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Positive consumption trends. Consumption trends continue to be strong in
India. Government-sponsored schemes (such as rural employment
guarantee, increase in minimum support prices for farm produce) and asset
inflation are helping transfer wealth from the rich to the poor, and from the
urban to the rural. Rising income levels are broadening the base of the
consumer universe and distorting the traditional consumer pyramid. This
trend is positive for FMCG firms, as it deepens their consumer base. There
are also several categories with low penetration rates, offering faster growth
opportunities. We have a favourable bias on the sector, and on a top down
view, expect sector growth to exceed 15% p.a. over the next two years.
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Stiff competition and margin pressures key concerns. Margins will be
under pressure in FY12, in our view, as there is not much room for
increasing prices in a competitive context. Furthermore, given a renewed
focus on volumes, room to cut A&P expenses over sustained periods is
limited. Although over the long term, ‘premiumisation’ can aid margins,
relatively higher input prices and stiff competitive pressures are key
challenges in the near term. Those with high exposure to commodity
segments (soaps, detergents, etc.) will be impacted the most, in our view.
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Valuations unrealistic. Stocks such as HUL (assume coverage with
UNDERPERFORM rating) are trading at the past ten-year peak multiples
and are pricing in medium-term sales and margins, at levels never achieved
in the past. With consensus downgrades continuing, we find it difficult for the
current re-rating to sustain, even though near-term momentum is in its
favour. We prefer ITC (assume coverage with OUTPERFORM rating), given
the trading discount and a relatively stronger business model.
Summary
While overall, we are positive on the consumption trends in the economy, we expect
competitive activity to cap margin growth for the sector and hence the re-rating of the
sector from 23x to 29x appears difficult to sustain. We assume coverage of the consumer
sector with an UNDERPERFORM rating on HUL and an OUTPERFORM rating on
ITC.(more of a relative pick). We prefer ITC over HUL given the trading discount and a
more stable business model.
Consumption trends favourable
Overall consumption trends are favourable in India with rising incomes, government
sponsored schemes driving an increase in income for those at the bottom of the pyramid
and a change in spending culture. Rising incomes across the lower income segment due to
various government schemes (led by schemes such as NREGA, rise in MSPs for farm
producers, free electricity to farmers, waiving of loans during tough times, etc.) is helping
redistribute wealth from the rich to the poor and from the urban to the rural areas. The shift
is positive for FMCG firms as it broadens its customer base. On a top down view, we
expect the FMCG sector in India to witness a 15% CAGR over the next two years.
Room for margin growth limited
Margins will be under pressure in FY12, in our view, as the room for increasing prices in a
competitive context is not very high. While over the long term, ‘premiumisation’, i.e.,
uptrading can help support margins for companies, we believe that relatively high input
prices in FY12 and renewed focus of some companies on volume growth will increase
competitive pressures. Companies having a high exposure to commodity segments (soaps,
detergents etc) would be relatively the most impacted while those catering to premium
segments and inelastic products such as cigarettes would be the least impacted. While we
expect sector volume growth to remain strong, there are headwinds in the form of rising
inflation (food prices, LPG etc) which could impact consumption growth, which while may
not necessarily impact volume growth, could trigger downtrading impacting margins for
corporates.
Valuations challenging
Consumer sector has seen a re-rating (from 23x to 29x) over the past year led by healthy
consumption trends, and more importantly led by a continued weakness in investment
sectors of the economy. We, however, note that sector revenue growth, margins and
ROE’s appear to be peaking and not pricing in risk of margin pressures led by high input
costs as well as competitive actions. Impact of inflation on spending power is another
concern. In any case, such steep valuations are already pricing in strong medium-term
growth, hence we assume coverage of HUL with an UNDERPERFORM rating. HUL’s high
market share in most categories, large exposure to categories with already high penetration
levels and slow pace of innovation in the past makes it difficult for it to outpace industry
growth, in our view. On ITC , we assume coverage with an OUTPERFORM rating, given its
exposure to a fairly resilient cigarettes business, especially on the margins front and its
strong execution abilities that should help ITC successfully diversify. Rising scale in other
FMCG business for ITC should help it generate profits in that segment and help outpace
growth at peers. ITC is also trading at a relative discount to HUL, which is unjustified, in our
view. ITC also is not cheap on absolute valuations, hence remains a pick relative to the
market.
