Not so fast

Slow growth and high valuations seem to be making investors wary of FMCG stocks

Although 2015 has not been an easy year for Indian industry in general, what with the disappointing rainfall and slow growth, FMCG companies seem to be more than a little worse for wear. “There is the reality of the rural market being under stress. We all know that this segment used to deliver 1.5-1.7x the growth seen in urban markets,” Hindustan Unilever’s CFO PB Balaji said during the company’s Q2 earnings call, as the company reported earnings lower than analyst estimates.

According to Bloomberg consensus estimates, analysts were working with sales figures of ₹8,030 crore and profit of ₹1,040 crore; the company, however, reported sales of ₹7,820 crore, while profit stood at ₹962 crore. Rural demand has been dealt a sucker punch by two consecutive rainfall-deficit monsoons, resulting in three back-to-back crop failures, that is, Kharif 2014-15, Rabi 2014-15 and, now, Kharif 2015-16, which have together drained farmers’ savings. Lower rains in CY15 also put at risk the upcoming Rabi crop (March/April 2016).

Skidding to a halt

FMCG sales growth has slowed down over the past 13 quarters

Apart from the several factors that have sapped the purchasing power of rural households, a moderate MSP increase over the last two years, higher cost of cultivation and low rural wage growth have also weakened the rural economy, says an analyst at Spark Capital who did not wish to be identified. 

All this doesn’t bode well for FMCG players like Hindustan Unilever, who make a large chunk of their sales in rural markets; HUL has as much as 35% of its sales coming from rural India. And it is not alone — as per a recent Nielsen market report, P&G, Nestle, Britannia and ITC derive 12-30% of their sales from rural markets. Given the circumstances, FMCG players are willing to let go of some of their realisations to sustain volume growth.

“The consumer sector is currently experiencing a sort of deceleration in demand. The volume growth seen has been on the back of compromises on pricing. Overall, the top line of FMCG companies has been decelerating. Some of the larger companies are trying to retain their market share at the cost of realisations,” observes Dhananjay Sinha, head of research at Emkay Global Financial Services. According to a note put out by IIFL, FMCG companies’ Q2FY16 ad spend was up nearly 16.7% Y-o-Y.

PB Balaji, Hindustan UnileverSanjeev Prasad, senior executive director and co-head at Kotak Institutional Equities, feels there could be more pain in the offing for these companies. “Historically, FMCG companies have seen price growth in line with or above inflation. Then, you have some amount of volume growth and some amount of up-trading, that is, consumers moving from lower-priced products to higher-priced products. However, with pricing likely to take a hit amid falling inflation, revenues are going to see a lower trajectory.”

One key trigger that could change the demand scenario in the coming fiscal is the Seventh Pay Commission, which could put an additional ₹1.02 lakh crore in the hands of government servants, including 47 lakh central government employees and 52 lakh pensioners. That could give an unexpected boost to demand, although it might take some time to kick in.  

But for now, even as FMCG companies’ sales are growing at their slowest pace in at least 13 quarters as per an IIFL note, some of them are trading close to or above their long-term average earning multiples. For instance, HUL is currently trading at one-year forward P/E of 36.4x, while its five-year average P/E is at 31.7x. ITC is currently trading at 25.9x, while its five-year average P/E stands at 26x. Colgate-Palmolive is trading at 37.9x; its five-year average P/E is at 33.9x.

According to Prasad, given the high multiples of these companies and top line and bottom line likely to be growing in the 10-15% range, it makes little sense to invest in this set of companies. Andrew Holland, CEO, investment advisory at Ambit Capital, who oversees the hedge fund Ambit Alpha, feels that there is no reason to be paying 30-40x for companies that are growing at an anaemic pace. Buying into these companies doesn’t make much sense unless the earnings multiples contract to the near-20s. Meanwhile, FMCG players hope that the worst is behind them as far as rural markets are concerned. “…our hope is that all of the bad news from rural India is already in our current performance, that’s at least our hope,” added Balaji during the earnings call. Amen to that.