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India Consumer
3QF11: Cost and Competitive Concerns to the Fore
We maintain our cautious industry view… Despite a
13% fall in the FMCG index YTD, group average
valuations at 22.4x our one-year forward earnings
estimates are in line with long-term average multiples –
even as sustained competitive pressures threaten to
disturb market share equilibrium across categories.
…but see an underappreciated opportunity to invest
in select companies: We favor product categories
levered to disposable income growth. We are OW on
ITC, Nestle, United Spirits, Dabur and Cox & Kings.
• We reiterate our UW on HUL: Earnings growth
volatility, sustained cost pressures and rising
competitive pressures are likely to result in further
stock de-rating.
• We upgrade Marico to EW: This follows recent
underperformance and higher than expected price
increases in its coconut oil portfolio.
• We downgrade Colgate to UW: This reflects a
potential increase in competitive pressures.
• We believe GCPL will give a better entry
opportunity as margins and market share in the
soaps business come under pressure and the
company consolidates its acquisitions.
3QF11 Results – Quick Snapshot
• Overall, MS India consumer companies reported
revenue, operating profit and net profit growth of
16%, 1% and (-)2% as against our expectation of
20%, 10% and 8%, respectively.
• Domestic FMCG sales (ex ITC & Nestle) grew by
12% YoY.
• Gross margins contracted by 190bps (ex ITC and
Nestle), driving an operating margins decline of
230bps. Interestingly ad spends to sales
(ex-Colgate) declined by 10bps during the quarter.
Summary and Conclusions
Why Our Industry View Remains Cautious
• We believe EBITDA margins for home and
personal care (HPC) companies have peaked
near term.
• Input costs are up sharply, putting further
pressure on FMCG (fast-moving consumer
goods) companies in an already intensely
competitive environment. We expect further
erosion in HPC companies’ operating margins.
• We estimate operating margins for HPC
companies under our coverage will largely
remain flat in F12, after a 160bps fall in F2011.
• Contrary to general market perception, we
expect sustained competition – driven by
players with long-term commitments and strong
balance sheets.
• Even after a 13% fall in the FMCG index YTD,
group average valuations at 22.8x our one-year
forward earnings estimates are just in line with
the long-term average.
What’s Driving Our Price Target and Estimate
Changes (see detailed tables on pages 3-4).
3QF11 Results – Broad Overview
• MS India Consumer (ex ITC & Nestle)
average adjusted net profit declined 2.4%:
Overall, MS India Consumer (ex ITC & Nestle)
reported revenue, operating profit and net profit
growth of 16%, 1% and (-)2%. Our expectations
were 20%, 10% and 8%, respectively.
• Domestic FMCG sales (ex-ITC & Nestle)
grew by 12% YoY: Marico surprised positively;
we found GCPL’s growth disappointing.
• Gross margins contracted by 190bps (ex
ITC and Nestle) during the quarter: Our input
cost index has risen 11.3% YoY in 9MF11.
Palm oil prices rose a further 4% YTD.
• Operating margins declined by 230bps (ex
ITC and Nestle): This occurred even as the
average ratio of advertisement and promotional
expenses to sales (ex-Colgate) fell 10bps
during the quarter. In our view, promotions, in
response to rising input costs, were lower
during the quarter – yet ad spending still rose.
• Competition and cost pressure visible: Most
company commentaries mentioned lack of
reduction in competitive intensity and that
managing cost pressure was the key challenge.
All companies except Dabur and ITC reported a
decline in EBITDA margins.
Disconnect between Industry Fundamentals and Group Valuations
Intense Competition Is Proving Disruptive
In our view, EBITDA margins of HPC companies have
peaked near term: We estimate that operating margins for
HPC companies under our coverage will largely remain flat
in F12, after a 160bps fall in F2011. This driven by a
combination of continuing intense competition, increased
advertisement expenses and sharp increase in input costs.
Competition threatens to disturb market share equilibrium
across product categories: We observe three key forces –
the increase in advertising expenditure, the focus among
global FMCG companies on increasing their consumer base in
India, and the decrease in the price component of revenue
growth. See the following section for details.
Meanwhile, group valuations are still around the long-term
average: Part of the stocks’ recent fall can be explained by the
fall in consumer stocks in emerging economies. The MSCI AxJ
consumer index has underperformed the MSCI AxJ index by
11% over the past six months.
Downside risk to our/Street estimates: Moreover, if
competition and cost pressures intensify, our (and indeed
consensus) estimates of FMCG company earnings may prove
aggressive. We cite two reasons:
1) Sharp increase in input costs: Our proprietary input cost
index for domestic FMCG companies is up 11.3% YoY in
9MF11. At current prices, it is likely to be up 13.2% for
FY11e. Price increases continue to lag cost pressures, in
our view.
2) Persistent competitive activity: Our base case factors in
a relatively small, 10bps increase in advertising spending
in F12. If cost and competitive pressures intensity, our
expectations on ad spend for F12 may eventually prove to
be conservative.
Where We Could Be Wrong
1. Growth in the consumer staples market could accelerate,
accommodating new players, driven by strong rural gains
and an improved product mix: FMCG companies are
spending disproportionate resources not only to gain
market share but also to bolster existing categories and
develop new ones. If industry revenue growth
re-accelerates to 18-20%, new players could be
accommodated, softening the competitive environment.
2. Competitive intensity could dissipate as companies
become reconciled to existing market shares in their
respective segments: This is unlikely, in our view. Lead
indicators point towards a sharp increase in competitive
pressures. However, in an environment of rising input
costs, FMCG companies could choose to protect margins
and reduce competition.
