Fast Moving Consumer Goods (FMCG) sector review, analysis and recommendations

Date: 2 September 2009

Report by Angel Broking:

A Raincheck on FMCG

Stellar 1QFY2010 results, consistent Earnings upgrades, and high visibility have helped FMCG
stocks in outperforming the Sensex over the past year. However, the sharp rally has come to a
halt, owing to the likely impact of a weak monsoon on the Top-line and volume growth.
Although we expect the monsoon's impact to be less severe than that in FY2003 and to be mixed
for companies, we change our stance on the FMCG sector, from overweight to equal-weight, as
we believe that both earnings upgrades and P/E re-ratings are likely to take a breather from the
current levels. Hence, we continue to emphasise selective stock picking, and prefer a set of
companies with a leadership position in their product categories, a diverse product portfolio and
with stronger pricing power, which are better placed to combat the vagaries of a weak monsoon.

- The Monsoon Scare - Is this the speed-breaker?: The four-year spell of a normal monsoon
has finally come to an end, with this year drifting towards a major drought. The cumulative
seasonal rainfall stood at 25% below the Long-Period Average (LPA), down from 26% a week
ago. However, the current monsoon season, though reminiscent of FY2003 in terms of such a
deficit, is not likely to have a similar impact on growth numbers, due to several mitigating
factors - 1) Preceded by four years of a normal monsoon; 2) A lower dependence on Kharif and
better irrigation to support food production; and 3) Government initiatives like higher MSPs,
NREGS, Farm waivers and Sixth Pay Commission dues, which will aid rural incomes.

- FMCG: Impacted, Yes, but less severe and mixed: The emerging drought situation carries a
downside risk to our estimates (both in volumes and in pricing), as rural consumption (a key
incremental-growth driver) takes a hit, albeit with a lag effect of three to six months. However,
the severity will be lower than that in FY2003 (owing to the above-mentioned factors), and
mixed for companies, depending on their sales mix and the exposure to rural markets. Hence, we
have not factored the same in our numbers, until clear signs of a slowdown emerge.

- Valuations appear rich: Most FMCG companies have witnessed a sharp rally in the recent
past, and are currently trading at rich valuations that are being driven by a steady Earnings
growth, significant Margin expansion, and a sustained volume growth. In terms of their One-
Year Forward P/Es, most companies are trading in line with their five-year averages, but at a 20-
30% discount to their peak valuations (in FY2007). While the long-term consumption story for
the FMCG industry remains intact, any further re-rating from the current valuations seems less
likely, owing to the concern over a weak monsoon.

Stick to Monsoon-defensive picks - ITC, Nestle, GCPL and Marico

Among the heavyweights, we maintain an Accumulate on ITC (with the worst behind us,
Earnings to revive and the lowest risk from the monsoon). For HUL, we maintain our Neutral
stance (with its market-share losses being a key concern), until clear signs of revival in core
categories emerge and monsoon concerns fade.

In Midcaps, we maintain an Accumulate on Godrej Consumer (GCPL) (with the significant

Margin expansion and the Godrej Sara Lee (GSL) consolidation to address portfolio concerns),
and on Marico (a play on the valuation gap). We upgrade Nestle to Accumulate, due to its urban
portfolio (low risk from the monsoon), and its strong Earnings growth.

We maintain a Neutral view on Dabur (with its core categories and growth drivers at a risk) and
on Colgate (the competition in the Toothpaste segment can intensify), due to their higher
vulnerability to the monsoon. While we continue to like GSK Consumer (GSKHCL), due to its
strong Earnings growth and a renewed momentum in new launches, the significant re-rating that
occurred in the recent past will cap any further upside. However, any significant correction (10-
15%) in stock prices can be used as a buying opportunity in these stocks.

Valuations: Appear rich; Stick to Monsoon-defensive picks

Key Takeaways
- Most FMCG companies, except HUL, recently touched their life-time highs
- We change our stance from Overweight to Equal-weight on the FMCG sector
- Both Earnings upgrades and P/E re-ratings, from current levels, to take a breather
- Recommend Accumulating Monsoon-defensive picks - ITC, Nestle, GCPL and Marico

Most FMCG companies have witnessed a sharp rally in the recent past and are currently trading
at rich valuations, driven by a steady Earnings growth, significant Margin expansion and a
sustained volume growth. In fact, all FMCG stocks under our coverage touched their life-time
highs recently, except for HUL, indicating a high appetite for defensives in the recent past.

