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S hould the sector trade at 20x+ PE?
Are high consumer sector multiples justified?
We believe the sector deserves to trade at a premium to other sectors. In this report,
we analyse the reasons why consumer staples companies continue to trade at a
premium to other sectors. We have used a two-stage forward PE target multiple
model to derive our sector target PE of 25.7x FY13E.
Analysing ROE, FCF and staple consumption spending in India
We have looked at key metrics—return on equity and free cash flow yields—and
compared them with similar metrics in other sectors. We have also analysed
consumption spending growth vis-à-vis historical savings growth and the sector’s
risk-adjusted returns and standard deviation of returns. Based on this analysis, we
have divided the consumer stocks under our coverage into two baskets.
Conclusions: sector has highest risk-adjusted returns and FCF yield
Our key conclusions are: 1) ROEs in the consumer sector are the highest across
sectors; 2) the consumer sector has the highest risk-adjusted free cash flow (FCF)
yields among the sectors we analysed; 3) savings have hedged consumption in the
past and we believe they will continue to do so; 4) over FY05-FY11 the risk-adjusted
returns of the consumer sector were the highest and the most consistent of the sectors
analysed; and 5) the sector’s corporate governance is among the best in India.
Analysis supports our top picks
Our top picks are ITC, Colgate-Palmolive India and Titan Industries. These
companies have high ROEs, positive FCF yields and low leverage. We also like
United Breweries and Godrej Consumer Products. We upgrade our rating for
Marico from Neutral to Buy. We have Neutral ratings on Nestle India and Dabur
India. We have a Sell rating on Hindustan Unilever.
Executive Summary
In this report we analyse the reasons for the high PEs at which consumer stocks
are trading. The sector is currently trading at 22.6x FY13E PE. The consensus
opinion is that this is too high a multiple for the sector; however, we believe the
consumer sector deserves to trade at a premium to the other sectors analysed.
We highlight five key reasons why we believe such high multiples are justified:
The ROE of the Indian consumer sector is the highest among all sectors and
the sector has historically had a higher ROE. Even in periods of economic
turbulence, consumer companies have recorded ROEs of 35-36%.
In FY11, the consumer sector had one of the highest FCF yields (post capex)
among all sectors, at 3.1%. The agri-chem, IT and metals sectors are all more
exposed to global economic downturns, in our view.
Indian consumption is still at a nascent stage and we believe there is
significant scope for growth given the low consumption per capita. We have
created a consumption basket to study the trend in consumption spending
versus savings growth in India, which shows that consumption spending
grew at a CAGR of 12% over FY00-11 and at 15.6% despite inflation in
FY10 and FY11.
Consumer stocks have historically given the highest returns. We have
compared the sector’s historical risk-adjusted returns with other sectors and
arrive at two important conclusions: 1) the average risk-adjusted returns of
the consumer companies we cover were the highest across sectors over
FY05-FY11; and 2) the variation in returns was the least for the consumer
sector over the same period, with a standard deviation of 0.8.
In our view, consumer companies also have the best corporate governance
standards across sectors, as the sector includes MNC subsidiaries listed in
India. Another major reason for the high corporate governance standards is
the absence of cash transactions in the sector.
Consumer sector PE derivation
We have arrived at our consumer sector PE target using the two-stage forward
PE target multiple model UBS’s India strategist Suresh Mahadevan used to
derive his Sensex PE in his report ROE pick-up likely to drive re-rating,
published 15 April 2010. Using an ROE of 32%, earnings growth rate of 14.2%
and cost of equity of 12.6% in the first stage and ROE of 11%, a long-term
earnings growth rate of 5% and cost of equity of 10% in the second stage, we
arrive at our target FY13E PE of 25.7x.
Based on our analysis, we have divided the companies under our coverage into two
baskets. The companies in the first basket are those with higher ROE, higher free
cash flow yields and lower leverage (with low or practically no debt as at end-FY11).
ITC, Colgate-Palmolive India, Titan Industries and Nestle India are the companies
in this basket. Companies in the second basket have a slightly lower ROE, slightly
lower FCF yield and slightly higher leverage. This basket includes most of the
consumer stocks.
Why should consumers trade at 20x PE+?
