demand recovery. Gross margins and earnings before interest, tax, depreciation and amortisation (Ebitda) should improve, given lower costs. FMCG companies will have to invest some of these gains in product innovation, and in distribution expansion and marketing spends, which may limit operating margin expansions. This trend may be visible in financials though it is at an early stage.

F&B (food & beverages) and home care continued to drive performance for essentials, growing by 12 per cent and 11 per cent, respectively, on four-year compound annual growth rate or CAGR. Growth is still led by pricing but volumes are expected to recover going forward.

Discretionary categories may still see deceleration in demand but segments like paints and fast food restaurants saw growth – the latter may be due to store expansion and because of an unlock effect. Cigarette revenues also grew on a low base. The prices of key inputs like palm oil, crude, crude derivatives, etc., saw softening, and most companies recorded sequential improvement in margins.

In aggregate, the FMCG sector saw mid-teen revenue expansion in FY23, with Ebitda margins improving to around 12 per cent. But unit volume expansion was around 5-6 per cent.

Fast food restaurants (quick service or QSR) was one of the categories which saw good FY23 performance but it levelled off in Q4. There were isolated pockets of really strong showing such as Godrej Consumer (GCPL) in soaps and Jyothy in fabric care, speciality restaurants in QSR and Dabur in F&B. Asian Paints also saw a pickup with growth acceleration. Most categories have seen declines in raw material prices in May over April and if this trend of moderating inflation continues, margin expansion is likely to be excellent in FY24.

Stocks like ITC, Nestle, Britannia, GCPL and Radico have comfortably outperformed the Nifty50 over the past 12 months, while in the last month or so, Hindustan Unilever has delivered strong share price returns. On Wednesday, the S&P BSE FMCG index scaled a new high of 18,486.79, before closing at 18,461.71.

The sector remains very highly valued as always. Companies in this space, by and large, have excellent balance sheets with low working capital needs and low debt. Most of the companies in this space do appear to have improving prospects and despite the high valuations, analysts have started to upgrade targets and make ‘buy’ calls.