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Indian FMCG
Palm oil structurally strong, some relief expected in
2H CY11
Palm oil inflation of 50%+ in last three months is justified due
to the spurt in incremental demand and supply constraints;
slight moderation in 2H CY11 likely
Palm constitutes c8-10% of sales of HUL and GCPL; actual
impact will depend on hedges and price increases
Prefer GCPL (Neutral) to HUL (Underweight) – sensitivity to
palm prices similar, but valuation gap has widened
We hosted a conference call on industry fundamentals for clients with Thilan Wickramasinghe,
our Asian soft commodities analyst based in Singapore.
Structural reasons for strength in palm prices. Mr. Wickramasingh highlighted that high
palm prices were the result of: (1) strong demand (especially industrial demand, which has
revived in line with economic revival), (2) increased bio-fuel mandates and its ripple impact
across the oil table, and (3) supply side problems with weather – heavy rainfall is causing
problems with pollination and harvesting. While prices are likely to moderate in H2, as the
weather improves and supply increases, they are still likely to remain c25% higher than last
year levels for CY11 vs. CY10.
Sensitivity to FMCG players. Palm oil is used mainly in soaps and represents c35-40% of the
sales from this segment. Both HUL and GCPL have c20-25% of their overall revenue from
soaps. Palm oil therefore forms c8-10% of the total top-line of these companies. Every 10%
increase in palm oil impacts the operating profit of these companies by c-5-7%, all other things
remaining equal. The exact impact, however, will depend on the range of price increases and
the extent of hedges. We currently keep our numbers unchanged but risks to our estimates may
be skewed to the downside.
Prefer GCPL to HUL: While GCPL and HUL have roughly the same sensitivity to palm oil
prices, GCPL stock has corrected 10% while HUL has gone up by 9% in the last month.
GCPL, which has traded at an average discount of 17% to HUL, is now trading at a discount of
28%, which, in our view, is excessive. We believe that while HUL’s management is doing the
right things, there are severe pressures from cost, competition, and category maturation. On the
other hand, GCPL is evolving into a mainly household insecticides player, a segment in which
it is performing very well. We therefore prefer GCPL to HUL.
Takeaways from the call
Mr. Wickramasingh mentioned that the sharp jump in palm oil is based on fundamental factors of demand and
supply and the mismatch has resulted in a situation that has not been seen in the last 15 years
Demand side
Demand is broken up into demand for food (70% of total), demand for industrial purposes (20%) and
demand for bio-fuel (10%)
Demand for food is growing as emerging economies such as China and India consume more – palm is one
of the cheapest edible oils and hence when people move up from poverty into the consuming class, they
first consume palm oil. However, this is not a new phenomenon, this has been growing well over the past
five years.
However, industrial demand has increased recently as economies come out of the recession. Palm is used
in a wide variety of industrial applications, such as pharmaceuticals, cleaners, electronics, leather, and
agrochemicals etc. in addition to soaps, hence is closely related to the economic cycle.
Biofuel demand is increasing due to regulatory requirements. This may be either palm directly being
consumed for biofuels, or other oils being consumed, which has a ripple impact on palm, being substitutes
for one another. For example, Argentina moved from a 5% blending to a 7% blending norm (Soya oil in
this case) recently. This has reduced the exportable surplus of soya oil, creating supply shortage of soya oil
and hence result in a higher demand for its substitutes i.e. palm. Similarly, Malaysia, Indonesia have
increased their bio-fuel requirements. Moreover, Europe, which has had a poor rapeseed production that
was used for biofuels, will also shift some of its dependence to palm.
Supply side
Rainfall in Sumatra and Malaysia has been higher by c30% than normal due to the La Nina effect. This
impacts pollination and harvesting of palm adversely. The La Nina effect is likely to continue up to AprilMay this year, hence supply in 1H CY11 is likely to be tight.
In the longer run, increasing supply to match demand is a slight challenge given the increased activism by
environmentalists (rainforests will have to be cut down to increase palm acreage). Moreover, palm is a
crop that has a long gestation period – typically takes six years to reach optimum production levels. Hence,
we could likely reach a bottleneck a few years down the line if acreage does not increase.
In conclusion, the demand supply balance is tight at the moment with low stock-to-use ratios. Moreover,
most substitutes are being affected by some weather effect or the other. Moreover, due to better prices in
wheat and corn, some farmers are shifting from palm to these crops as well. Last, with hog prices in
China going up, there is an increased demand for soya meal, reducing availability of Soya oil.
