Volumes growth for fast-moving consumer goods (FMCG) sector will remain flattish due to muted rural growth and flat urban demand in Q2, says Varun Lohchab, Head of India Research, CIMB Equities. However, his only buy recommendation in the sector is ITC.On ITC, he says: “The worst of the volume decline is over for its cigarettes; it will trade at 20 times the valuations in second half and will witness earnings growth in FY17.” Lohchab is of the view that advertising and promotional spends will continue to rise going forward due to increasing competition and lower demand.He is underweight on midcap stocks as their valuations are at a significant premium to largecaps, with most trading 40 times. He says the risk reward is unfavourable for such FMCG stocks. Meanwhile, CIMB has upgraded Titan for investors with 12-18 months view. This comes on the back of expected rise in jewellery demand and earnings growth, Lohchab adds.On commodities, he says lower prices will prevail for another 12-18 months. Below is the verbatim transcript of the interview.
Nigel: More analysts are now pricing in a moderation in volumes growth for the second quarter. How are you anticipating volumes to pan out for the second quarter?
A: For Q2, we believe volume growth will be at best flattish on a sequential basis for most of the companies and in fact for some of the companies, we are seeing a moderation because rural growth has been quite muted. So, as per our channel check, urban demand is sort of flattish, so there is no uptick or downtick in terms of urban consumption but on rural there is slight downtick. So, volume growth for most companies are at best flattish to slight moderation compared to Q1 levels.
Reema: In your note, you are particularly underweight on midcap FMCG companies, what is the rationale?
A: If you look at the valuations for the midcaps, they are trading at a significant premium to largecaps for most of the staples companies. So that is why we believe risk reward becomes more unfavourable in case of midcaps because most of them are trading at more than 40 times on a one year forward price to earnings ratio (PE) basis whereas I do not think the growth differential for those companies will be much higher going forward.
So, the margin tailwind which is there will remain only till Q2 and for some extent say Q3 and post that the earnings growth moderation will happen for most of the companies because topline growth is not coming in. Therefore the midcap valuations are making us more cautious on them at this moment.
Nigel: Do you anticipate further expansion in margins owing to declining commodity prices or do you expect the advantage to moderate as well? How are you reading the advertising as well as promotion spends and also what will their impact be on the margins?
A: On commodities we do not have a very strong view. What we have assumed is that the current commodity prices will continue into the rest of the year as well as next year FY17. So, most of the commodities have already fallen quite a lot and we expect those sort of lower prices to prevail over next 12-18 months. If they fall further from here then we could have some potential margin upsides in FY17 as well but that scenario as of now, we are not building in our base case.
If you look at advertising and promotion (A&P), we expect an uptick in this quarter also and that to continue in the next few quarters because the gross margin expansion will be ploughed back by most of the companies because the volume growth is not coming in. We are seeing a rise in competitive intensity in a lot of the categories like detergents and soaps and biscuits where you are seeing a lot more promotions on the ground.
Therefore, A&P will remain at elevated levels and probably even inch higher from what we had seen till Q1 and commodity prices, we have assumed, will stay at these levels for the next 12-18 months.
Reema: You have a buy on ITC and that seems to be you only buy in the consumer staples space. Tell us why because the stock has not done too much at least in the last few months.
A: So, in pure staples, we have ITC as the only buy and we have Titan as the other buy in the sector, which is more consumer discretionary.
In case of ITC, our view is that the worst of the volume decline is over. If you look at Q1, we had almost a 16-17 percent sort of a volume decline in cigarettes and we expect that to slightly look better going forward. Q2, we are expecting another 13 percent sort of a volume decline on year-on-year (Y-o-Y) basis but in second half we expect volume growth to come to a very small decline number or a low single digit sort of a number.
So, the earnings before interest, taxes, depreciation and amortization (EBITDA) growth trajectory and overall earnings trajectory of ITC will improve in second half and valuations out there are quite reasonable at 20 times FY17. Vis-à-vis the sector where we expect the earnings growth to actually moderate into second half as the tailwind of margins will go away.
So, the earnings growth for ITC will start to converge with the rest of the staples companies from second half and therefore the valuation discount that ITC is trading at makes it fairly attractive in our view.
Nigel: You have also recommended switching from Jubilant Foodworks to Titan. What is the rationale behind that?
A: Jubilant we had recently downgraded. Post Q1 numbers, stock is at around Rs 1,800. We believe that the risk reward was not looking as attractive, so we had downgraded it from add to hold.
Titan on the other hand, we have upgraded it post Q1 from hold to add. So, therefore, we were recommending that investors with a 12-18 months view should start accumulating Titan at these levels because risk reward is attractive.
On Titan we believe that the jewellery demand has probably seen the worst. Q2 will be a weak quarter but that is more or less expected because last quarter in the base we had a big number from Golden Harvest Scheme winding down. So, if you exclude that we believe earnings will be quite reasonable and that will probably accelerate going into second half plus we will have the positive impact of the new Golden Harvest Scheme. The earnings growth trajectory and the overall jewellery growth trajectory will improve in case of Titan going forward.
In case of Jubilant, it is a hold for us. At a lower level, one can probably look at it but at current levels, valuations look full to us. We do not believe that same-store sales growth (SSSG) will have a very sharp recovery from current levels of around 4-5 percent, which they have been witnessing in last couple of quarters.
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