In terms of their One-Year Forward P/Es, most companies are trading in line with their five-year
averages, but at a 20-30% discount to their peak valuations (in FY2007). Similarly, the Premium
to the Sensex for most FMCG companies is hovering around their five-year averages.
Nonetheless, Colgate, Dabur, GCPL, ITC and Marico are trading at lower premiums in
comparison to their peak in FY2007. While the long-term consumption story for the FMCG
industry remains intact, any further re-rating from the current valuations seems less likely, owing
to the concern over a weak monsoon.

 
 

Stick to Monsoon-defensive picks - ITC, Nestle, GCPL and Marico

We shift our valuation methodology from purely average P/E-based, to an equal-weight (50-
50%) combination of the average P/E and the average Premium/Discount to the Sensex. Hence,
based on the Earnings CAGR and the vulnerability of Earnings to the monsoon, we have
allocated a certain premium/discount to the averages, and changed our Target Price for the
stocks under coverage.

We change our stance from Overweight to Equal-weight on the FMCG sector, as we believe that
both Earnings upgrades and P/E re-ratings are likely to take a breather from the current levels.
However, a strong defensive appeal and a steady Earnings growth are likely to cap the downside
as well. Hence, we continue to emphasise selective stock picking, and prefer a set of companies
with a leadership position in their product categories, a diverse product portfolio and with
stronger pricing power, which are better placed to combat the vagaries of a weak monsoon.

Among the heavyweights, we maintain an Accumulate on ITC (with the worst behind us,
Earnings to revive and the lowest risk from the monsoon). For HUL, we maintain our Neutral
stance (with its market-share losses being a key concern) until clear signs of revival in core
categories emerge and monsoon concerns fade.

In Midcaps, we maintain an Accumulate on GCPL (with the significant Margin expansion and
the GSL consolidation to address portfolio concerns), and on Marico (a play on the valuation
gap). We upgrade Nestle to Accumulate, due to its urban portfolio (low risk from the monsoon),
and its strong Earnings growth.

We maintain a Neutral view on Dabur (with its core categories and growth drivers at a risk) and
on Colgate (the competition in the Toothpaste segment can intensify), due to their higher
vulnerability to the monsoon. While we continue to like GSKHCL, due to its strong Earnings
growth and a renewed momentum in new launches, the significant re-rating that occurred in the
recent past will cap any further upside. However, any significant correction (10-15%) in stock
prices can be used as buying opportunity in these stocks.

Valuation Snapshot

 
 

 
 

 
 

Financial Outlook: Earnings momentum likely to be maintained

Key Takeaways
- Revenue growth to slow down, as price hikes take a backseat
- The Deficient monsoon poses a key risk to our estimates (not factored for the same)
- Gross Margins to expand - GCPL and ITC to post the highest expansion
- Midcaps to post a higher Earnings growth in FY2010E, led by GCPL

Revenue growth to slow down; focus to shift to volume growth

During the period FY2009-11E, we expect our FMCG universe's revenue growth to slow down
to a CAGR of 13.9%, v/s 16.8% during FY2005-09, as price hikes take a backseat and the focus
shifts to sustaining volume growth. Better reach (significant investments in distribution
infrastructure) and support from rural markets (higher MSPs, NREGS and rising food prices to
drive rural incomes), will be the key drivers aiding a modest volume growth for our FMCG
universe. GSK Consumer and Nestle are expected to post an above-average Top-line growth,
driven by steady volumes in their core brands and in new launches, while the Fem Care
consolidation and a strong growth in International business will boost Dabur's Top-line.

 
 

 
The downside risks to our estimates include: 1) A lagged effect of the economic slowdown on
consumer spending (less likely); 2) The Impact of a drought on rural incomes (likely, though not
as severe as that in FY2003); and 3) Down-trading to a cheaper brand (likely).

Everybody Gains: 150bp EBITDA Margin expansion

A low base of Gross Margins (2Q and 3QFY2009 were the worst hit from rising input costs),
falling input costs, and the savings from operating efficiencies will aid our FMCG universe in
posting a 150bp Margin expansion during FY2009-11E (with a 100bp expansion in FY2010E
itself), despite most companies re-investing part of the gains into higher advertising spends.
Hence, the EBITDA is expected to grow at a CAGR of 18% during FY2009-11E, much higher
than the 14.9% growth posted during FY2005-09. We expect Margin expansion to be most
prominent in the case of GCPL (a sharp fall in Palm Oil prices, holds inventory till December
2009), and ITC (Price hikes in Cigarettes, better profitability in the Agri-Business and a
recovery in Hotels).

