Indian FMCG-hopes and concerns; sector update:: Edelweiss

Visit http://indiaer.blogspot.com/ for complete details �� ��

Indian FMCG – Hopes and concerns

       FMCG stocks have done remarkably well (absolute return of 32% vs. Sensex at 16% YTD

       Our interaction with investors have thrown up 7 key concerns. In this report we attempt to address the same.

       Concern 1: Volume growth has tapered off

       Concern 2: Gross margins are under huge pressure

       Concern 3: Advertising and Sales Promotion (A&P) spend is going to keep margins under pressure

       Concern 4: Pricing power has not improved

       Concern 5: International growth a question mark

       Concern 6: De-rating might happen following input cost pressure

       Concern 7: FMCG has become very expensive

Summary of our take on 7 key concerns

       Concern 1: FMCG pack has largely delivered in Q2FY11; Q3FY11 likely to be even better

       Concern 2: Though there is inflation risk on a broad brush basis; United Spirits and Nestle are going to be benefitted by softening of input costs going forward

       Concern 3: Easing off promotional pressure will cool off A&P spending from Q3FY11 onwards. Companies will continue investing in Ads, which we believe is good for long term

       Concern 4: We believe pricing power will continue to improve following Q2FY11 trend 

       Concern 5: International markets present long term growth opportunity for Indian FMCG companies, and we remain +ve on Indian FMCG companies expansion internationally

       Concern 6: We believe margin slippages in Q2FY11 is a short term phenomenon and de-rating will not happen as pricing power is returning back.

       Concern 7: Although FMCG valuations are high, Indian FMCG companies have 105% more growth to offer than global peers and have 58% P/E multiple premiums assigned to them.

We believe these high levels of valuations are going to continue, and advise Investors to add on dips.

Based on our analysis, our top picks currently are ITC, HUL, Dabur, GCPL and United Spirits

Asian Paints

Investment rationale

􀁹 Domestic volumes in decorative business to be a leveraged play on GDP growth rate. Expects rural growth to

outperform urban growth in the coming quarters corroborated due to good monsoon.

􀁹 Being market leader g commands high pricing power. Current market share of 51%.

􀁹 Price increases taken to cushion RM inflation partially. Undertaken price hikes of 4.15% on May 01 and 2.6% on

July 01, 2010 and price hike of 1.2%, applicable from August 01, 2010.

􀁹 Automotive and industrial paints segments are expected to do well due to improved GDP outlook

􀁹 Increase in income tax exemptions slabs to boost paint volumes

Key risks

􀁹 Increased ad spends

􀁹 Sharp rise in crude oil prices could hurt margins, leading to high inflation in raw material costs

􀁹 Availability risk of key commodities like titanium dioxide

Colgate

Investment rationale

􀁹 Earning growth to slow down considerably from earlier growth rate

􀁹 Valuation expensive – single product company

􀁹 Hindustan Unilever has upped the ante in terms of ad spends and low priced units whereas Dabur’s aggressive

promotions - are likely to limit Colgate’s incremental market share gain.

􀁹 P&G is likely to enter the oral care market in H2FY11, which will put additional pressure on Colgate.

􀁹 Tax rates ballooned and are further expected to increase thereby reducing profitability (~18% in FY10 and

further expected to go up to 24%).

􀁹 Volumes dip due to current low A&P spending thereby reducing profitability.

Key risk

􀁹 Sharp correction in input prices

􀁹 Lack of concerted attack by competition will not dent Colgate’s base significantly.

Dabur

Investment rationale

􀁹 Volume growth to remain high because of herbal positioning. Achieved ~10% Y-o-Y volume growth in Q2FY11.

􀁹 Domestic EBITDA margins to sustain; international margins to expand. To maintain margin of ~20% in FY11.

􀁹 Acquisition of Namaste Labs (US) and Hobi (Turkey): ~20%+ growth in the next year. Effective integration can

derive huge synergistic value. Company looking for more international acquisitions.

􀁹 Pricing power evident: taken ~2% hike in Q1FY11, 2.5% in FY10 and the rise in FY11 is likely to be 4-5% which

should be able to offset raw material inflation. Volume growth is not adversely impacted in spite of price hike.

􀁹 Looking at consolidating brands/products launched in FY10 — Uveda, new hair oils, beverages

􀁹 Skin care segment expected to grow at 25% in FY11, and company expects Fem to sustain 28% margin

􀁹 Higher traction and expansion in retail business. Number of stores likely to be 40-45 by FY11 end from current

19.

Key risks

􀁹 Seasonality risk since some products are seasonal in nature; Loosing market share in shampoo category

Emami

Investment rationale

􀁹 Herbal positioning, with exciting hamper of high growth potential products; low risk from MNC players

􀁹 With a four-year CAGR of 38.4%, international business currently contributes ~13% to top line; Emami intends

to grow both organically and inorganically

􀁹 Huge brand creator with dominant share in cooling oil, antiseptic cream, balm and fairness cream for men

􀁹 Lower SKU of Zandu Balm (INR 2), launched in August 2010. Zandu delivered 26% volume growth in Q2FY11

􀁹 Zandu Ayurvedic medicine portfolio CAGR expected to be ~40% in next 3 years, with 40%+ net profit margin

􀁹 Navratna Cool Talc is the next block buster; strong momentum in Navratna cool talc to continue

􀁹 International acquisitions in Egypt and Bangladesh

Key risks

􀁹 Seasonality risk since most products are seasonal in nature

GCPL

Investment Rationale

􀁹 Soaps: Focus on profitable growth. Dependence on soaps reduced to just 30% vis-à-vis 60% two years ago.

