Prefer ITC, HUL, Marico: Kotak Institutional Equities

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Manoj Menon, senior analyst at Kotak Institutional Equities told CNBC-TV18 that the FMCG companies are in for a challenging times. As demand decelerate, volume growth of FMCG companies will take a hit. He feels HUL will continue to gain rural market share and ITC will benefit from the steps taken to create a buffer before excise duty is hiked in Budget 2012.

For FY13, he expects HUL to register 14% sales growth, but ITC remains the preferred stock in the sector.

Below is an edited transcript of his interview. Watch the accompanying videos for more.

Q: There is talk about packaging changing and how that may be a game changer for FMCG companies in a negative context. Would you expect this to be a tougher year for FMCG companies?

A: Yes, indeed. It seems to be a year when you look at CY12, January to December as one period and if you look at one-year forward, it seems to be a year which is going to challenging from a business point of view compared to what they have faced not just in the last year but in the last three years. Packaging change in my view is possibly only one event which is yet to happen but its still six months away.

But it may not necessarily happen in the same form, we just need to wait and watch. The way the proposals have to be implemented, the way it is there currently it is going to be significantly negative for two reasons; one is it would make many products knocked out of the carnage currently which could impact the affordability and the number of transactions etc. It also takes away one of the significant leeway's which the consumer companies exercise today in terms of their margin management in the short-term so they will have to take price increases only to manage margins.

Secondly, from a sector point of view we do believe that this year is going to be challenging particularly from a volume growth point of view maybe not substantial but definitely there is a deceleration in demand which we have been expecting for about six months now considering the fact that many of the things which has been tailwinds for the sector whether it's the national rural employment guarantee scheme (NREGS) and spends by the government or the faster pace of growth in the minimum support prices (MSP) in the agri inflation etc while those things are continuing its happening at a much lower incremental growth rate.

So to that extent we were expecting a deceleration in the growth rate for the last six months and which possibly is due to happen in the next couple of quarters. The way we look at it is, considering the structural story to play India consumer we would look at it as a buying opportunity rather than a massive sell opportunity where we are currently.

Q: Do you think it affects all companies universally or between HUL, Godrej Consumer and Marico some companies tend to get affected more by the kind of sluggishness that you are describing?

A: There are two differentiations to be made here - one is the contribution of rural sales or the semi urban sales for companies and the second part is the kind of categories which companies operate in. If I do such a metrics, definitely companies like HUL, Godrej etc have got possibly a higher chance of getting impacted but at the same time we have companies like a Glaxo Consumer or ITC or Marico as a matter of fact which are essentially urban driven so maybe they have a lesser impact. Also the fact that possibly these are companies where there is still a lot of penetration led growth to be driven.

Q: How are you mapping ITC given the price hike that they have taken off-late and expectations that the budget will be unkind to then once again? Is it still on your preferred list?

A: Definitely. We have about five preferred picks out of 15 companies which we cover and ITC is one of them for a long period of time and remains so. One difference this time as we go into the budget expectations currently where we are sitting, there is a lot of predictability in terms of the fact that it's going to be a penal budget from a company point of view in terms of taxation at least that's what our sense is.

The fact that two out of the last three years, an excise increase has not happened, only one out of three years you had the central government increase the excise for the cigarette industry and you saw the benefits relatively for the company as well despite the fact that the state level VAT has gone up substantially for the company.

In the balance when I look into the next couple of months probably mid-March when the budget gets presented, the price increases are essentially a manifestation in my view of the predictability which the company and the industry is having currently that it is going to be a difficult year in terms of excise increase per se so you are probably not going to wait till March 15 to take on those price increases. You are probably going to spread it over a period of time to ensure that possibly the impact on the consumer demand is moderated.

Q: Hindustan Unilever is also part of your preferred list and has probably got the most loftiest valuations. What do you expect to see in sales growth from that and what kind of price target are you working with on Lever?

A: We have an add rating on HUL with a target of Rs 420 wherein we had upgraded the stock in May 2011. It's been one of our preferred picks for the last seven-eight months and it still remains the same. The only point to not incrementally when I look into the next one year is that it's going to be an interesting two halves of January to June and July to December. The operating conditions for the company in the first six months, the way I look at it, it seems to be quite good despite the fact that there could be some headwinds for rural and semi urban growth.

Interestingly, one of the tailwinds which the company has created for themselves is the distribution expansion in terms of direct distribution. They have moved up from a 1 million direct reach to be 1.5 million in the last couple of years which essentially means you stand a good chance to continue to gain market shares in the rural area. So while the sector could grow at a little lesser rate than what it was growing in the last couple of years, the company has got an opportunity to outperform the industry growth and that's what they have been going and I expect that to continue.

So our estimate for FY13 of sales growth for the company is around 14% which is broadly split into volume plus price mix of 7 plus 7 and we expect some margin improvement considering the fact that the price war in detergents with Procter & Gamble seems to be behind the company. We are working with around 18-19% EPS growth for the company in FY13.

Q: What do you do with Titan which has now been through two sticky quarters? Have valuations corrected enough? Is the business prospect still lucrative for you?

A: Titan is one interesting case where the valuations are definitely attractive considering the long-term potential for the categories where the company operates in and secondly the market leadership which the company has got in the relevant categories. Point number two is that valuations are in your favour. However, it's an interesting stock at least in my coverage universe where numbers of moving parts are probably the maximum. You actually have an issue in terms of headwind in terms of consumer demand particularly on the discretionary side. So that's not going to change anytime soon, it's probably at least few quarters away.

That is definitely the volume headwind for watches as well the jewellery business. A significant contributing factor to Titan's earnings growth is gold prices also per se because 70-80% revenue of the company comes from gold and essentially the gold price which the company charges the consumer is a pass-through. For any reason, gold prices in rupee terms in FY13 is not higher than FY12 then what you will actually get in the company in the jewellery business is only the volume growth which doesn't look good. Things are in the balance currently. In my view, valuations are in favour so it's definitely a stock to look for a long-term holder at these prices.

Q: Any thoughts on Marico as a stock, where the management came out with a fairly circumspect kind of guidance a few weeks back?

A: Marico is another interesting case. If you look at one of the key inputs for Marico which is kopra which has got a significant contributing factor to the way the company manages has to look at their profitability. It's been a very sticky inflation for kopra for a fairly long period of time. In that sense Marico is facing some tricky situations in terms of the price increases etc and what they need to do if the input gets further inflationary.

However, we still like Marico, its one of the preferred picks for me for the simple reason that the same reason which we attributed to HUL in terms of distribution led growth. Marico is another company which has significantly invested in the last one-and-half years in terms of rural distribution wherein the current contribution of the rural sales for the company is around 32%. A couple of years back this number was around 26-27%. So it actually had made those front-end investments thus the company got a chance to outperform the industry growth.

Secondly, hair oil as a category in the last couple of years seems to have come of age wherein the attributes of personal care business seems to be what the consumer is believing in hair oil wherein Marico is a large beneficiary which has manifested in the superlative growth what the company has in the value added hair oil which is upwards of 25-30%. I would expect that trajectory to continue for some more time.