We See Ongoing Competition Altering Market Equilibrium…
We see no evidence of diminishing intensity in competition in
the domestic FMCG industry. On the contrary, we expect
competition to alter market equilibrium across product
categories, fueled by three main sources.
Increase in Advertising Expenditure
The ratio of ad spending to sales remains above historical
levels, though it is down 10bps YoY (ex Colgate): In our
view, promotional expenses were lower in the last quarter, in
response to input cost pressures. Media spending still remains
at elevated levels. In quarterly commentary, most companies
maintained that this ratio should be higher for the FY – a good
predictor of continuing competitive activity in quarters to come.
The Impact of Global FMCG companies
Giants such as P&G are focusing on increasing their
consumer base in India: We expect Procter & Gamble to up
its planned investments in India. The global giant has signaled
renewed aggression in emerging economies; it will likely
introduce new products (at various price points) and new
categories. For instance, P&G has recently announced its
foray into the hair color market in India. In the recent Q2F11
earnings call, P&G global management reiterated their stated
plans to enter 12 new category country combinations, 40 new
category price tier combinations and 25 new category channel
combinations in the second half of FY11. The Indian business
was a strong performer for P&G in almost all categories, with
shampoo shipments +25%, Olay skincare more than doubling
YoY, Tide shipments +60% and value share in Laundry up
200bps YoY.
Price Component of Revenue Growth Has Decreased
Domestic revenue growth of FMGC companies accelerated to
12% in 3QF11 vs. 8% in 1HF11. Interestingly, the pricing
component remains negative despite easier comps. We
continue to believe that gaining volume market share is likely
to be the mantra of industry players over the next few
quarters.
…and with Input Costs Jumping, We See Margins Under Pressure
Sharp Increase in input costs amidst continuing
competitive intensity… Morgan Stanley’s Input Cost Index
(ICX) was up 11.3% in 9MF11 vs. 9MF10. Palm oil and copra
prices were up 24% and 34%, respectively.
• MS ICX for all consumer companies is now up between
9% and 35% YoY.
• For Q3F11 vs. Q3F10, input costs for Nestle rose the
least amongst our coverage (Nestle MS ICX +8.5%)…
• …while the input cost index for Marico increased the most
(Marico MS ICX +36%).
• HUL MS ICX (+10%), GCPL MS ICX (+25%), Colgate MS
ICX (+30%) & Dabur MS ICX (+13%) were also up yoy.
…which puts added pressure on the domestic FMCG
industry: If MS ICX remains unchanged at February 2011
levels, it is likely to be up 13.2% YoY in FY11e. Though some
companies have taken input-cost led price hikes in Q3 in
certain categories, we believe only a part of the overall cost
inflation has been passed on to the end-consumer.
• In terms of sensitivity, every 10% change in palm oil
prices affects HUL’s and GCPL’s operating profit margin
by ~80bps.
• Every 10% change in copra prices affects Marico’s
operating profit margin by ~200bps.
The Net Result – EBITDA Margins Likely to Narrow
We believe EBITDA margins for most FMCG companies
have peaked and will largely remain flat in F12: This
follows a 160bps decline in F11. If cost pressures are
sustained amidst intense competition, our and consensus
earnings estimates for FMCG companies may be too
aggressive. FMCG companies tend to reduce their advertising
and promotional expenses to control operating costs during
periods of input cost inflation. However, in the current
competitive environment, a sharp increase in input costs is
likely to erode margins.
Valuations: Exploring the Disconnect with Industry Fundamentals
Despite a 13% fall in the BSE FMCG index YTD, group
average valuations at 22.4x our one-year forward earnings
estimates are just about in line with the long-term average –
even as cost and competitive pressures threaten to disturb
market share equilibrium across categories.
Part of the stocks’ recent fall can be explained by the fall in
consumer stocks in emerging economies. The MSCI AxJ
consumer index has underperformed the MSCI AxJ index by
11% over the past six months.
We believe a heightened competitive environment could
manifest itself in a de-rating in stock valuations: We have
seen numerous examples of how stocks/industries have been
de-rated when competitive pressures are expected to rise,
including Hindustan Unilever’s sharp de-rating during the
laundry pricing war with P&G (2003-04) and Colgate’s during
the oral care marketing battle with HUL (1994-2001).
Highlights from F3Q11
• In F3Q11, the primary driver of revenue growth for
most companies and categories was higher volume.
Indian HPC firms continued to focus on increasing
market share. We believe this growth will slow over
the next few quarters as the price actions already
taken in some categories in order to mitigate input
cost pressures flow through.
• Domestic FMCG sales grew 15% in 3QF11 against
steady growth of 11% in 3QF10.
• The ratio of ad spending to sales for the industry
remains at historical highs despite declining yoy for
some companies. Ex-Colgate, ad spending was
down 10bps for the quarter.
• HUL and Marico disappointed with another quarter of
EBITDA decline.
• Marico has effected a 32-33% price increase in the
key Parachute CNO portfolio – volumes will likely
de-grow in 4Q
• GCPL’s international business (ex currency and
acquisition) disappointed. However, the international
businesses of Marico and Dabur continued to
perform strongly during the quarter, led by volume
growth.
• Colgate’s OPM declined by 800bps during the
quarter, driven by 630bps increase in ad spending.
Interestingly, ad spending in Q3F11 was the highest
since September 2001, the period when Colgate was
defending its market share against HUL
• Overall, FMCG companies reported results were
disappointing, in our view. Interestingly tax rate was
surprisingly low for all companies.