However, a low pricing leverage (lack of price hikes) and the higher costs of most inputs
(significant in agri-commodities) is likely to limit the Margin expansion in FY2011E.
Nonetheless, we believe that FMCG companies still have some leeway, albeit limited, in their
advertising spends, in order to sustain their Margins.

 
 

 
 

Higher Earnings growth in Midcaps; Heavyweights to catch up in FY2011E

Midcap FMCG companies (ex-HUL, ITC) will outperform the heavyweights in terms of their
Earnings growth, due to the slack performance of HUL (a fall in Other Income and re-investing
Margin gains for sustaining its market share). Hence, we expect our FMCG midcap universe to
post an Earnings CAGR of 22%, v/s 16.9% for our entire FMCG universe during FY2009-11E.
However, we expect this gap to narrow in FY2011E, as both ITC (a recovery in Hotels, higher
profitability in the Agri-Business) and HUL (a low base effect, an improvement in pricing
power) regain lost ground. While GCPL clearly emerges as the winner in terms of Earnings
growth due to a significant Gross Margin expansion, Marico, GSK Consumer, Nestle and Dabur
are also expected to report a robust 20%+ Earnings growth during the period FY2009-11E,
driven largely by Margin expansion.

 
 

Outperformances Galore

Key Takeaways
- FMCG stocks outperform the Sensex over a five-year period (except HUL), driven by a steady
Earnings growth of a 20-25% CAGR
- Midcaps, led by Marico, Dabur and GSKCHL, outperform heavyweights (HUL and ITC)
- A sharp volatility in Earnings and in the markets helps FMCGs post sharp gains over a one
year period - led once again by Midcaps (GCPL, GSKCHL and Colgate)
- Constant Earnings upgrades - a key driver for sustained outperformance
- Monsoon concerns slam the brakes; one month returns weaken

FMCG stocks, generally perceived as defensive plays (a low beta, strong cash flows and rich
dividend yields), have not only exhibited significant strength during the economic downturn, but
outperformed the Sensex over a five-year period (except HUL). On an average, FMCG stocks
have delivered CAGR returns of 25-35% over the last five years. We attribute the steady
earnings growth of a 20-25% CAGR as the key factor behind this outperformance. Hence,
Midcaps, led by Marico, Dabur and GSKCHL, have clearly outperformed the heavyweights,
HUL and ITC, due to their stronger earnings growth and P/E re-ratings.

One-year returns even more impressive

The outperformance by FMCG stocks during the past year gained the maximum momentum as
the economic downturn intensified, the volatility in earnings in most sectors raised concerns, and
growth stories/ high beta stocks took a backseat. While HUL clearly emerged as laggard in terms
of returns (ITC has recently caught up, after the budget), the Midcaps continued to deliver
superior returns, outperforming the heavyweights by a significant margin, led by GCPL,
GSKCHL and Colgate.

 
 

Stronger volumes (in rural markets), inorganic growth and a higher contribution from
international business, coupled with a significant correction in input costs and savings from
excise cuts, led to consistent Earnings upgrades for most FMCG stocks, driving such an
outperformance. Colgate, GSK Consumer, Dabur and Marico registered the maximum EPS
revision for their FY2010E estimates. GCPL's EPS remained the same, despite a significant
revision in profitability, due to heavy dilution (the share swap deal to acquire GSL).

 
 

Monsoon concerns slam the brakes; one month returns weaken

However, concerns over a weak monsoon have slammed the brakes on the outperformance by
FMCG stocks, as uncertainty over the Top-line (due to an impact on volume growth), fears of
down-trading and down-pricing, and the intensifying competition have started bothering
investors. Only GCPL has continued to outperform the Sensex and, more importantly, delivered
positive absolute returns.