ITC (ITC.BO, Rs196, OUTPERFORM, Rs225.9); Summary view
(Please refer to detailed note on ITC released on 7 July , titled , “Rich valuations; relative
pick in the sector”)
Despite rich valuations, we initiate coverage of ITC with an OUTPERFORM rating given our
favourable bias on fundamentals. We prefer the stock, relative to HUL given its valuation
discount despite better historic and forward earnings prospects.
We expect ITC to deliver a mid-teen CAGR led by success in diversification and loss
reduction in the other FMCG business. We expect volume growth for cigarette business to
rebound in FY12 given no increase in excise duties. Margins should be fairly resilient in
India given 1) ability to increase prices with limited impact on volumes,(cigarette is a price
inelastic product), 2) consolidated industry with ITC maintaining its dominant positioning,
3)limited risk of new entrants emerging given the inability to advertise, ban on FDI in
cigarette manufacturing/potential ban in FDI in distribution and 4) an enabling cost structure
as tobacco forms a small part of overall costs (immune to commodity price increases).
Another key factor supporting margins in the coming years will be the reduction in losses in
its other FMCG business. ITC has been executing this business well and has a strong back
bone in terms of sourcing supply chain as well as a front-end distribution, hence rising
scale of business will reduce losses. We expect this segment to breakeven by FY14/15.
We also expect growth for ITC to be driven through diversification. Diversification, in our
view, is a relevant and important strategy for ITC given the regulatory risks associated with
its core business. ITC’s diversification efforts which stared as early as 1975 have seen a
marked acceleration over the last decade. Non cigarette business now accounts for over
40% of sales and 20% of profit. ITC’s diversifications have been bottom-up and have been
largely successful reflecting the strong execution capabilities of the company.
HUL (HLL.BO, Rs333, UNDERPERFORM, Rs301); Summary view
(Please refer detailed note on HUL released on 7 July, titled “Volume recovery is priced in”)
We assume coverage of HUL with an UNDERPERFORM rating and a target price of Rs301.
While volume growth for HUL has recovered and will sustain in the coming quarters, we
believe that investor attention will switch to margins and profitability, especially given the
steep valuations at which the stock trades. The stock is pricing in strong medium-term
growth which has downside risk (large exposure to slow growth segments, high RM prices,
stiff competition and less room for tweaking A&P expenses given the focus on volumes).
While we see scope for short-term returns on the stock especially around the current quarter
results, it is difficult to justify sustained outperformance at current valuations.
The current focus of global management is on volumes, and hence, HUL has managed to
obtain five quarters of strong volume growth (with base supporting the first four quarters)
which were attributed to: 1) an increase in the pace of launches, 2) increasing direct
distribution reach, 3) using IT solutions (IQ) to improve sales force servicing levels. Our
analysis of HUL’s innovations/launches over the past 10 years however suggests that it is
very common to revamp a large part of existing portfolio every year, hence, the recent spurt
in volumes cannot be attributed to this aspect alone, while benefits from distribution level
push and expansion are difficult to quantify and assess. Given the lack of a single key
identifiable factor driving volumes, we believe that investors may be concerned on their
ability to sustain that . We, however, believe that given the focus of management on
volumes and a fairly buoyant demand environment, it would be reasonable to expect
volume growth to sustain in the coming quarters. Ability to sustain both volumes and
margins over the next few years is, however, difficult.
Despite a rebound in volume growth last year, profit remained flat YoY and profit growth
has steadily declined after the peak in 2007. While HUL’s aim is to drive growth through
strong profitability, rising commodity prices and competition are both expected to pressure
margins for HUL. Margins in the soaps and detergents segments are at multi-year lows and
may rebound from current levels with growing volumes, we though expect immense
pressure in the personal products segment where there has been price cuts by peers.
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