FMCG stock valuations have soared over the past year, benefiting from the investor flight to quality, even as these companies weathered the challenges of inflation reasonably well. However, valuations have now been re-rated to levels that allow little margin of safety to investors and the time appears ripe to take profits on select stocks. The stock of GlaxoSmithkline Consumer Healthcare, trading at about Rs 2,500, offers a good opportunity to book profits.

The stock has been an outperformer in the FMCG space, delivering a 58 per cent return since our ‘buy' recommendation in March 2010 and a 18 per cent gain from our reiterated ‘buy' in February 2011. The stock's price earnings multiple has climbed from 29 times (trailing 12-month earnings) then to 34 times now.

Outperforming the sector and delivering earnings growth that justifies these valuations may prove difficult for GSK Consumer, given the likelihood of higher input cost pressures in the year ahead and higher competition that ups uncertainties in its key categories of health drinks, biscuits and noodles.

The recent moderation in crude oil prices may temper raw material-related pressures for FMCG makers in categories such as detergents or shampoos whose inputs are linked to the petrochemical price table. However, this will not materially benefit GSK Consumer, for whom the key inputs are agricultural — malt extracts, milk, wheat and sugar.

GSK Consumer managed to tide over the moderate 7 per cent escalation in its input costs in 2010 by resorting to pre-emptive price increases. Prices of sugar, malt and milk are expected to rise more sharply this year; but significant price increases for GSK Consumer may be curtailed by the rising competition in every category in which it operates.

While Hindustan Unilever (Kissan Nutrismart) recently forged an entry into malted food drinks, Britannia and ITC represent potent challenges in the premium biscuits segment. Even noodles, where GSK's Foodles did make headway last year has become a more contentious segment with ITC rolling out Yippee noodles, Hindustan Unilever promoting Knorr and Nestle fortifying its Maggi. Both biscuits and noodles have proved to be fairly price-sensitive segments where consumption is driven by low unit pricing.

With new forays and high competition, GSK Consumer may also have to retain a higher ad-spend-to-sales ratio (15-16 per cent) within the FMCG space, requiring a further sacrifice on margins.

After closing 2010 with a scorching 20 per cent growth in sales and 28 per cent increase in net profits, GSK Consumer's performance in March 2011 quarter showed some moderation. While sales growth was tempered to 9.5 per cent, net profits expanded by 15 per cent. While a single quarter's performance may not be cause for concern, a sustained moderation in growth will be a challenge to the high valuations enjoyed by the stock.

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