Ride high on FMCG

Slowdown may affect demand in other sectors, but nobody is going to cut their grocery bills. R Sree Ram looks at the best bets.

R Sree Ram | Print Edition: Jun, 26, 2008

Why is sector lucrative

Least affected by slowdown in economy

Regained pricing power at the end of 2007-8

Premium products to result in better margins

Consistent dividend payers, with companies on an average paying 150% a year

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Starting from that first cup of coffee in the morning right up to that relaxing malt beverage at night, we rely heavily on fast-moving consumer goods (FMCG). Everything from toothpaste to processed foods and health drinks to body care products comes from FMCG companies. With demand unlikely to really slow, these companies are in a sweet spot, especially when compared with sectors like automobile and real estate.

The FMCG sector has always been a reliable performer. In fact, since January 2008, the BSE Sensex lost over 27%, while the BSE FMCG Index fell only by 3.2%. Which is why, as concerns about an overall economic slowdown are becoming widespread, experts are looking at the FMCG sector as the silver lining. “The FMCG industry is normally the last to benefit from high GDP growth and is also the last one to witness a slowdown in case the economy enters a downturn.

Hence, they generally act as a good defensive bets particularly in tough economic times as being witnessed now,” says Anand Shah, research analyst at Angel Broking. While the last financial year was not very good for FMCG due to shrinking margins, the sector has regained its pricing power towards the end of the year. This is visible in the latest fourth quarter results where the sector registered an impressive average of 27.49% growth in net profits.

“With a basket of premium brands, these companies are geared up to reward customers with on-pack promotional offers or soft discounts if they face any slowdown in sales. In such cases, the companies also mitigate their risk by shifting advertisement spend to below-the-line activities,” says Shirish Pardeshi, research analyst at Anand Rathi.

So, what price do you pay for a slice of this definitive earnings growth story with limited scope for downside? With most FMCG companies trading at price to earnings ratio of more than 20 times, they definitely seem expensive, considering a Sensex P/E of 18.8 times.

However, experts argue that FMCG stocks always quote at a premium to the Sensex, owing to their rich cash flows, strong return ratios, steady earnings growth and modest dividends. Moreover, being low beta stocks (high beta implies stock moves in tandem with market), FMCG companies command a premium in times of uncertainties as they tend not to follow the market when it goes down.

“FMCG stocks generally command 18-25 times one year forward P/E in terms of valuation depending on the size of the firm and its earnings growth. Heavyweights like HUL and Nestle usually quote in excess of 25+ P/E multiples while mid-caps trade in the range of 15-20 times P/E multiple,” says Shah.

The best bets

With consistent revenue growth of over 20% in the last five quarters, Nestle India is regarded as a sure thing in the FMCG space. The company, a leading player in the processed foods and chocolate segments, is riding the wave of increased awareness of health and hygiene products. The company was among the first to detect a change in consumer preference, and tapped in to the health food segment early on with fat-free products including Kit Kat Lite, Polo Sugar Free, Nesvita Probiotic Curd, Slim Dahi and Probiotic fruit yoghurt.

“A strong product portfolio with demonstrated pricing power in an inflationary environment makes Nestle a strong and relatively safe pick,” Deutsche Bank notes, while setting a target price of Rs 2,000 implying a potential upside of 23% from the current market price.

In the mid-cap space, Godrej Consumer Products is seen as a good bet. With a 35% market share in hair dyes, the company is planning to piggy-back on its recent South African acquisition, Kinky Group, by taking its product portfolio of wigs, hair sprays and styling gels to African markets.

The company’s hair colour business, which has grown at over 21% after a gap of seven quarters, has seen its EBITDA margins expand by three percentage points to 20.8% in the fourth quarter. The stock is rated ‘buy’ in light of relatively cheaper valuations.

Interestingly FMCG giant Hindustan Unilever is the least favoured of the lot. Lack of momentum in the counter apart, the company’s increasing ad spend to defend its market share is making experts wary of recommending this stock. “One of the reasons why HUL is preferred by FII/MF is due to ample liquidity.

Otherwise HUL is relatively more expensive to its FMCG peers. At current valuations, our preference is towards smaller caps like Dabur and Marico, which have better earnings growth and visibility,”says Hemant Patel, research analyst at Enam Securities.

With a 70% market share in the Rs 1,600 crore malted foods space, GSK Consumer Healthcare is regarded as a good bet in the processed foods segment. With its flagship brand Horlicks contributing majority of the revenues, the company has a presence across price points and age groups through its brands like Boost, Viva and Maltova. The company is planning to bring in new products in the lucrative health and nutritional food product segment to beef up its product portfolio.

However, despite being a category leader, the company was not able to generate investor confidence in the past due to its over-dependence on Horlicks. “Glaxo remains one of our top picks in the sector. At a current market price of Rs 646, the scrip is trading at 14.5 times and 10.8 times its projected 2007-8 and 2008-9 EPS respectively. We recommend a buy with a target price of Rs 896 with a one year horizon,” says Pritee Panchal of SBI CAP Securities.

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