We use a two-stage forward PE target multiple model to derive our consumer
sector PE target. The first stage is the growth phase, where we expect earnings
to grow 14.2% (the coverage space EPS growth for FY12/13E is 19-21%, hence
we believe 14.2% is justified for the growth phase period), ROE of 32% and
COE of 12.6%. The growth phase is 20 years. The second stage is the terminal
stage, where we assume a long-term earnings growth rate of 5%, ROE of 11%
and COE of 10%.
The growth phase contribution to our total target PE multiple is 11.3x and the
terminal phase contribution is 14.4x, as the growth phase extends only for 20
years whereas the terminal phase is open ended. Our two-stage forward PE
target multiple for the consumer sector is 25.7x
Derivation of consumer sector FY13E target PE
Long term and growth period assumptions
Stage 1: Growth period assumptions
Return on equity (ROEg) 32.0%
Assumed growth period earnings growth rate (Gg) 14.2%
Growth period inflation forecast 5.0%
+ Growth period real risk free rate forecast 2.6%
= Growth period nominal risk free rate (RFg) 7.7%
+ Growth period equity risk premium 5.0%
= Assumed growth period cost of equity (Kg) 12.6%
Duration of growth period (years) 20.0
Stage 2: Terminal period assumptions
Return on equity (ROEt) 11.0%
Assumed terminal period earnings growth rate (Gt) 5.0%
Terminal period inflation forecast 2.5%
+ Terminal period real risk free rate forecast 2.5%
= Terminal period nominal risk free rate (RFt) 5.0%
+ Terminal period equity risk premium 5.0%
= Assumed terminal period cost of equity (Kt) 10.0%
Sector target one year forward P/E multiple
Contribution of growth period on target P/E 11.3x
Contribution of terminal period on target P/E 14.4x
=Sector target one year forward P/E multiple 25.7x
Source: UBS estimates
PE range of 24-27x, sensitivity analysis
We have done two sensitivity analyses to back check our PE target model.
Table 3 shows the sensitivity of our PE model to growth phase earnings growth
rates (%) and growth phase ROE. For most companies, a reduction in ROE
would yield a higher growth rate forecast either in the same year or ensuing
years (ie capex increasing capacity in future, as in the case of Nestle).
In the case of Titan Industries (Titan), where our growth phase growth rate
expectations are higher but the ROE in the business has been stable, the market
has re-rated the stock on the increase in growth expectations.
Table 4 shows the sensitivity of our PE model to terminal year earnings growth
rates and terminal year ROE. We have used the UBS standardised terminal year
growth rate of 5% as the standard and an 11% terminal year ROE for the sector.
For every 20bp improvement in the terminal year growth rate (with the terminal
ROE remaining the same) we estimate our target PE would rise 12bp
We would like to thank Uma-Maheswari Yanamandra and Yuvrajsinh-
Mahipatsinh Sarvaiya, employees of Cognizant Group, for their assistance in
preparing this research report. Cognizant staff provide research support services
to UBS.
Marico Ltd Investment Case
We expect Marico to face gross margin pressure in FY12 due to commodity cost
inflation. We like management’s strategy of not increasing prices to encourage
consumers to upgrade to branded hair oil as Marico’s flagship brand Parachute
has high stickiness rates and the strategy should encourage consumer upgrades
during inflationary times, leading to good volume growth across cycles. We
expect Marico to benefit from: 1) rising rural incomes as consumers upgrade to
branded hair oil; and 2) higher spending on health/functional foods, ie Marico’s
Saffolla brand. We think the share price pullback following management’s 14
September 2011 profit warning has brought valuations to an attractive level.
Statement of Risk
The key risks that could affect the sector include continued upward movement
of downstream petrochemical products and higher agri-commodity based raw
material costs and the inability of branded consumer companies to be able to
pass on price increases in an increasingly competitive market. Higher excise
duty on cigarettes and state taxes on liquor could delay uptrading in cigarettes
and to better quality ENA-based spirits. The sector enjoys low corporate tax
rates because of factory locations in areas that are designated as tax benefit
zones; any change in this law could affect earnings.
