Does FMCG still remain a dependable defensive bet?

FMCG valuations 

Amit Gupta, vice president and fund manager of ICICI Securities Portfolio Management Services, also links the sector’s underperformance to its high valuations.

So the question to be asked is: are FMCG stocks still a dependable defensive bet? Jefferies report notes that they have outperformed the Nifty in a difficult macro environment, and cites four examples to illustrate. In CY00-01, post the dotcom bust in the US and with weak monsoons, FMCG saw a minor 2% decline over the two year period versus 28% decline of Nifty. In CY08-09, after the Global Financial Crisis (GFC) caused the Nifty to decline 50% in CY08, FMCG saw a lesser than 10% decline in CY08 and 40% return in CY09. In CY10-13, when there was a slowdown in GDP growth and a sharp surge in inflation, along with high oil prices, elevated CAD and currency depreciation, the sector’s outperformance continued with earnings growth and valuation re-rating (see below). 

In CY17-March 20, when GDP growth was impacted by disruptive events such as demonetisation, GST rollout and the pandemic, FMCG outperformance continued with margin expansion and valuation re-rating over volume and revenue growth (see below). 

This time, Jefferies is optimistic, seeing a turnaround in the sector’s earnings in the second half of this financial year because of factors including demand recovery and price hikes that can finally offset cost pressures. Added to that, valuations have corrected 15-35% from their 52-week highs and their one-year forward price-to-earnings (PE) multiples are either at or lower than their five-year average multiples.

Sharekhan’s Kaustubh Pawaskar sees “limited downside risk” to the FMCG stocks’ valuations.

“FMCG stocks have corrected from their highs and most of them are trading at discount valuations to their historical average,” said Pawaskar, deputy vice president of fundamental research at Sharekhan by BNP Paribhas.

In contrast, HDFC Securities remains “mildly underweight on the sector and prefers selective picks”.

Despite their poor performance, FMCG stocks haven’t corrected sharply enough and valuations remain high, said Jasani.

“We believe that the rising new-age competition, along with being at peak margin will continue to keep valuations in check for the major FMCG basket. Companies’ own initiatives to boost earnings (by new product introduction, expanding distribution and cost cutting) will continue to be monitored for valuation purposes,” he added.

Pressure on margins to ease 

Market experts interviewed by Moneycontrol  expect margins to be under pressure in the first half of  financial year 2023, but to improve in the second half.

“While H1FY23 is likely to be challenging with higher input costs and muted buying sentiment, we expect recovery in H2FY23 with a caveat that the monsoons are normal,” said HDFC Securities’ Jasani. That said, various reports are already alerting us to a monsoon deficit. A recent Nomura report said that, until June 27, the monsoons have been deficient with India recording 10% below average, with a significant deficiency (>40%) in the key states of North and West India. 

Yes, commodity prices are cooling, but they are still high. “In the very near term, specifically for Q1FY23, prices of key inputs for the sector have come off their peaks, but still remain high on a year-on-year (YoY) as well as sequential basis. High-cost inventory will hurt FMCG players for the better part of Q2FY23. If commodity prices witness further correction from the current level, the margins might witness a sequential improvement from Q3FY23,” he said.

Any rise or drop in commodity prices kicks in with a lag of two months for FMCG companies, said SBICAP Securities’ head of fundamental equity research Sunny Agrawal.

The securities firm expects the lower commodity prices to start reflecting from August 2022 and hence the margins to benefit partially from Q2FY23.

“Full impact will be visible during Q3FY23 and Q4FY23,” said Agarwal.

FMCG prices 

Pawaskar said that in the second quarter of FY23, companies may focus on regaining volume growth and would pass on some benefits to consumers in the form of price cuts or additional grams in their packs.

Price hikes by FMCG companies have not been enough to offset the rise in input cost and that will continue to weigh on the margins in the first half, said Nirvi Ashar, manager fundamental research, Religare Broking.

“We expect improvement in margins in H2FY23 with some respite in input cost, nominal price hikes and saving measures taken by the companies,” he said.

Stock picks

Among FMCG large caps, Sharekhan likes Hindustan Unilever, Nestle India and Asian Paints for their strong product profile, leadership positioning in key categories and extensive distribution reach, which the brokerage believes will help them achieve faster recovery compared to peers in the event of demand recovery and stable raw material prices. They also picked Tata Consumer Products and Marico, “which are likely to perform well in Q1FY2023 due to lower input cost pressure compared to other FMCG companies”. In the small-to-midcap space, they like Zydus Wellness for its strong portfolio in the niche and under-penetrated categories, and which is currently focusing on expanding its distribution reach and is revamping the market strategies to gain market share in key categories.

Religare’s Ashar picked Britannia and ITC. “Even in Q4FY22, their product portfolio, segment mix and cost-optimised measures supported them to sail through tough times,” he said.

ICICI Securities PMS’ Gupta said FMCG companies that are more dependent on agricultural inputs whose prices have corrected are the ones posting better numbers.

“The companies which have gained market share in these categories are going to benefit going forward,” he said, adding that the intense summer had also given the beverage segment a leg up. “Volume growth of these companies should come out better,” he said.

Companies such as Tata Consumer Products (TCPL) and Varun Beverages could fall under this category.

SBICAPS’ Agrawal named Dabur, ITC, HUL and Asian Paints. Dabur because its product portfolio is inclined towards the rural market and it has a unique proposition based on Ayurveda, and also because high agri-based commodity prices is a positive for rural income growth.

HUL’s strength too is linked to its branded and diversified product portfolio, which has a “huge headroom for premiumisation”. ITC’s recovery momentum is likely to continue, he said, “with healthy traction in cigarette volumes, improvement in hotel business led by increase in corporate and leisure travel, and gradual improvement in profitability of FMCG business”.

Despite an emerging competitive landscape, Asian Paints continue to be the “best business to ride on the shortening paint cycle in India, healthy housing demand and premiumisation in home improvement solutions,” Agrawal said.

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