􀁹 Hair Color: Market share increased to 29.9% in value terms. Took ~8% price increases in Q2FY11 and delivered

12% volume growth.

􀁹 Household insecticide category gaining market share and offers better margin.(Market share jumped to 36.2%

in Q2FY11 vis-à-vis 32.7% Q2FY10)

􀁹 Ramp up in rural distribution from 7,000 villages to 15,000 in FY10 to capture rural demand

􀁹 Acquisition done in emerging economies similar to India considering penetration and growth. Megasuri, Tura and

LatAm business (Issue + Argencos) - synergy benefits to flow from FY12 onwards. Company scouting for more

acquisition opportunities.

􀁹 GCPL to benefit from likely participation in Kiwi’s licensing rights in South Africa; Indonesia and UK.

Key Risks

􀁹 Company does not have a strong product in the higher end of hair color; Loosing market share in soap category

HUL

Investment rationale

􀁹 Increasing distribution to 500,000 new stores. Triple the number of rural retail outlets on a direct basis

􀁹 Exciting bouquet of new products: soupy noodles (two products priced at INR 10) and cooking aids like

seasonings and spices under the Knorr brand, Sure Antiperspirant, g p , p p , Cif surface cleaner, new variants of Pure-it

water purifier (including INR 6,000 premium version), Sehatmand tea , and fabric conditioner ‘Comfort’

􀁹 A&P spends currently at its peak due to new product launches

􀁹 PP margins (~22%) are subsidizing warfare in soaps and detergents

􀁹 Vaseline, petroleum jelly, transformed from heel cream to up market body lotion. Dove: Transformed from INR

750 mn to INR 5 bn brand (No. 1 in modern retail)

􀁹 Takes 35 days to land the product in the market now from 70 days earlier

Key risks

􀁹 Little/no market share gain despite price cuts in soaps and detergents

􀁹 Continued margin pressure following price wars

ITC

Investment rationale

􀁹 Leadership status allows premium pricing and margin expansion. Lucky Strike launch is a step in the right

direction. 59 mm category cigarette launch at INR 1.5 is structurally positive.

􀁹 FMCG losses to decline by 15-20% in FY11. BEV expected in FY13; foods now profitable. New launches in skin

care a big long-term positive ; likely gain ~5% share in soaps in 2 years.

􀁹 Agri business to be driven by high leaf tobacco prices in export markets; expect 10% margins with a 10-15%

sales growth in FY11E.

􀁹 Improved efficiency in new pulp mill, combined with rising paper costs, will aid margin growth in paper segment;

expect 10-15% sales growth and 20% margins in FY11E.

􀁹 Recovery continues in hotel business. Plans to add hotels in Chennai, Kolkata, Ahmedabad and Gurgaon in the

next 2-3 years.

Key risks

􀁹 Significant decline in cigarette volumes on the back of price hikes could dent profitability and valuations

Marico

Investment rationale

􀁹 Marico has near monopoly in most of the categories it operate, with brands such as Parachute in Coconut hair oil

and Saffola in branded edible oil.

􀁹 Q2FY11 volume grew ~10% and ~28% Y-o-Y for parachute and Saffola, respectively. Company plans to

leverage Saffola as a leading healthy lifestyle brand with Saffola Arise and Saffola Oats.

􀁹 International business: can clock growth of ~20% per annum over the next few years. International acquisition

(Ingwe, Derma Rx, Code 10) to provide entry in fast growing emerging market and huge synergistic value.

􀁹 Eyeing growth through low unit packs (LUPs)

􀁹 Breakeven of Kaya’s domestic business – Kaya business PBT +ve in Q2FY11 following Derma Rx acquisition.

Key risks

􀁹 Coconut oil forms the biggest share of Marico’s top line and bottom line. Increase in price of copra a risk.

􀁹 New product: More misses than hits (Revive Liquid Stiffener, Parachute Advanced Night Repair Cream, Maha

Thanda Tel, Parachute Advanced Revitalizing Hot Oil)

Nestle

Investment rationale

􀁹 Consistent growth of existing portfolio despite increasing competitive intensity

􀁹 Benign RM outlook due to good monsoon. Fall in milk, wheat and sugar prices positively impact margins.

􀁹 New products to drive future growth (Multigrainz Noodles, New Tricky Tomato, and Thrillin Curry).

􀁹 Introducing stock-keeping units (SKUs) below INR 10 (Maggi INR 5 & Kitkat 3 finger INR10) to expand into tier

II and tier III cities

Key risks

􀁹 Competitive intensity rising: GSK Consumer and Hindustan Unilever (HUL) have entered the fast growing

noodles category.

􀁹 Nestle will have to increase A&P spend to maintain its market share, which will exert pressure on margins in the

coming quarters.

United Spirits

Investment rationale

􀁹 Volume growth in domestic business remains strong. Likely growth 14-15% Y-o-Y.

􀁹 Benign molasses outlook: Molasses prices declined ~15-20% M-o-M in April 2010; likely to remain soft in FY11.

Benefit expected to be reaped from Q3FY11 onwards.

􀁹 Debt levels of USL have come down; current debt/equity 1.2x against 3.1x in FY09

􀁹 White & Mackay (W&M): We continue to believe that long-term strategy of branded whisky will be good for the

company as this will provide higher margins.

􀁹 Likely sale of some IPL teams will set higher benchmarks

􀁹 Volumes growth remains robust at 16% Q2FY11

Key risks

􀁹 Increase in taxes, changes in the distribution structure, prohibition of liquor in any state could hit USL