India Equity Research Reports, IPO and Stock News
Visit http://indiaer.blogspot.com/ for complete details �� ��
S hould the sector trade at 20x+ PE?
Are high consumer sector multiples justified?
We believe the sector deserves to trade at a premium to other sectors. In this report,
we analyse the reasons why consumer staples companies continue to trade at a
premium to other sectors. We have used a two-stage forward PE target multiple
model to derive our sector target PE of 25.7x FY13E.
Analysing ROE, FCF and staple consumption spending in India
We have looked at key metrics—return on equity and free cash flow yields—and
compared them with similar metrics in other sectors. We have also analysed
consumption spending growth vis-à-vis historical savings growth and the sector’s
risk-adjusted returns and standard deviation of returns. Based on this analysis, we
have divided the consumer stocks under our coverage into two baskets.
Conclusions: sector has highest risk-adjusted returns and FCF yield
Our key conclusions are: 1) ROEs in the consumer sector are the highest across
sectors; 2) the consumer sector has the highest risk-adjusted free cash flow (FCF)
yields among the sectors we analysed; 3) savings have hedged consumption in the
past and we believe they will continue to do so; 4) over FY05-FY11 the risk-adjusted
returns of the consumer sector were the highest and the most consistent of the sectors
analysed; and 5) the sector’s corporate governance is among the best in India.
Analysis supports our top picks
Our top picks are ITC, Colgate-Palmolive India and Titan Industries. These
companies have high ROEs, positive FCF yields and low leverage. We also like
United Breweries and Godrej Consumer Products. We upgrade our rating for
Marico from Neutral to Buy. We have Neutral ratings on Nestle India and Dabur
India. We have a Sell rating on Hindustan Unilever.
Executive Summary
In this report we analyse the reasons for the high PEs at which consumer stocks
are trading. The sector is currently trading at 22.6x FY13E PE. The consensus
opinion is that this is too high a multiple for the sector; however, we believe the
consumer sector deserves to trade at a premium to the other sectors analysed.
We highlight five key reasons why we believe such high multiples are justified:
The ROE of the Indian consumer sector is the highest among all sectors and
the sector has historically had a higher ROE. Even in periods of economic
turbulence, consumer companies have recorded ROEs of 35-36%.
In FY11, the consumer sector had one of the highest FCF yields (post capex)
among all sectors, at 3.1%. The agri-chem, IT and metals sectors are all more
exposed to global economic downturns, in our view.
Indian consumption is still at a nascent stage and we believe there is
significant scope for growth given the low consumption per capita. We have
created a consumption basket to study the trend in consumption spending
versus savings growth in India, which shows that consumption spending
grew at a CAGR of 12% over FY00-11 and at 15.6% despite inflation in
FY10 and FY11.
Consumer stocks have historically given the highest returns. We have
compared the sector’s historical risk-adjusted returns with other sectors and
arrive at two important conclusions: 1) the average risk-adjusted returns of
the consumer companies we cover were the highest across sectors over
FY05-FY11; and 2) the variation in returns was the least for the consumer
sector over the same period, with a standard deviation of 0.8.
In our view, consumer companies also have the best corporate governance
standards across sectors, as the sector includes MNC subsidiaries listed in
India. Another major reason for the high corporate governance standards is
the absence of cash transactions in the sector.
Consumer sector PE derivation
We have arrived at our consumer sector PE target using the two-stage forward
PE target multiple model UBS’s India strategist Suresh Mahadevan used to
derive his Sensex PE in his report ROE pick-up likely to drive re-rating,
published 15 April 2010. Using an ROE of 32%, earnings growth rate of 14.2%
and cost of equity of 12.6% in the first stage and ROE of 11%, a long-term
earnings growth rate of 5% and cost of equity of 10% in the second stage, we
arrive at our target FY13E PE of 25.7x.
Based on our analysis, we have divided the companies under our coverage into two
baskets. The companies in the first basket are those with higher ROE, higher free
cash flow yields and lower leverage (with low or practically no debt as at end-FY11).
ITC, Colgate-Palmolive India, Titan Industries and Nestle India are the companies
in this basket. Companies in the second basket have a slightly lower ROE, slightly
lower FCF yield and slightly higher leverage. This basket includes most of the
consumer stocks.
