For FMCG cos, all eyes on demand recovery

Shares of fast-moving consumer goods (FMCG) companies such as Hindustan Unilever Ltd (HUL), Dabur India Ltd and Nestle India Ltd rose 18-36% from their 52-week lows seen in the first half of CY22.

Predictably, the excitement revolves around the improving margin outlook for FMCG companies with lower commodity prices. This should provide some relief, as companies have faced severe pressure on their margins in recent quarters due to high input costs. Prices of key commodities such as crude oil and palm oil have fallen around 29% and 55% from their respective highs seen in March. HUL and Godrej Consumer Products Ltd are the main beneficiaries of this slowing trend.

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Prize winnings

Gross margins are expected to increase from the third quarter as the current September quarter (Q2FY23) would see the negative impact of high cost inventory. But ultimately, it remains to be seen whether margins reach pre-covid (FY20) levels. “Assuming a normalization of input costs beyond FY23 and a partial reversal of the numerous (but calibrated) price increases, we expect a significant gross margin expansion in FY22-24E, bringing it closer to FY20 levels,” said a report from Nirmal Bang Institutional Equities dated Sept. 8. Gross margin for FMCG companies under Nirmal Bang coverage contracted more than 400 basis points over the course of exercise 20-22.

However, a possible increase in advertising and promotion expenses could weigh on the Ebitda margin. Companies may resort to higher advertising and promotion expenditures to increase volumes. Here, cost control measures would provide comfort. “Increased focus on cost savings and profitability, particularly over the past two years (largely due to multi-year inflationary pressure), has led to a leaner profit and loss account (reduced cost structure ) for the FMCG coverage universe,” Nirmal Bang’s Report said.

That said, all eyes would be on the extent of the recovery in demand in the short to medium term. “On the macroeconomic front, the positives outweigh the negatives with a pick-up in consumer confidence, a good monsoon, steady collections of goods and services taxes and an increase in the kharif minimum support price which is expected to accelerate growth,” said a BNP Paribas Securities India report dated September 8.

Improving demand is crucial for volume growth, which was relatively weaker across all businesses. Against this backdrop, higher product prices drove revenue growth.

The compound annual growth rate of overall FMCG segment three-year revenue in the first quarter of FY23 was 8.3%, a high in seven quarters.

Going forward, volume growth could also be driven by a reversal of price increases given weaker input prices. This trend started to show up in the soap category with the drop in palm oil prices. ITC Ltd has corrected the prices of the Vivel brand to improve its competitive positioning, specifies BNP Paribas. Marico reduced Parachute Coconut Oil prices slightly in light of weak copra prices.

A recovery in rural demand is essential and demand trends during the festival season need to be monitored more closely. A rise in commodity prices could upset the mood of investors. At the same time, with the rising stock prices of FMCG companies, valuations have increased. Shares of HUL and Dabur are trading at nearly 53 times and 44 times estimated earnings for FY24, respectively, according to Bloomberg data. Consumer staples companies are trading at a steep premium to their history, according to the BNP Paribas report.

The main concern would be that demand conditions do not improve sufficiently. However, if the demand environment deteriorates here, the margin improvement the street expects in the second half of FY23 is at risk.

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