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Indian consumer sector
Rising costs to hurt margins
Event
We analyse Indian FMCG companies’ FY12E outlook against the backdrop of
high raw material (RM) inflation and continued competitive pressures in the
FMCG sector. We prefer ITC amongst large-cap FMCG players, as the
company will be least affected by RM pressure and is facing the least
competitive threat. On the contrary, Hindustan Unilever (HUVR) is facing
pressure on both the RM and the competition fronts. We recommend
switching to ITC from HUVR.
Impact
RM inflation – a key drag for the sector. Indian FMCG players are facing
severe RM costs pressure, as crude oil (↑ 22% since January 2010), palm oil
(↑50%), copra (↑80%) and agri product inflation is scaling new highs. As crude
oil prices trend towards US$100/bbl in 2011, FMCG players will be under
severe strain on both raw material and packaging cost fronts. The only
exception to RM cost inflation is ITC, as leaf tobacco prices have been flat.
Gross margins likely to contract 100-300bp. We are cautious on FMCG
players’ margins due to RM cost pressure and high advertising and promotion
(A&P) spending due to intense competition in most categories. Competition
prevents companies from raising product prices in line with cost inflation.
However, we think ITC is likely to expand margins due to its strong pricing
power coupled with flat leaf tobacco prices (cigarettes add >80% to profits).
High food inflation – risk of down-trading. As current domestic food
inflation is above 18%, FMCG players with or without food business could see
consumer down-trading. Moreover, food product companies without pricing
leverage could face margin pressure due to high RM (agri products) costs.
Personal products margins for HUVR not sustainable. In addition to the
strong domestic competitors, we are seeing large multinationals such as P&G,
L’Oreal, Reckitt, Shiseido, Estee Lauder and Revlon increasing their presence
in the personal care segment. As the competition intensifies, we expect
personal care margins to decline from current ~25%. Personal products’
margin for HUVR has declined 500bp in last 5 years.
Emami is best placed in mid-cap space. Mid-cap FMCG companies’
margins will also see margin compression due to cost pressure despite
volume and sales growth. We believe that Emami will be the least affected
amongst mid-cap peers given its low exposure to crude-linked RM.
Outlook
RM inflation to be the key theme for 2011. We believe that managing RM
inflation in 2011 will be a key challenge for the FMCG players and will test
their pricing power. As the possibility of crude, palm oil and agri-commodity
prices coming off is low, maintaining margins will be difficult. The current high
valuations increases the risks further; we remain cautious on staples.
Switch to ITC from HUVR on 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. Despite this,
HUVR is trading at a 25% premium to ITC, which we believe is unwarranted.
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