Why should consumers trade at 20x PE+?
We use a two-stage forward PE target multiple model to derive our consumer
sector PE target. The first stage is the growth phase, where we expect earnings
to grow 14.2% (the coverage space EPS growth for FY12/13E is 19-21%, hence
we believe 14.2% is justified for the growth phase period), ROE of 32% and
COE of 12.6%. The growth phase is 20 years. The second stage is the terminal
stage, where we assume a long-term earnings growth rate of 5%, ROE of 11%
and COE of 10%.
The growth phase contribution to our total target PE multiple is 11.3x and the
terminal phase contribution is 14.4x, as the growth phase extends only for 20
years whereas the terminal phase is open ended. Our two-stage forward PE
target multiple for the consumer sector is 25.7x
Derivation of consumer sector FY13E target PE
Long term and growth period assumptions
Stage 1: Growth period assumptions
Return on equity (ROEg) 32.0%
Assumed growth period earnings growth rate (Gg) 14.2%
Growth period inflation forecast 5.0%
+ Growth period real risk free rate forecast 2.6%
= Growth period nominal risk free rate (RFg) 7.7%
+ Growth period equity risk premium 5.0%
= Assumed growth period cost of equity (Kg) 12.6%
Duration of growth period (years) 20.0
Stage 2: Terminal period assumptions
Return on equity (ROEt) 11.0%
Assumed terminal period earnings growth rate (Gt) 5.0%
Terminal period inflation forecast 2.5%
+ Terminal period real risk free rate forecast 2.5%
= Terminal period nominal risk free rate (RFt) 5.0%
+ Terminal period equity risk premium 5.0%
= Assumed terminal period cost of equity (Kt) 10.0%
Sector target one year forward P/E multiple
Contribution of growth period on target P/E 11.3x
Contribution of terminal period on target P/E 14.4x
=Sector target one year forward P/E multiple 25.7x
Source: UBS estimates
PE range of 24-27x, sensitivity analysis
We have done two sensitivity analyses to back check our PE target model.
Table 3 shows the sensitivity of our PE model to growth phase earnings growth
rates (%) and growth phase ROE. For most companies, a reduction in ROE
would yield a higher growth rate forecast either in the same year or ensuing
years (ie capex increasing capacity in future, as in the case of Nestle).
In the case of Titan Industries (Titan), where our growth phase growth rate
expectations are higher but the ROE in the business has been stable, the market
has re-rated the stock on the increase in growth expectations.
Table 4 shows the sensitivity of our PE model to terminal year earnings growth
rates and terminal year ROE. We have used the UBS standardised terminal year
growth rate of 5% as the standard and an 11% terminal year ROE for the sector.
For every 20bp improvement in the terminal year growth rate (with the terminal
ROE remaining the same) we estimate our target PE would rise 12bp
We would like to thank Uma-Maheswari Yanamandra and Yuvrajsinh-
Mahipatsinh Sarvaiya, employees of Cognizant Group, for their assistance in
preparing this research report. Cognizant staff provide research support services
to UBS.
Marico Ltd Investment Case
We expect Marico to face gross margin pressure in FY12 due to commodity cost
inflation. We like management’s strategy of not increasing prices to encourage
consumers to upgrade to branded hair oil as Marico’s flagship brand Parachute
has high stickiness rates and the strategy should encourage consumer upgrades
during inflationary times, leading to good volume growth across cycles. We
expect Marico to benefit from: 1) rising rural incomes as consumers upgrade to
branded hair oil; and 2) higher spending on health/functional foods, ie Marico’s
Saffolla brand. We think the share price pullback following management’s 14
September 2011 profit warning has brought valuations to an attractive level.
Statement of Risk
The key risks that could affect the sector include continued upward movement
of downstream petrochemical products and higher agri-commodity based raw
material costs and the inability of branded consumer companies to be able to
pass on price increases in an increasingly competitive market. Higher excise
duty on cigarettes and state taxes on liquor could delay uptrading in cigarettes
and to better quality ENA-based spirits. The sector enjoys low corporate tax
rates because of factory locations in areas that are designated as tax benefit
zones; any change in this law could affect earnings.
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