Not fair or lovely: Why FMCG shares are now on the sell-list

By Rajanya Bose

Even in a slowdown, people have got to eat. They’ve got to brush their teeth and have a bath. This is the logic for choosing shares of fast-moving consumer goods (FMCG) companies - the so-called defensive sectors - when market sentiment is weak.

And they’ve delivered. FMCG shares have outperformed the Bombay Stock Exchange Sensex for almost two years now. In the first quarter of this fiscal, the BSE FMCG index outperformed the Sensex by 15.6%. Valuations are high, at 23-25 times next year’s earnings (2012-13).

Is the FMCG story now coming to a close? As a Business Standard report points out, intensifying competition and expensive valuations will mean one cannot expect much upside from here on. GSK Consumer, Colgate, Marico and Nestle are trading at 14-43% premia to their historical valuations. And there are clouds on the horizon.

The main worries relate to volatile raw material prices and intensifying competition. Angel Broking, in its results preview for the first quarter (Q1) of 2011-12, is calling for caution. Post the significant rally in ITC and Hindustan Unilever (HUL), the brokerage firm maintains a neutral view. In the mid-cap segment, it recommends a partial sell on GSK Consumer, Marico, Colgate and Nestle. It is neutral on Godrej Consumer, Britannia and Asian Paints.

Angel Broking and Religare are expecting strong topline growth for the FMCG sector this quarter, ranging from 19-21%. This will be due to the fact that the budget spared them an excise hike, and also volume growth and price increases. But the concerns remain over operating margins shrinking because of rising input costs and compromised pricing power due to rising competition.

One of the main factors that help protect margins is pricing power. Though it is important for any sector and any company, it becomes visibly crucial for the FMCG sector, where competition is high.

An IIFL report interestingly shows five factors that determine pricing power in certain segments like, soaps, detergents, biscuits, etc, or for a company. It defines pricing power as the ability of a brand to raise prices relative to competitors without losing consumers to cheaper alternatives or reducing consumption demand from existing consumers. A brand’s pricing power cannot be de-linked from the competitive context of its category.

The five factors it talks about are a brand’s market share, the difference in market share between the leader and the No. 2 player, the growth rate in the category the player is present in, the deep pockets of competitors which determine their ability to sustain losses or low margins for long time, and local or unbranded alternatives available in the market.

IIFL says pricing power is highest in health supplements, hair oil, skin care, home insecticides and pain balms. Where pricing power is compromised the most are detergents, soaps and biscuits. This suggests that GSK, Emami, Nestle, Godrej Consumer and Marico face minimum risks of hyper competition.

The entry of new players who undercut pricing and are ready to sustain losses also poses immense threat to players. This is best exemplified by the aggressive pricing policies of P&G wherever it has entered.

What could be a major threat to the FMCG sector, as assessed by Spark Capital, is slowing down of the rural market - which absorbs a third of the volumes - and which has grown 1.5-2% faster than urban markets. Inability to pass on the entire cost increase to consumers and growing general inflation could be other dampeners for the sector. However, Spark likes companies that are exploring markets abroad.

Overall, the long term consumption story in India can remain intact. But most brokerages warn that profits might not match revenue growth. For investors, this means they should not depend on these stocks excessively in a bear market. They should book partial profits in these stocks now.