Is the worst over for FMCGs?

Atul Rastogi, Senior Analyst at Motilal Oswal, remembers a stray comment he heard at an analysts' meeting some quarters ago. "Perhaps, FMCGs should be rechristened as SMCGs," someone quipped, leading him to wonder what went really wrong with a sector that used to be known as the fail-safe investment avenue for investors interested in long-term returns and growth.

The reasons were not difficult to fathom - cut-throat competition from regional players, falling demand, loss of wallet share and commoditisation were just some of the ailments Rastogi could list immediately. But when even good monsoons and a booming economy have not brought the cheer back to FMCG stocks, Rastogi has begun taking a closer look for tell-tale signs of stress.

Among the new things he has noted is the sharp increase in raw material prices, which has forced market leader Hindustan Lever Ltd (HLL) to increase the retail price of Lux by 50 paise a bar.

Equally worrisome for him is the new price war that has broken out - not with the usual regional brands, but another 800-pound MNC gorilla, P&G, which recently cut the prices of flagship detergent brands Ariel and Tide by 25-50 per cent. How will this price war play out?

Rastogi was not exactly surprised by the P&G move. He had been anticipating some such gambit, given the fresh burst of aggression the company had been showing in India and the need to focus on volumes in a bid to expand its market size beyond the premium segment.

With HLL cutting prices to guard its market share, there is no doubt that margins in the industry will take a hit. Will volumes grow to make up for this drop? How will market shares get redistributed?

Rastogi, for one, is not writing off the sector. He reckons that history is on his side. Historically, during an upturn in the business cycle, sectors like capital goods and commercial vehicles tend to lead the upturn after which the effect trickles down to the FMCG sector, which is typically the last sector to show growth. Rastogi is hopeful that history will repeat itself this time too.

HLL chairman M S Banga certainly believes in the lag effect. After announcing the company's results a few weeks ago, he said good monsoons help rural demand only after a gap because the first impulse of rural people who get more money in their hands is to reduce debts. The FMCG buying comes only later.

But even as HLL waits for that happy development, it has a more pressing problem at hand: the P&G cut-and-thrust. Not that Banga was surprised by this manoeuvre. In mid-February, Banga told shareholders that the company recognised the challenge of intensified competition from both low-priced players as well as international companies.

"Most recently, P&G have reduced prices and increased aggression in laundry. Our response, when faced with such challenges, will be to face them 'unblinkingly', with the level of investment required to both protect and grow our market positions." True to his word, HLL has reduced the prices of its detergent brands Surf Excel and Surf Excel Blue after P&G fired the first salvo.

A section of analysts feel that the price cut by P&G may end up bruising HLL's margins without giving P&G any significant gains in market share. What they are wondering is whether the profitability tweaked out of efficiency gains have peaked, now that price cuts are the order of the day.

"The fault lies with the players themselves," opines Nikhil Vora, FMCG analyst at brokerage and research firm SSKI. "The FMCG giants were complacent in their approach to the markets. There were hardly any value-for-money products and price increases in the industry were almost never accompanied by any significant value addition, setting the scene for the present problems of the industry," adds Vora.

He says the biggest reason for the sector's slowdown is its loss of consumer wallet share. "Over the past decade, consumer spending on non-durables has shrunk from 54 per cent to 48 per cent of their disposable income. That's because FMCG firms have been unable to innovate so as to capture a larger share of consumers' incomes," he reckons.

The BSE FMCG Index has underperformed the Sensex last year, growing by 32.32 per cent between February 2003 and February 2004 compared to a 77.68 per cent surge in the index.

A peek at the performance of FMCG majors on a year-on-year basis reveals that stocks like Tata Tea, Gillette, Marico, ITC, Dabur and Godrej Consumers were the pick of the lot, recording fairly decent growth.

However, HLL was a notable exception and actually slipped by a little over 6 per cent in the year. The stock performance of Colgate Palmolive, P&G and Nestle India were also rather subdued (see table).

Things seemed to be getting better around mid-2003, when HLL recorded the sharpest topline growth in seven quarters with a 4.2 per cent growth y-o-y in the September 2003 quarter, led by the beverages and personal care businesses, which had grown 9 per cent and 15 per cent respectively.

However, analysts' hopes of an encore were quashed by the December-quarter results which disappointed them on both topline and bottomline. For the full year, net profit was up by a mere 2.3 per cent.

Post-extraordinary items, net profit growth was flat. That was not the case with the other FMCG biggie, ITC, whose December-quarter results saw an impressive net revenue growth of 10.6 per cent y-o-y and 5.6 per cent q-o-q, after three quarters of stagnant growth.

What awaits the FMCG sector in the coming year is a million dollar question that we asked the hallowed clairvoyants (read: analysts) at various brokerages and this is what we found out:

Feel-good factors augur well

Analysts say there is no shortage of feel-good factors in the sector. This includes the good monsoons of 2003, the higher than expected GDP growth and rising prices of agricultural produce. In fact, analysts expect the highest rainfall in the last 10 years to yield healthy kharif and rabi crops.

