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Consumer Staples: Sector Outlook
Raw material inflation to be the key theme for 2011. We believe that managing raw
material inflation in 2011 will be a key challenge for the FMCG players and will also test their
pricing power. As the possibility of crude, palm oil and agri-commodity prices coming off is
remote, maintaining margins will be difficult. The current high valuations for the sector
increases the risks further; we remain cautious on consumer staples.
Gross margins likely to contract 100-300bp. We are cautious on FMCG players’
margins due to raw material cost pressure and high advertising and promotion (A&P)
spending due to intense competition in most categories. Key raw material costs such as
crude oil (↑22%, since January 2010), palm oil (↑50%), copra (↑80%) and agri product
inflation are scaling new highs. Existing high level of competition further prevents
companies from raising product prices in line with cost inflation.
Volume growth to moderate to 11%: We expect sector’s volume growth will be driven by
under-penetrated personal care categories such as skincare, hair care, deodorants,
household care and food categories. Volume growth should slowdown on price increases
and higher base of previous 12 months. We expect 11% volume growth for the sector in
2011, down from 15% this year.
High food inflation – risk of down-trading. Food contributes ~50% to an Indian
household's consumption basket. As current domestic food inflation is above 18% on a
very high base effect of 2010, FMCG players, including categories like laundry, personal
wash, hair care, could see consumer down-trading to cheaper variants.
Global FMCG majors are getting aggressive in Indian market. Global Home and
Personal Care (HPC) companies P&G, L’Oreal, Shiseido, Estee Lauder, Revlon, Reckitt
Benckiser and SC Johnson are increasing their presence in India. Multinational companies’
(MNCs) focus on the Indian market was highlighted by Reckitt’s aggressive US$750m
buyout of Paras Pharma (an Indian personal care company). Over the years, L’Oreal
(7.5% market share in skincare) and P&G have increased their product range in the
premium to mid-priced segments. We expect global majors will increase their presence in
India through new launches and expansion of distribution reach during 2011.
Rich valuations add to our concerns: One of the risks to our above investment
arguments is that if the broader market turns bearish, consumer staples tend to
outperform. However, we believe rich valuations, provides limited scope for any upside for
Hindustan Unilever stock. We prefer ITC over Hindustan Unilever. Amongst midcaps, we
prefer Emami over Marico, where we believe the downside risk to margin is the highest
Sector Top Picks
Top Buy Recommendation/s
Margins likely to expand in inflationary environment. We believe ITC is likely to be the
only exception to raw material cost inflation in the FMCG sector. We expect margins
expansion for ITC due to pricing power in the cigarette business and flat leaf tobacco
prices.
FMCG business is likely to breakeven in FY12E. We believe ITC’s FMCG business is
likely to breakeven in FY12E as the company is fast reversing its negative margin. ITC’s
FMCG margin has increased to -6.3% in 2Q’FY11 from -10.4% in FY10.
Key Near-Term Catalyst
Cigarettes sales volume growth return to positive and moderate hike of tax on cigarettes in
the union budget.
Top Sell Recommendation/s
Hindustan Unilever (Ticker: HUVR IN) (Underperform; TP: 210; Downside – 30%)
Raw material inflation to hurt margins. As crude oil prices trending towards US$100/bbl,
HUVR’s margins are most likely to witness compression, since 62% of its raw material
costs are linked to crude derivatives. Further, high competition in key categories also
makes margins susceptible due to lack of pricing power.
Personal products margins may not be sustainable. HUVR’s personal products’ margin
has declined over 1,000bp in last 7 years. As competition led by multi-national firms
intensifies, we believe personal products margins can decline even further from current
level of ~25%.
Key Near-Term Catalyst
Volume growth back to low single digits as low base effect evaporates
Top Switch Idea
Switch from HUVR to ITC
ITC has better profit and growth outlook. We expect ITC’s profit and sales to grow at
CAGRs of 19% and 13%, respectively, in the next three years vs profit and sales growth of
9% for HUVR. Also, we expect margin expansion for ITC due to pricing power in its
cigarette business (>80% of its total profit) and flat leaf tobacco prices. On the contrary,
HUVR is facing margin pressure due to high competition and raw material costs pressure.
ITC is trading at discount to HUVR. ITC and HUVR are currently trading at 21.6x and
27.3x its FY12E earnings, respectively. Despite superior growth and earnings outlook, ITC
is trading at a 21% discount to HUVR, which we believe is unwarranted.
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