1QFY2010 Results - Stellar Earnings drive a re-rating

Key Takeaways
- Top-line growth slows down - focus shifts to volume growth
- HUL and ITC disappoint; GCPL, Dabur and Marico beat our expectations in the Top-line
- Robust Earnings growth (except HUL), driven by higher Gross Margins
- Colgate, GCPL, Dabur and Nestle beat our expectations in Earnings
- A low base and a significant fall in input costs aid Gross Margins (except Colgate)
- Input costs harden almost 30-40%, on average, from their bottom
- Most FMCG companies up their ad spends (except Colgate), in both yoy and qoq terms

For 1QFY2010, our FMCG Universe continued to deliver a stellar performance on the Earnings
front, despite a slowdown in Top-line growth, driven by higher Gross Margins and better cost
management. For the quarter, our FMCG universe posted a Top-line growth of 10% and an
Earnings growth of 15.9%. However, Midcaps (excluding HUL, ITC) continued to outperform,
posting a stronger growth of 19% and 35.9% in their Top-line and Earnings, respectively.

Volume driven Top-line growth; Heavyweights become laggards

While the heavyweights (HUL, ITC) posted a muted Top-line growth for the quarter (in line
with expectations), the Midcaps continued to post a modest growth, driven largely by volumes,
as the effect of price hikes (value growth) tapers off.

HUL's Top-line was hit due to a muted performance by its core Soaps/Detergent segment (grew
9.5% yoy), and a drop in Exports by 34.6% yoy (due to a planned decline in non-core Exports).
For ITC, the Top-line growth was subdued, despite the steady performance of the core Cigarette
Division, as its Non-Cigarette FMCG business registered a subdued growth of 9.5% yoy, while
its Hotels and Agri Businesses registered sharp declines of 28% (due to the economic
slowdown) and 49% yoy (due to the rationalisation of its Agri-commodity portfolio),
respectively.

 
 

Among the Midcaps, GCPL, Dabur and Marico beat our expectations on the Top-line front,
driven by a stronger volume growth and the robust performance of their international business
(which was partially aided by a favourable currency impact). Such volume growth was
attributable to the following factors:

- Growing consumer demand: Rising income levels and growing aspirations, coupled with
lower penetration levels, have fueled a strong demand for Lifestyle and Value-added products.

- Rural India drives incremental growth: Even as urban consumers rationalise spending, rural
India is giving FMCG firms a lot to cheer about. While FMCGs are seeing a volume growth of
just 6-7% in metros, their growth in rural markets is over 20%. According to a recent study by
the Rural Marketing Association of India (RMAI), rural income levels are on the rise, driven
largely by a continuous growth in agriculture for four consecutive years. The government's
continued focus on rural development initiatives has further empowered the rural consumers,
fuelling a fresh demand for FMCG firms.

- Price hikes take a backseat: During FY2009, most FMCG companies had resorted to
judicious price hikes to protect their dwindling Margins. However, as the economic slowdown
takes its toll on consumer spending, even as inflation declines, FMCG companies are tweaking
their pricing strategy to retain consumers and to safeguard their volume growth.

- New Product launches: In a bid to garner a higher market share and sustain long-term growth,
most FMCG companies have launched new products, largely in the form of variants/extensions
of their existing brands, to boost growth.

 
 

Strong Earnings growth led by higher Gross Margins

All FMCG companies under our coverage, except HUL, posted a robust performance at the
Earnings front, driven largely by higher Gross Margins. HUL's Earnings declined largely due to
three reasons: 1) A Higher Tax rate; 2) A Sharp drop in Other Income (partially due to a MTM
charge on account of forex cover); and 3) A higher Advertising spend to support brand activities.
Among the Midcaps, Colgate, GCPL, Dabur and Nestle beat our expectations, despite higher
advertising spends.

 
 

Except for Colgate, all FMCG companies registered a Gross Margin expansion, aided by a low
base (1QFY2009 witnessed high input cost inflation) and a significant fall in most input costs
(reached their recent lows in March 2009) due to the economic slowdown. Since, most FMCG
companies carry inventory for two to three months, the maximum impact has been felt in this
quarter (with a lag effect). Moreover, the carry-forward impact of price hikes (as many
companies resorted to price hikes during the latter part of 1QFY2009) also aided Margin
expansion. The Highest Gross margin expansion was registered by GCPL (correction in Palm
Oil), Marico (correction in Copra, Safflower Oil) and ITC (price hikes in Cigarettes).