A key risk to this story is if weather does not behave as predicted i.e. monsoons abate soon, which will
result in better yields for palm and bring down prices.
Sensitivity of palm to FMCG stocks
Palm oil is an important ingredient in the manufacture of soaps. We estimate that c35-40% of net sales of soaps
is palm oil costs. Given that for both HUL and GCPL, soaps comprise c20-25% of the top-line, we estimate
palm constitutes c8-10% of overall sales of these companies.
Our analysis shows that for every 10% increase in palm cost, operating profits for these companies can be
impacted by c5-7%.
However, the actual impact will depend on: (1) the effective consumption price of palm oil by the
companies, which is a function of the nature of hedges that they carry and (2) whether price increases
passed on to the consumer.
In the last few months, HUL has taken a c5% price increase on its soaps portfolio and GCPL has taken a
smaller increase. These price increases are not enough to offset inflation; however forward contracts
(GCPL has 3-4 months of forward contracts, information on HUL not available) could mitigate the hit. If,
however, palm prices hold firm, companies will have to take a price increase – to what extent is this
possible in the competitive market is a bit premature to analyse. Risks to our estimates may be skewed to
the downside if this situation continues.
Prefer GCPL to HUL
We prefer GCPL to HUL: while the sensitivity to palm price inflation is similar for both, the valuation
gap has widened. Since 1 December, GCPL has declined by10%, while HUL has gone up by 9%. GCPL
which has traded at an average discount of 17% to HUL is now trading at a discount of 28%, which, in
our view, is excessive.
While we agree that HUL management is doing all the right things, pressures from the environment, such
as input cost inflation (affects margins), food inflation (affects consumer demand), competition, and
category maturation would result in EPS growth for HUL being one of the lowest (flat for FY11 and 15%
for FY12) among peer group in India. The valuations seem to have a disconnect with the business
performance at 29x PE, i.e. c20% premium to the sector and to HUL’s own history.
On the other hand, GCPL is evolving into mainly a household insecticides player. Three years down the
line, soaps is likely to become an insignificant part of the business. The company is doing very well in
this segment – it is the market leader in India and has a large presence in Indonesia. We believe that
company will spread its presence across other countries in Asia, Africa, and parts of Latin America
gradually. The stock is trading at a PE of 21x.
HUL Valuation and risks
We maintain our 12-month target price at INR287. This is derived by using a target multiple of 23x on
September 2012e EPS. The forward multiple has averaged 25x over the past three years, in a band of 18-
30x. We apply a 10% discount to the average to reflect the effect of heightened competition on the bottom
line. The stock is currently trading at c29x 12-month forward EPS, c20% above our target multiple.
Under our research model, for stocks without a volatility indicator, the Neutral band is five percentage
points above and below our hurdle rate for Indian stocks of 11%. This translates into a Neutral band of
6% to 16% above the current share price. Our target price of INR287, including an estimated 2.1%
dividend yield, implies a potential return of -9.8%, which is below the Neutral band. Thus, we reiterate
our Underweight rating on HUL shares.
Upside risks include: competition from international players in high growth categories lower than
anticipated; benign cost environment; ability to raise prices of products to improve margins; price war
that does not continue for long.
We maintain our 12-month target price at INR445. This is derived by using a target multiple of 21x on
September 2012e EPS. The forward multiple has averaged 17x over the past three years, in a band of 10-23x.
Declining exposure to the mature soaps business and a diversified portfolio justify the c20% premium to
historical average, in our view. The stock is trading at 21x forward PE, in line with our target multiple.
Under our research model, for stocks without a volatility indicator, the Neutral band is five percentage
points above and below our hurdle rate for Indian stocks of 11%. This translates into a Neutral band of
6% to 16% above the current share price. Our target price of INR445, including an estimated 1.5%
dividend yield, implies a potential return of 15.2%, which is within the Neutral band. Thus, we reiterate
our Neutral rating on GCPL shares.
Upside risks include: 1) ability to raise soap prices to improve margins, 2) lower raw material costs, and 3)
lesser than expected erosion of market share in the hair color market in face of increased competition.
Downside risks include: 1) increased competition in soaps 2) rising raw material costs and 3) new players in
the hair color market, eating into company share.
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