India Consumer Staples Sector Update - Q2FY12 Review: Prabhudas Lilladher,

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India Consumer Staples

Sector Update - Q2FY12 Review: Tier I outperforms!!

Q2FY12 performance for our Consumer universe was a mixed bag, with large-caps Tier I Hindustan Unilever (HUVR) and ITC clearly outperforming the mid-tiers. While volume growth for most of the universe has remained healthy, margins continue to remain a challenge in volatile input cost regime with incremental worry of currency depreciation. Curtailment of ad-spends has helped cushion the margins, but we remain sceptical of this strategy delivering any sustainable benefit. We prefer large-caps, as mid-tiers face erosion of pricing power as well as currency risk (given high international exposure and overseas debt). ITC remains our top pick, notwithstanding the approaching budget and usual excise noise. 

n  Tier I outperforms; mid-tiers profitability falters: Sales, EBITDA and PAT for our consumer universe grew 21.5%, 19.2% and 17.1% YoY v/s our expectations of 19.3%, 17% and 17.6%, respectively. However, dispersion in performance was significant as HUVR and ITC singularly drove the above performance, with ~18% and ~22% sales and PAT growth. Mid-tiers reported subdued profitability despite reduction in ad-spends, though volumes remained healthy. Entire coverage universe reported gross margin decline, while 5 out of 8 reported operating margin decline; HUVR, ITC and Godrej Consumer Products (GCPL) expanded their operating margins YoY. Except Colgate (CLGT) and Asian Paints (APNT), ad-spends declined as % of sales for the rest.

n  Broad takeaways from management calls: A) Though demand has remained intact as yet and benefits of good monsoon can be seen in the subsequent quarters, impact of food inflation on urban wallets, leading to down-trading, is a threat. B) Competitive intensity remains high and ad-spends should move up in H2FY12e. C) Currency depreciation will impact input costs in H2FY12e.

n  What surprised us? Positives: 1) Volume growth of 9.8%, 8% and 14% reported by HUVR, ITC and Marico 2) HUVR’s operating margin expansion of ~100bps. Negatives: 1) Dabur’s subdued volume performance. 2) Fourth consecutive quarter of PAT decline in CLGT. 3) Sharp operating margin decline in APNT (~400bps).

n  What lies ahead? 1) Possible moderation in volume growth owing to a) fading impact of government social spending schemes in rural areas and b) sustained high inflation leading to down-trading in urban markets 2) We believe pricing power will continue to be tested in an environment of high input costs, sticky food inflation and elevated competitive intensity. Price hikes taken so far haven’t neutralized gross margin pressure and further price hikes will be essential to sustain brand investments.  3) Current strategy of reducing ad-spends to manage operating margins is not sustainable in our view and will impact volumes, going forward.

n  ITC remains our top pick: We expect large-caps to continue to outshine mid-tiers, given the high international business salience and currency depreciation risk pertaining to overseas debt. Premium valuations and outperformance will limit absolute upside for the sector in our view; however, broader market concerns and volatility continues to provide relative comfort.