Diverging performance

FMCGs are no longer likely to report broadly homogenous sales or profit growth trends. The June quarter numbers underline this. For the quarter, Hindustan Lever and Nestle India, two of the largest players, have suffered a 45 per cent and 36 per cent drop in their respective profits. In contrast, profit growth has been robust at Britannia (70 per cent growth), Godrej Consumer (25 per cent), and Colgate Palmolive India (23 per cent).

There is also a sharp divergence in sales growth between players. A few appear to have notched up reasonable growth, despite the slowdown in their underlying categories, but others have not.

Colgate and Godrej Consumer, for whom toothpastes and soaps are the key revenue drivers, reported sales growth of 7 per cent and 15 per cent respectively for the quarter. But HLL's toothpaste and soap sales were flat this quarter, indicating a reshuffling of market shares in favour of the former.

Product profiles influenced sales and profit growth this quarter. Those in the detergent and shampoo segments suffered a sharp dip in their contribution margins, as price cuts of 20-25 per cent, effected in March, cut into their bottomlines. On the other hand, players in the soap, cosmetics and toothpaste segments, where price wars have not yet surfaced in a big way, fared much better. This divergence could continue for the next three quarters, given the base effect.

Spectre of choppy earnings

Investors should prepare for negative surprises, even in categories where there have been no overt price wars. Price wars have so far happened only in detergents and shampoos. But pricing pressures are actually exerting an influence in most other FMCG segments as well.

In mature categories such as toothpastes, soaps — even tea, players are trying to broaden their market through "affordable" packs, with price tags of Rs 5, 10 and 20. Experience suggests that effecting hikes in selling price from such price points can be tricky, and may meet with consumer resistance.

Local brands have mushroomed and are looking to crawl into any gap in the market. And MNCs such as P&G and Gillette, which earlier stuck to the premium end of the market, have turned price warriors. All this combines to create an environment where price increases for any FMCG product will be difficult and, if effected, will have to be donewith a watchful eye on the competition. With the comfort of regular hikes in product prices no longer available, players may have to absorb sharp swings in commodity prices into their margins. This will mean more volatile profits than in the past.

Still looking for growth drivers

With most FMCG categories shrinking or crawling in single digits, the industry is still looking for a big growth opportunity that will add substantially to its size. Forays into food, once billed a high-potential market, have not yet worked for most players. In mature categories such as soaps, detergents and toothpastes, players are trying to rope in new consumers by making some sacrifices on price. But a faltering monsoon, with its implications for rural income, is not helping these efforts.

Yes, a yawning gap still exists between Indian usage levels for most FMCG products and those abroad. But with several new product categories emerging to compete for the consumer's wallet, premium FMCG brands may not be the uppermost in their shopping lists. For now, robust sales growth for individual players will have to come from market share gains or successful forays into niche markets. By virtue of their small base, it may be easier for smaller players to notch up respectable sales growth than it is for players who have a lion's share of any category under their belts.

Profit growth through lower tax incidence

Most players in the FMCG sector are seeking to pep up their profit margins by putting up new manufacturing facilities in excise- and tax-free zones. This strategy could give companies greater manoeuvrability with respect to their profit margins; a larger portion could be ploughed back into brand-building efforts or price cuts.

Colgate-Palmolive India, Godrej Consumer, Marico Industries, Dabur and Britannia, as also HLL, are looking to source a substantial portion of their output from tax-free zones. Profit growth could outpace sales growth as these capacities come up over 2004 and 2005. This will make for reasonable, but certainly not spectacular, profit growth.

Payouts may swing valuations

With interest rates flattening out and treasury operations recording lower returns, piles of cash on the balance sheet may not be attractive from an investor viewpoint. Companies that pay out more cash through dividends and buybacks may be command better valuations in the market.

Parameters such as dividend yields, payout ratios and buybacks may increasingly influence FMCG stock prices. Regular buyback programmes that mop up their shares from the market appear to have helped Britannia, Godrej Consumer and Nestle keep their stock prices steady over the past year, despite the ups and downs in their underlying businesses.

Rejigging your FMCG portfolio

FMCG stocks may no longer be defensive investment candidates. But this does not mean that they do not present any money-making opportunities for investors. They may deliver high returns in short bursts of activity. Colgate-Palmolive has appreciated an impressive 28 per cent since June 2004. P&G Hygiene has, likewise, put on 14 per cent over the past month.

Such trends, driven by a turnaround in performance, may be difficult to spot in advance. But picking out FMCG stocks based on their relative price-earnings multiple, is certainly a strategy that has paid off over the past couple of years.

Stocks of FMCG companies such as Marico and Godrej Consumer would have offered you a respectable return, no matter when you picked them up, over the past two years. The valuation for these stocks has moved up from a modest 9-11 times their earnings, to 15-19 times over the past two years, as they were re-rated for their better growth rates and friendly distribution policies.

For the present, if you are a risk-averse investor, it may be safe to pare exposures to some of the larger FMCG players with stiff earnings multiples. Nestle India trades at a hefty valuation of 23 times despite its recent profit drop; so it may be time to reduce exposures to the stock.

Despite their better growth prospects, their high PEMs may make Gillette India and Tata Tea vulnerable to even a quarter of poor numbers; investors may be better off reducing exposures to these too. Investors can hold Colgate-Palmolive, P&G Hygiene, Godrej Consumer and Dabur India, in light of a revival in profit growth in recent times.

HLL's valuations have slumped from about 22-23 times to 18 times over the past year, on the back of lacklustre earnings performance. Based purely on its earnings prospects as of now, the present valuation appears high. But given the buzz about Unilever's plans to outsource products from its Indian subsidiary, investors in the stock can hold on to it for now.

Indian FMCG companies do have access to a low-cost manufacturing base and any such initiative could open up a new avenue for volume growth. Fresh investments in the stock need not be considered for now as this development is purely in the realms of speculation.

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