High input cost will continue to hit margins

Margin pressure is likely to accelerate as input costs continue to show an uptrend. The March 2011 quarter (Q4FY11) is likely to be better compared to the previous quarter (Q3FY11) for FMCG companies, especially in terms of margins due to price rise (steep in some cases) undertaken by all companies in response to unabated rise in input costs.

However, year-on-year (y-o-y), the revenue growth is expected to be lower as volume growth is likely to come off marginally (though in mid-teens) due to price hikes and end of festive season in Q3FY11.

The aggregate revenues of 12 companies is expected to grow 17 per cent y-o-y at Rs 23,202 crore, led by ITC (further higher volume growth in cigarettes from about three per cent in Q3FY11), Hindustan Unilever or HUL (double digit volume growth for fifth consecutive quarter), Asian Paints (strong demand in Tier-II and Tier-III cities) and Nestle (better penetration of processed foods in semi-urban areas).

Unlike the declining trend in past quarters, the operating profit margin (OPM) is likely to improve marginally by 32 basis points (bps) y-o-y at about 18.7 per cent helped by price hikes. Net profit margin (NPM) is also expected to move up by 48 bps to 12.8 per cent.

Margin support is expected to mainly come from ITC (price rise in cigarettes, lower losses in FMCG business), Titan (making charges linked to gold prices) and Nestle (relative stable agri-based inputs compared to volatile crude-based raw materials).

Excluding ITC, OPM (13.8 per cent) and NPM (10 per cent) is expected to be flat, partly due to drop of 125 bps in HUL’s OPM (lowest ever 11 per cent) and flat NPM (nine per cent).

Going ahead, FMCG companies are in a fix. Robust volume growth of past several quarters, the only growth driver for FMCG companies, is at risk in the event of any further price hike especially when most companies are focussed on price sensitive rural consumers for growth.

Trend of raw materials estimated by most analysts show an uptrend in the medium-term. Price-led growth also looks difficult due to limited pricing flexibility thanks to competition and high food inflation, which will prompt downtrading by consumers in certain product categories, where threat of substitute is high. Thus, robust revenue growth of past quarters is unlikely to continue if input costs continue to rise. And acceleration of margin pressure across companies looks a more probable scenario.

Amid the worsened macro scenario, FMCG companies’ valuation (near peak levels) of average 25 times FY12 estimated earnings (five-year average), makes risk-reward ratio unfavourable. Analysts are underweight on the sector. They prefer to be selective and favour companies having market leadership, diversified product portfolio, strong pricing power, niche presence with low competition, less sensitivity to input cost inflation and better visibility on volumes (demand) and profitability. ITC, Asian Paints, Nestle and Titan Industries are the top picks in this space, they say.