Consumption theme has been a flavour of this season, but of late concerns over margins hover around FMCG sector -- as reflected in earnings of Hindustan Unilever, Asian Paints and Kansai Nerolac -- owing to a surge in crude oil prices and a depreciating rupee, which pushed up the costs of raw material for the FMCG companies. This has raised concerns that valuations of FMCG players may not have come closer to fair levels despite two steep market corrections so far this year. The comfort of GST-induced low base is also unavailable in the September quarter earnings. As market was pencilling in higher growth for the FMCG players, the downward projections are indeed likely.
If one goes through the minutes of the RBI's fourth bi-monthly policy, one thing is clear - food inflation is benign. The monetary policy committee (MPC) noted that the actual inflation outcomes in July and August were below projections. While the MPC is not much worried about food inflation, it was uncertain how much impact, hikes in minimum support prices (MSP), will have on food inflation.
MSP hikes were announced in July. Besides, the upward pressure on crude prices still exists even as Brent has fallen below $80 a barrel level. While Saudi Arabia has ensured that it will increase its supplies to India as US sanctions on Iran come in effect from November 4; in this scenario it is unsure how much impact the fall in crude supplies will have on crude prices globally. This is at a time when the rupee is on a free-fall, and the RBI has hinted it would not go aggressive on restricting the rupee fall. This could hit prices of crude and crude derivatives such as linear alkyl benzene (LAB) used by FMCG companies as inputs, which may hit the margins of FMCG players, if the increased cost is not passed on to consumers. While few analysts believe FMCG companies may manage to protect margins, others differ. They see earnings downgrades ahead.
HDFC Securities has cut its FMCG universe's earnings estimates by 3-4 per cent over FY18-FY21E. "With sharp movement in crude and rupee depreciation, the cost inflation will rise in the coming quarters. FMCG companies will pass on the cost inflation, but we may have to revisit our earlier margin improvement expectations. With sustaining macro headwinds, we build lower margin expansion attributed by higher packaging & distribution cost and crude-based derivatives," HDFC Securities said.
K Vijayakumar Chief Investment Strategist at Geojit Financial Services, however, believes FMCG firms will manage to protect margins if crude stabilises at around $80 levels and rupee at around 73 versus dollar. "But if crude and rupee further depreciates from the current levels, there could be a challenge," he says.
Margins under pressure
Since the sharp movement in crude and rupee had only started closer to the end of the September quarter, analysts do not expect much impact in Q2 results. They see double digit growth in revenues, profit and EBITDA front as was evident from the Hindustan Unilever's second quarter numbers. HUL reported a 10 percent volume growth, 12 percent profit growth and 19 percent PAT growth in Q2. That said, the FMCG major's Ebitda margin declined 190 basis points on a sequential basis. It recorded just 160 basis points growth year-on-year.
Sharekhan noted the rupee depreciation coupled with hike in MSPs and increased crude-link derivatives -- linear alkyl benzene prices are trading at 20 per cent higher on a y-o-y basis -- will affect the profitability of most companies under its coverage.
"In Q2FY2019, most companies under our coverage (except for HUL, ITC, Britannia Industries and Marico) would see 50-150 bps dip in operating profit margin (OPM). Marico's OPM is likely to improve by above 100 bps mainly on account of a sharp decline in copra prices and higher realisation growth on account of price hikes undertaken in the earlier quarters. Companies having exposure to international geographies such as Godrej Consumer Products, Emami and Dabur India are expected to post a decline in margins during the quarter," says Sharekhan.
Selective price increases to counter the rising raw material costs can mitigate any significant erosion in margin. However, the price increases have to be moderate so as not to impact the volume growth and affect consumer demand towards other products available at lesser entry points.
Naveen Kulkarni, Head of Research, Reliance Securities believes FMCG companies do have pricing power, but the current sharp run up in crude oil prices has led to commodity inflation and is likely to pose near-term challenges.
"FMCG companies generally try to pass on the input costs in a gradual manner and this time the case may not be materially different. While they have been more focussed than ever on volume growth and market share, further rise in input cost will pose challenges, but the current rise in input cost inflation is in a manageable range for the FMCG companies," says Kulkarni.
Demand scenario remains intact
The demand scenario continues to remain robust in the urban and rural markets with the latter outpacing the former. "Rural demand is still holding out, and with the expectations of MSP hikes both for the kharif as well as the rabi crop, the discretionary spending is expected to hold up and rural consumption is expected to outpace the urban consumption, reflecting in reasonable earnings growth For FMCG companies," says Mayuresh Joshi, Fund Manager, Angel Broking.
But one has to pay heed to two-wheeler volumes for the month gone by, which are a true indicator for rural demand. This is reflective of below-average monsoon, which recorded 9 per cent below normal rains this year, technically qualifying as a drought year. Motilal Oswal Securities, however, noted that reservoir levels at 74 per cent were still highest in the past four years and marginally ahead of the 10-year-average, mitigating any adverse impact.
Joshi agrees and says volume growth should hold out despite below average monsoon as FMCG companies might roll out promotional schemes to prop up demand.
Sanjiv Bhasin of IIFL is also bullish on the demand scenario. "Coming from the double whammy of demonetisation and GST, we have seen a strong rebound in consumption in 2018. The underlying theme remains that Indian demographics are expanding on the upside. As we see real income levels rise, FMCG sales will only get stronger," he says.
While the consumer stocks have corrected sharply amid recent market fall with the FMCG index down over 11 per cent in the last two months, they are still commanding high valuations as compared to their long-term averages. But analysts have justifications.
"Majority of FMCG companies have created strong moats around their brands and their market leadership positions in these categories should ensure reasonable earnings growth compounding over the next few quarters also justifying the case for valuations sustaining above their mean averages," Joshi says.
Bhasin of IIFL pointed out that the recent market correction had more to do with mutual fund imbalances and overweight stature on NBFCs, which after the IL&FS fiasco hurt their net asset value (NAVs), and to protect those, they sold their winners in FMCG space.
"For us, names like ITC, HUL, Dabur, Colgate and Nestle are all buys as we think the way forward on rising incomes and consumption spending will see large brands only get bigger," he says.
An analyst with a leading brokerage firm pointed out that FMCG index is still richly valued, but one may look at individual consumer names that have fallen over 15-20 per cent.