As we were getting ready to wind down 2016 we were hit by the government's demonetisation move and the fast moving consumer goods (FMCG) sector has borne the brunt of that. How will 2017 pan out with the cash crunch headwinds still looking intact. In an interview to CNBC-TV18's Sonia Shenoy & Reema Tendulkar, Varun Lohchab, MD & Head of Research at Religare Capital Markets, Abneesh Roy, Associate Director at Edelweiss Securities and Amnish Aggarwal, Senior VP-Research at Prabhudas Lilladher did review FMCG space for 2016 and how 2017 will pan out for the sector.Below is the verbatim transcript of the interview.
Sonia: Some of these companies have been reporting weak earnings or weak volume growth even before the demonetisation impact hit them. How long do you think this slower earnings and slower volume growth is going to last?
Roy: Obviously in Q3 post November 8 there has been impact initially, as per our detailed channel checks, there was almost 60-70 percent drop in the first few days but then it started improving. For the full quarter we still expect declines for most companies depending upon category there will be the range. In Q4 we expect towards the end of February things should start normalising because now the government has also stepped up the printing of the Rs 500 note and companies are also taking lot of proactive action, more promotions are happening.
Now advertising spend also which had become curtailed in November by most fast-moving consumer goods (FMCG) companies, had started to come back. So, in Q4 from maybe March we should see recovery definitely happening. Things are becoming better but recovery should happen on a year-on-year (Y-o-Y) basis mostly from March. That is how I see.
Reema: Compounding the problems for the FMCG stocks over and above the demonetisation is the fact that we have seen a consistent increase in raw material prices and that might impact the margin picture going ahead. How are you pencilling in the revenue as well as the margin pressure FMCG companies could see in Q3 as well as Q4?
Lohchab: If I look at revenue growth, we believe in the negative price impact which we had on the sector for the last few quarters. So, Q2 it was starting to get neutralised anyway. Now we expect some positive pricing to come. So, that should help the revenue grow to some extent but we believe the margins clearly have a room to go down. We are sitting on peak margins for most of the companies.
The raw material inflation has been quite sharp in lot of the commodities like palm oil and some of the other crude derivatives and we believe in this environment when the underlying demand is very fragile; if you look at the previous raw material up cycles which was in 2007, early 2008 and 2011-2012, at that time the underlying demand was much better, so companies were taking quite proactive price hikes but despite that we had seen margin erosion for these companies at gross margin levels and even to some extent at earnings before interest, taxes, depreciation and amortisation (EBITDA) margin level. In this environment it would be probably even sharper.
Therefore, we have recently cut our earnings estimate for most of the company for FY17-FY18-FY19 and this is more predicated on the raw material increase which we are seeing which will lead to mild kind of downtick in the EBITDA margins and the gross margins of the company and on topline we have built in slightly higher inflation, but net-net earnings will get impacted.
Sonia: I wanted your thoughts on the price action because some of these stocks like Marico have been great multi-baggers in the past but recently since the month of July-August these stocks have fallen about 20-30 percent. At what point do they start to become interesting buys again?
Aggarwal: The stock price movements sometimes may be not only the function of fundamental but market expectations because what has happened is that there was a lot of hope which was built on that the second half of the year would be good, the demand will come back. However, as things have not moved out in that manner the stocks have corrected because earlier what was happening was it was more like a margin expansion and price-to-earnings ratio (PE) expansion. So, that is why not only Marico many of the other FMCG stocks have also corrected.
Reema: Right now the street is expecting that the situation should improve by H2 of FY18. Is it all in the price? Is there an opportunity to buy any individual FMCG names right now and if yes what will be the investment thesis?
Aggarwal: First, we have not seen earnings cut happening in the estimates from the streets for most of the consumer names. Second, we are having a very different cycle this time around as not only the demand has got impacted but the input costs are also moving up. So, I don't think that even if the demand comes back in a quarter or maybe two quarters then the margins can support the kind of earnings growth we have seen in the past two-three years._PAGEBREAK_Sonia: I wanted to discuss also at length what is happening at paint space. The paint companies seem to have been bearing the biggest brunt of the demonetisation impact on demand. Some of the stocks like Asian Paints have seen absolutely no recovery since demonetisation was announced, in fact fallen about 20-25 percent. Is it because of how expensive valuations are or is it because there is no way to find out what the damage on demand could be?
Roy: No, we are positive on Asian Paints. Obviously the fall has made it more attractive. In paints because of demonetisation there is slight difference. The painting may get postponed unlike consuming chips or any other snacks - that opportunity gets lost because of demonetisation. In paint what will happen when cash comes back the demand will come back in most cases plus because of GST there will be market share gains and in the past we have seen also that paint companies have consistently given the strongest volume growth even in the last one year and because of very high pricing power. So, yes, crude oil has moved up but if you remember crude is still way below the USD 100-120 per barrel we have seen earlier. So, these companies have strong pricing power. So, in our thesis clearly paint is one of the highest conviction bets in the consumer space.
We believe it is a good time to start buying these companies. Correction has happened because these stocks are over-owned, there is a broader market correction, crude prices have gone up, but if you really go deep there is strong pricing power in this industry and anyway demand trends are quite strong. Demonetisation has derailed everything but we believe because of GST also 30 percent of the unorganised sector that definitely market share gains will happen for Asian Paints, Berger Paints India etc. So, we are positive on that space.Reema: Would you concur, would you believe Asian Paints has the pricing power in the situation we are currently in which can protect its margins because you don't have a buy recommendation on Asian Paints.
Lohchab: Yes, we have had a sell recommendation on Asian Paints for for last 9-12 months. We believe valuations had gone just way out of whack and risk reward was unfavourable on the stock. Pricing power is there definitely. We have seen in the past that paint companies are quite nimble in terms of taking price hikes and even passing on the cost advantage at times with some sort of price declines which we have seen earlier this year at the beginning.
However, as I said, probably in February or March of this year we expect Asian Paints to take a price hike but we doubt they would be able to take the big quantum of 8-10 percent which might be needed to completely neutralise the RM pressure. What they might take is 3-4 percent price hike and they would look to absorb some sort of impact on gross margins because anyway they are sitting at really high gross margins if you look at the last five year sort of trend. So, yes, pricing power is there but from these levels we expect some moderation in gross and EBITDA margins even for Asian Paints.
Sonia: You are positive on Pidilite Industries. The earnings have been decent but the stock has fallen considerably over the last couple of months. Do you think that one can get better levels in the quarters to come or do you think that this is a good price to buy? Roy: The stock has corrected a lot. It is a good time to buy again, a very quality name. This company in fact has higher market share even than Asian Paints in its respective space. We hardly know any pan-India competition to Pidilite which has existed for a long time. Asian Paints has come in this space in some segments of Pidilite but definitely Pidilite's market share is very strong, very strong pricing power.
Yes, the margins for most of these companies are at a life higher. There could be some shave off of the margins but definitely with discretionary consumption coming back after demonetisation eases off and because of GST -these are the companies which will gain market share. There are lot of regional players in this. We don't know those names because those are very small names in respective states but there is a lot of market share gain opportunity available again for Pidilite also.
The key raw material is vinyl acetate monomer. So, that has some indirect correlation with crude oil, but as I said last one year most of these companies have not taken price increase at all. In fact there has been a price cut for most of these companies. So, we have to see beyond March. After March clearly there will be price increase for these kinds of companies which is having high discipline, high pricing power and for the last one year there has been a price cut. So, there is opportunity for price increase for these kinds of companies.
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