FMCG sector: Pressures mount on earnings and valuations

When markets are in a correcting mode, one sector that jumps to mind for its ‘defensive’ qualities is the FMCG sector. With their staple business, non-discretionary spending holds revenues in good stead. But FMCG companies have instead corrected about 20% from their October ’21 peak. Against the Nifty 50, they have been underperformers over the past two years. So, what gives?

Around this time last year, we had analysed the FMCG sector’s March 2021 quarter earnings. Though companies, then, clocked strong numbers, we’d added a cautionary note on creeping input cost inflation. This risk took firm hold as the year progressed and FMCG companies have had to raise product prices, hurting demand and volumes, to combat pricier inputs by the March 2022 quarter. 

Can they tide over this bump? With the correction, does the sector now offer better valuations? In this report, we dig into the FMCG sector Q4 results and explain where the sector stands now.

Overview of FMCG Q4 results

Inputs for FMCG companies are wide-ranging, from agri inputs to crude oil derivatives to packaging. Rising commodity prices had already begun last year. The Russia-Ukraine war exacerbated the situation, as did an export ban on palm oil – a key FMCG input – by Indonesia. 

FMCG companies had to raise product prices to combat costlier inputs. Consequently, volumes were hit in the March 2022 quarter and earnings growth came mainly from price increases. For Hindustan Unilever (HUL), Godrej Consumer (in its India business) and Tata Consumer, growth came purely on the back of price increase with volumes staying flat, and Dabur saw some decline in volumes. The situation remains challenging for the companies as they have to take more price increases. That can trigger down-trading, where consumers switch from expensive products to cheaper alternatives, impacting both volumes and margins in the short term. 

With a decadal shift happening in commodity prices, inflation and interest rates, here are the key challenges that the FMCG sector currently faces.

Key Challenges

#1 Weak earnings growth

Both FY22 and the March 2022 quarter throw signs of weakness for the FMCG sector in terms of growth. Weak rural economic recovery, which contributes between 30-50% of sales of FMCG majors, was cited as one of the reasons. Rural demand was also affected by sharp price increases taken by companies, to the extent of 11.9% compared to 8.8% for urban areas, in Q4 FY22, according to a Nielsen study.  Urban demand also tapered off in the March quarter due to high inflation (See Steep price hikes hit rural demand | The Financial Express).

Companies managed to grow revenues in line with their 3-year average, through higher product prices even as volumes slowed. However, price hikes were not enough to absorb input prices, and FMCG companies saw profitability growth coming off. As the table shows, EBITDA and PAT growth for companies were far below their average, except for outliers such as Tata Consumer and Marico (more on that later).

#2 Input cost headwinds

As mentioned above, costs were the primary concern for all FMCG companies in FY22 and especially so in Q4 FY22. The biggest impact has been in the oil basket - sunflower oil, rice bran oil, palm oil, and so on, which are up between 35-50% year-on-year. This hurts companies that are either in edible oils or use them as inputs in their packaged foods; along with an 11% jump in wheat prices, another key input. Other inputs like soda ash and plastics saw a 20-30% jump in prices. The most impacted are companies with a high share of personal care products like shampoos & soaps in their portfolio. 

The only segments to see relief were those such as tea & copra, which were two commodities in a deflationary cycle during the quarter. This acted in favour of companies like Marico & Tata Consumer. Copra prices were down 9% sequentially and down 31% year-on-year while India tea prices declined 20% during the March quarter.

The higher input prices have led to gross margin (sales – raw material cost) contraction for most companies. FMCG major HUL saw a 3.1 percentage point contraction in gross margins in the March ’22 quarter, similar to that of Nestle India. This is despite increasing prices during the quarter. Dabur and Britannia managed comparatively better, with margins dropping 1.3 and 2.4 percentage points respectively. A poor show in its Indonesian market hurt Godrej Consumer, which took the steepest gross margin at 6.3 percentage points. Marico and Tata Consumer were relatively less affected this quarter, as they escaped the pricier inputs as explained in the point above. 

The table below shows how raw material prices impacted gross margins for FMCG sector companies in Q4 FY22

However, in times of costly raw material, FMCG companies use the ad spend lever to curtail costs. Companies cut back on ad spends, which shored up their operating profit margins along with other cost-saving measures. While industry biggie HUL cut advertising back by 1.9% in the March 222 quarter over the year-ago period, other FMCG companies pared spending by 0.6% to 1.9%. Marico alone was an exception. As the graph below shows, companies have managed to sustain overall profitability, barring Godrej Consumer.

But that’s not much to cheer at, as companies cannot cut promotional spending for long without it hurting toplines. In any case, all FMCG companies have sounded cautious notes on the margin picture for the next two quarters and don’t expect improvement. Companies also expect demand to be tepid due to high inflation. The only player that appeared optimistic was Tata Consumer, which is still in a transformation process and expects several levers including brand strength, distribution expansion and scale to positively impact margins.

#3 Volume growth concerns

With companies raising prices, volumes have taken a hit. A prolonged volume slump is challenging as price growth alone cannot sustain revenues, which needs support from underlying volume expansion. Low volumes are also a sign of poor consumer demand.

