FMCG leaders on a roll

The consumption story is valid, but stock prices of ITC and HUL seem to be running ahead of fundamentals.

The BSE FMCG index reached its lifetime peak on Friday, propelled by ITC’s new high and Hindustan Unilever reaching a 10-year high. What is surprising is that both stocks were at their 52-week lows just about six months ago. They have now rallied around 50 per cent from those levels.

But analysts are becoming increasingly wary of FMCG stocks, as they feel valuations (average 24 times) are running ahead of fundamentals across the space. Though good monsoons will lead to the twin benefits of higher demand (especially from rural markets) and softening of agricultural-based input costs, crude oil-based raw materials offer little comfort. Also, the price hikes effected in the last six months will have an impact on volumes in the coming quarters. What’s more, competition will keep ad spends high and limit pricing flexibility of players beyond a certain extent.

ITC and HUL trade at price-to-earnings multiples of 24 times and 28 times estimated FY12 earnings, which are quite high in absolute terms and also when compared to their historical levels. The consumption story does sound exciting, but these valuations look even more expensive, given that challenges in their respective businesses still persist.

Though HUL raised prices of soaps and detergents (S&Ds) – which contribute nearly half of its revenues – by three to eight per cent after almost a year, analysts feel any benefit on margins will be negated by rising input costs and intense competition. Costs of raw materials like palm fatty acid distillate, soda ash, LAB and HDPE are moving up, too. However, other businesses like personal products and beverages are doing relatively well.

ITC is far less vulnerable to competitive pressures compared to HUL. Still, analysts feel its scrip’s current valuation – in the aftermath of a stellar show on the bourses – factors in all the positives. Though the company enjoys leadership position in the cigarette business and is least affected by competitive pressures, volume growth has been impacted (down 3.5 per cent in the first quarter of FY11) due to the price hike of 15 per cent (thanks to excise duty hikes). For FY11, analysts expect a lower single-digit volume growth in cigarettes. As for FY12, there is growing uncertainty about the impact of GST on price and, hence, volumes.

The silver lining is that ITC’s other businesses (which contribute 42 per cent to revenues) are expected to provide some support over the long term. Non-tobacco FMCG businesses (biscuits, snacks, confectionery, personal care and branded foods) are growing steadily, while the expansion in hotels business, which is booming, will contribute significantly within the next few quarters.