FMCG beats Sensex at its own game, but valuation a turn-off

Market trading hours on Thursday could well be a key gauge of the strength of the fast-moving consumer goods (FMCG) sector. Even when the Sensex shed 2 percent, the FMCG index managed to hold ground, sliding by 0.19 percent.

But don’t think of diving into these stocks just yet: most consumer goods stocks are trading at expensive valuations. Hair care product manufacturer Marico, for instance, is trading at 28 times its one-year forward earnings while Hindustan Unilever (HUL) is trading at 27.4 times. ITC is trading at 25.6 times, according to JP Morgan estimates.

More significantly, all the top-rated stocks have given a 10-30 percent return over the past six months. Will the winning streak continue? While several analysts are optimistic about the outlook for consumer goods stocks, the fact is most stocks are expensively valued. So, will that make the FMCG sector the next underperformer?

Judging by the June-ending quarter results, the sector seems to be cruising along. Overall, consumer goods companies have posted a healthy 2.5 percent growth in revenues, and an 18 percent growth in net profit, primarily due to good volumes, price hikes in several categories and cuts in advertising spending.

Most companies cut advertising spend in commodity price-sensitive products like soaps, detergents, hair oil, although some of them pushed up spending on packaged foods and the personal products sectors. Such cost cuts helped restrict any steep falls in margins because of higher input prices: operating margins contracted by just 112 basis points – 100 basis points make one percentage point – compared with last year.

Product price hikes also benefited companies. While HUL hiked prices by 3-6 percent for its detergents, Rin and Surf Excel, ITC raised prices by 10 percent on its premium brand of cigarettes, Classic. Nestle India continued its series of price hikes; its latest move was to raise prices by 3-7 percent on its dairy whitener, coffee and baby foods. GSK Consumer also raised prices by 2.3 percent on an average across products; the company had earlier hiked prices by 5 percent around 9 months ago.

This year, an extra bonus could appear in the form of a good monsoon, which should stabilise food prices - key inputs for these companies. Crude prices have also cooled, which should reduce costs of crude-oil based packaging materials. Crude oil derivatives account for a significant proportion of packaging costs for the sector, and those costs could decline if crude oil prices continue to fall.

Edelweiss says FMCG companies typically spend 16-35 percent of their total costs on packaging; if these costs come down, margins could improve. According to JP Morgan, HUL and Dabur have higher exposure to crude or energy-related raw materials. Lower prices for wheat and coffee will benefit companies such as Nestle. Marico, too, could gain from the more than 10 percent drop in copra – a by-product of coconut – prices.

In spending mode

In addition, unlike companies in other sectors, which are busy contracting investment spending, consumer goods companies continue to be in expansion mode: Dabur launched a carbonated fruit-based drink called Burrst Fiz while Emami made a debut in the glucose drinks market with Zandu Glucose Charge. Agro Tech Foods entered the ready-to-eat meals market with Sundrop 10- minute Yummeals, which was introduced in major metro cities.

The buoyancy seems set to continue. In its latest report, CRISIL said consumer goods companies would continue to pursue acquisitions over the medium term as they attempted to dominate or enter new product segments and new geographies. In 2010, consumer goods companies made 113 major acquisitions worth Rs 5,000 crore.

This year, also, companies have gone on a shopping spree: in February, Marico took over International Consumer Products Corp of Vietnam while in June, Godrej Consumer Products snapped up a 51 percent stake in Darling Group Holdings of Africa.

With so many things going on, analysts remain upbeat about the sector, with Sharekhan and KR Choksey maintaining a positive outlook. Despite its high valuations, Edelweiss still has a ‘buy’ rating for Marico, with a target price of Rs 185, while Standard Chartered rates Britannia a ‘buy’, with a target price of Rs 512.

Optimism about the sector is widespread. David Pezarkar of Daiwa Mutual Fundrecently told CNBC-TV18 that investors must stay invested in the FMCG sector in the volatile conditions, despite expensive valuations.

While we completely understand the growth potential of the consumer goods sector given the buoyant consumption prospects in India, it is difficult to fathom the kind of return these stocks can promise given their high valuations. Indeed, this sector could turn into the next underperformer!