According to Nielsen data, the overall FMCG sector has seen a value growth of about 6% in Q4 FY22 while volumes shrunk 4.1%. The de-growth in volumes was significantly higher for non-foods at 9.6% y-o-y compared with a contraction of 1.8% y-o-y for food.

A key factor affecting volume growth is downtrading, which is expected to continue in coming quarters as well. HUL has introduced bridge packs (intermediate grammage by bridging price gaps) in several product categories, which confirms the down-trading trend. And according to Dabur, its low-priced sachets are faring better than larger packs, with the exception of modern trade.  

Another factor impacting volumes are companies resorting to grammage cuts and introducing lower-weight packs – which also affects volumes - instead of hiking prices which could hurt demand. 

For HUL, volumes were flat in the March quarter, though sales and profits grew 10% led by price increase. Dabur saw a drop in volumes. Godrej Consumer and Tata Consumer saw domestic business grow through price increases rather than volumes. Only Marico and Britannia bucked the trend, with the former holding on to 1% volume growth led by its Saffola franchise and the latter managing a mid-single digit volume growth.

Valuations continue to stay rich

FMCG stocks were the market darlings between 2012 and 2020. But that has since turned tide. The FMCG Index delivered 16% absolute returns from January 2020 (pre-Covid) to date against 30% for Nifty 50, despite growing earnings during this period. On a 3-year CAGR basis, earnings grew 7-11% between FY19 and FY22 despite Covid.

So, 2 years of low returns and a correction higher than Nifty should mean valuations moderated. And that certainly has taken place. As the table below shows, current PE multiples for the FMCG sector companies have significantly come off their highs.

But when seen in context of the current higher interest rate scenario, valuations are still on the expensive side even after moderating. A measure of this is the earnings yield, which stands anywhere between 1.5 to 2.5% at present. This is in comparison to Nifty 50 earnings yield of ~4.5%.

Earnings yield: This is inverse of PE ratio and helps to check stock valuations by comparing their earnings yield with the bench mark index earnings yield and the govt of India bond yield. Since FMCG companies are known for stable earnings with moderate growth, a comparison with bond yield makes sense.
With interest rates rising globally and India 10 year bond yields soaring to 7.3%, a re-check on valuations is necessary.

Even if we assume a 10-15% earnings growth for FY23, on the back of price increases, the earnings yield will be 2% to 3% compared to Nifty 50 earnings yield of ~4.5% and India 10-year bond yields of 7.2-7.4%. To justify current valuations, a 10-15% growth calls for a 3-3.5% earnings yield. That implies a further correction of 15-20%.

Also, a comparison of historical valuation of companies may provide more light on valuations. A 10-year PE ratio chart of the above FMCG sector majors is below.

From the chart, you can see that most of the companies were trading in the 20-40 times PE ratio band at the beginning of the decade while they ended up in the 40-80 times PE band at the end of the decade, before the recent correction.

Now, the valuations have moderated to 40-60 times PE band. If interest rates rise more, a further contraction in the PE band cannot be ruled out. Do note that interest rates were rising between 2010 and 2011, when repo rates reached 8.5% and remained elevated at 7.25-8% until nearly the end of 2015. Rates moderated from then on to bottom out at 4% in the aftermath of Covid. Rates are on the rise again.

The FCMG sector, being a secular earnings story, had a stellar ride over the last decade. A margin expansion along with a falling rate scenario had helped the PE expansion in the sector, as did the ‘quality’ and ‘consumer’ tags that these companies enjoyed. That case is now being tested.

What is in store for investors?

The FMCG Index is already underperforming the Nifty 50 as explained above. FMCG companies are known to survive inflationary and high-cost situations through various measures – smaller pack sizes, product price hikes, cutting back adspends, and cost rationalisations. The short-term impact of these measures will be felt on volume growth, and margins may recover gradually. 

In the present scenario, FY23 may be a flat year for earnings growth - unless volumes recover in the second half, aided by rural demand. Companies do appear optimistic on a rural demand revival with a forecast of normal monsoons and higher agri commodity prices. However, sedate rural wage growth and high rural inflation are factors that still need to be watched. 

So, based on how the second half of FY23 will play out, the following scenarios may emerge in FMCG sector stocks:

1. Price may continue to correct, in turn moderating valuations 
2. Stocks may not correct, but consolidate for an extended period until valuations eventually moderate as earnings come in

Considering the present environment of slowing consumer demand, high inflation and interest rates, we are not seeing a case for these stocks to make new highs. We’d take a re-look at these companies if valuations moderate further, or input cost inflation cools off, or rural demand shows clear revival.

In the medium term, companies are optimistic on growth led by organic and inorganic initiatives. For example, Tata Consumer has decided to put its Rs. 2,500 crore cash kitty to work to acquire more brands, while holding its guidance on double-digit growth with margin expansion as it builds scale. Marico holds a medium-term aspiration (not guidance) of delivering 13-15% growth on the back of 8-10% volume growth. Britannia has set its sights on organic growth through major expansion in dairy while Dabur is banking on its health and juice verticals for growth.

Therefore, more comfort on the valuation front or the margin front will be key to capturing this longer-term growth story in consumer staples.

Quick note - most of the data that we have used here are from Prime Stock Screener and you can also make use of it to run data, download it in excel, save in the stock screener itself and retrieve any time.