Investors should book profit in Colgate given market share, margin worries

Despite higher spending on advertising, high competition in toothpastes could restrict meaningful recovery in lost market share and weigh on earnings

Expectations of an earnings boost from lower corporate tax rates and market share improvement following the appointment of the new managing director (Ram Raghavan from August 2019) had kept investor sentiment buoyant in Colgate stock. Shares of Colgate, as a result, had risen nearly 35 per cent during the three months period ending October 23. However, concerns on operating margins and market share recovery in its key toothpaste segment post September 2019 quarter (Q2) results, suggest that investors should tread with caution.

India’s largest toothpaste maker announced its Q2 results last Thursday and since then, the stock has lost 2.6 per cent as against a gain of about 2 per cent in the Nifty FMCG (fast-moving consumer goods) index. While the loss in market share has been testing investor patience for the past several quarters, margin pressure has now added to the woes. There is little doubt that the company’s focus on regaining toothpaste market share with higher advertising spends is in the right direction. However, the Street seems to be less confident for now.

While some analysts believe that competitive intensity from Patanjali has abated to a large extent, those at SBICAP Securities say that other large and strong players such as Hindustan Unilever, Dabur and GlaxoSmithKline Consumer are very aggressive in the toothpaste category, which would make market share recovery difficult for Colgate despite the higher advertising spends.

A few others are also sceptical about Colgate’s success in the naturals segment (Swarna Vedshakti). “Although Colgate shall continue with higher ad-spends and trade promotions to gain lost share, lack of a block buster product in the naturals/Ayurvedic segment makes it extremely difficult for it to gain lost share,” analysts at Prabhudas Lilladher said in Q2 updated report.

Even in Q2, despite a sharp rise in advertising and promotional spends, Colgate continued to lose market share (see chart). Analysts at Edelweiss Securities say, further loss in Colgate’s toothpaste market share in spite of higher promotional and advertising spend remains a cause of concern. After losing 380 basis point toothpaste market share since June 2016 to June 2019, this figure is estimated to have drifted down further by around 50 basis points in September quarter. The company has stopped disclosing market share data.

On the other hand, advertising expenses as a percentage of operating revenue surged by 250 basis points year-on-year to 14.4 per cent, hurting EBITDA (earnings before interest, tax, depreciation and amortisation) margin and bottom-line in Q2. Colgate witnessed a 178 basis point year-on-year contraction in EBITDA margin in Q2 to 26.4 per cent; lowest in the last nine quarters. Its profit before tax was down about 7 per cent year-on-year to Rs 278.8 crore. A 24.3 per cent jump in net profit was on account of lower corporate tax rates, and thus not comparable.

Going ahead, expectations of higher advertising and promotional expenses amidst subdued demand environment could weigh on the company’s earnings growth. Analysts at Kotak Institutional Equities, thus have trimmed their earnings estimates by 4.8 per cent and 2.4 per cent for FY20 and FY21, respectively.

Though some analysts believe that higher investments in advertising offers long-term growth levers for the company, the jury is still out on this.

Overall, investors should avoid taking fresh exposure to the stock until there is a structural improvement in market share with consistent margin performance. Current stock valuation of around 42 times FY21 estimated earnings is also 15 per cent higher than its historical long-term average valuation.

Currently, almost 60 per cent of 37 analysts polled by Bloomberg have a ‘hold’ or ‘sell’ rating on the stock; at least four have downgraded it post results. Their average one-year target price of Rs 1,509 is also lower than current price of Rs 1,535.