Consequently, foodgrain production in India is likely to witness a growth of over 12 per cent. Rural demand is also expected to kick in from the fourth quarter of fiscal 2004, indicating a higher growth for FMCG products in FY05. The primary reason for this is that penetration of FMCG products is already high.

As a result, analysts expect 50 per cent of HLL's demand to come in from the rural areas. "Given the high ratio of rural customer base that these companies have, this year's good monsoon and its even spread augur well for the industry after two years of depression," says Abhijeet Punde, analyst at IDBI Capital Markets. The core point all FMCG analysts concur on is a huge spurt in volumes.

However, translation of the volumes into bottomline growth is the key. "The FMCG sector, on the whole, should witness good volume growth, given the rising amount of disposable incomes with rural consumers and the ensuing willingness to go up the value chain," says Harrish Zaveri, FMCG analyst at Edelweiss Capital. Analysts attribute their optimism to the fact that rising prices of agricultural produce should lead to higher rural consumption.

Price cuts to the fore

The big fish in the FMCG pond are drastically slashing prices to compete with the small fry and wrest back lost market share. Analysts reckon that this could translate into higher volumes for sure but that does not mean clawing back market share.

"Big players cannot wish away the competition from regional players. Brands like Anchor toothpaste have built their own brand loyalty and are strong contenders, particularly in the western parts of India like Gujarat and Rajasthan," says Punde.

However, Rastogi of Motilal Oswal Securities believes that it was primarily the weaker players who felt the brunt of the invasion by regional players. "The big players would have lost a great deal if the price cuts did not come about. However, small players like Anchor and Ghari detergents did more to hit the market shares of weaker players in the segment like Babool and Nirma rather than strong brands like Colgate or Wheel, which commanded more customer loyalty." Rastogi feels that the topline growth of FMCG players would grow exponentially given the positive factors present but the focus will shift to how companies manage to grow their bottomline in the face of rising raw material costs and price wars even at the premium end of the market. The fact is operating efficiencies have been driving bottomline growth so far.

New launches in the offing

To see off the challenge from regional brands, big FMCG companies have switched strategy from pull to push. With prices being cut, big boys had also cut down on advertising spends till the September quarter. This move seemed to make sense in absorbing a small part of the negative effect of increases in raw material costs.

However, things seem to have started changing of late. A recent phenomenon is the spate of new launches. Analysts say FMCG majors are already factoring in an upturn in demand following the economic revival. They are thus pumping money into new launches.

Apart from new brand launches like Rejoice, a lot of money is being spent on brand extensions and relaunches. One proof of the phenomenon is the increase in the advertising and sales promotion spends of players like ITC, Marico, GSK Consumer, Britannia and Dabur in the December quarter in the range of 8 per cent to 30 per cent.

FMCG companies are also focusing their ad spends better by adopting the so-called power brand strategy. HLL was the first to talk about doing so, but the strategy has now been adopted by most players in the sector, including Marico, ITC and Nestle - in some form or the other.

But ailments persist

Dr Feel-good, however, needs to take care of some more ailments, and one of them is rising input cost. Prices of palm oil and other edible oils remain a concern. In the September quarter, palm oil prices rose by 27 per cent.

Also, the average prices of palm oil were 10-12 per cent higher in the quarter ended December 2003, as against prices in the quarter ended December, 2002. While players initially cut down ad spends, category leaders like HLL have started passing on some of the cost increases to buyers by raising the prices of soap and Godrej Consumer is expected to follow suit.

Vora feels that the price increases will not serve the purpose of neutralising the pressure of raw material increases. Says he, "If you look at the real price increase after taking into account inflation of around 4-5 per cent, you would find that actually prices have declined, which brings an element of deflation in the scenario".

With the benefit of lower interest rates, spending has risen on consumer durables. Players are still expected to be plagued by the phenomenon of lower wallet share, or lesser disposable income to spend on FMCG products after paying off installments on loans used to buy consumer durables.

Looking ahead

The way ahead is full of possibilities, says Punde, who foresees FMCG companies, preferably smaller ones, tying up with huge retail chains to sell their products directly, eliminating dealers and middlemen in the process. Branding of products can be done by the retail chain itself.

Hypermarket Big Bazaar currently sells vegetables under its own brand name. The same could be done for soaps, detergents and tea. The initial reach would primarily be urban, but would increase to rural areas in the longer term. HLL has also entered the branded vegetables market and its retailing arm, SangamDirect, is gathering momentum, although on a small base," feels Punde.

The prognosis

So what is the prognosis for the year? The verdict is unanimous: FMCG companies should see growth in terms of volumes, but would have to increase margin efficiency by way of innovations and pricing strategies to stay ahead in the game.

"The inability to innovate and get into new categories is the biggest negative plaguing the industry today. In spite of a GDP growth of 8 per cent and strong double-digit agricultural growth, the sector is only likely to witness single-digit growth," says Vora.

However, a majority of analysts concur that the industry should see good topline growth and the focus will shift to maintaining bottomline growth in the face of increasing raw material prices and competition.

In terms of valuations, analysts agree that these are at their lowest levels, but there is no reason for big changes here. "The sector on the whole should witness a sure growth of 10-12 per cent this year," says Punde.