 
 

Input costs - Down but not out

Most commodity prices softened during 2HFY2009, which aided Margin expansion for FMCG
companies, in yoy terms, during the current quarter. However, during 1QFY2010, these
commodities have been witnessing an upward growth trajectory, due to a sharp spike in the
broader markets, across asset classes. The prices of input costs for FMCG companies have risen
by almost 30-40%, on average, from their bottoms. Agri-commodities, particularly those sourced
domestically, are expected to remain firm. While Wheat, Barley, Copra and Safflower prices
continue to remain benign, other commodities like Sugar, Tea, Coffee and Milk are expected to
rise further in the coming quarters, largely due to the poor monsoon in India.

 
 

Advertising Spends up - Re-investing for volume growth

With the focus back on volume growth and on sustaining market shares, coupled with the room
to spend more (due to higher Gross Margins), most FMCG companies increased their
advertising spends (except Colgate), in both yoy and qoq terms. Moreover, the telecast of two
major cricketing events during the quarter - the IPL, in April-May, in South Africa, and the T20
World Cup in London, in June, also aided higher advertising spends, as companies rushed in to
get a pie of quality media slots to reach the maximum consumers.

Leading the pack in this trend were GCPL and GSK Consumer, which continued to invest
heavily in advertising to support new product launches. While GSK Consumer launched two
new products, Junior Horlicks Toddler Biscuits and Chill Dood, GCPL launched a new variant
under Godrej No.1 (Lime and Aloe) and re-launched Godrej Nupur Mehendi. HUL also
registered an 179bp jump yoy in advertising spends to support its re-launches of Liril, Lifebuoy,
Pond's White Beauty, Vaseline and All Clear. Colgate was the only exception, registering a
454bp yoy decline in advertising spends during the quarter, due to a high base effect, no new
product launches and a less intense competitive scenario in Oral care.

Monsoon Scare - Is this the speed-breaker?

Key Takeaways
- Current Monsoon deficit stands at 25% below LPA - Drought looms ahead
- Out of 36 meteorological subdivisions, 23 face a significant deficit
- FY2003 dejà vu? - Agri growth to decline; GDP estimates toned down
- We don't expect an FY2003 repeat due to: 1) Four years of normal monsoons preceding this
drought year; 2) lower dependence on Agri; and 3) Govt. initiatives like NREGS, Farm Loan
waiver, Sixth Pay Commission dues and higher MSPs to aid income levels

The four-year spell of a normal monsoon has finally come to an end, with India drifting towards
a major drought this year, reminiscent of FY2003. While the month of July showed signs of a
revival, the monsoon has clearly taken a turn for the worse. IMD's current forecast pegs the 2009
Jun-Sept season rainfall deficit at 13% of the LPA, but the latest trends indicate that this is due
for revision. The monsoon scare has raised significant concerns over macro factors like the
decline in food production, the return of inflation, and the spillover impact on economic growth
and consumption.

Signs of a revival, but is it too late?

Current Status (Week ended August 26)

- The Rainfall deficiency (% deviation from the LPA) for the country as a whole for the week
stood at 5%, a sharp improvement from 56% a fortnight ago (2% deficiency a week ago). There
has been improvement in monsoon activity for the second consecutive week. This week recorded
significant improvement over Central India and the South Peninsula. Rainfall was normal in
Northeast India; meanwhile, subdued rainfall activity was witnessed over Northwest India.

- However, the cumulative seasonal rainfall, received by the country as a whole, stood at 25%
below the LPA, down from 26% a week ago.
 

- The subdivision-wise cumulative seasonal rainfall distribution continues to remain poor. Out of
the country's 36 meteorological subdivisions, 1 received excess rainfall, only 12 received normal
rainfall, over 22 saw deficient rains (-20% to -59%), and 1 received a scanty share (-60% to
-99%). The worst hit areas are Haryana, Chandigarh and Delhi.

FY2003: Dejà vu? Less likely!

The current weakness in the monsoon has brought about a sense of déjà vu of FY2003, when the
rainfall deficiency of the Jun-Sept season hit 20.6% of the LPA. The immediate impact of the
drought was felt severely on Agri growth, which dipped 7.2% yoy during FY2003, dragging the
overall GDP growth to a sluggish 3.8% yoy. Taking cues from the same, economists have
revised their GDP growth estimates for FY2010E downwards by 50-100bp, discounting a
decline of 2-4% in Agri growth.

The Monsoon is clearly the most important season for the Indian subcontinent, owing to the fact
that almost 65% of the Indian population is dependent on the agrarian economy for a livelihood.
However, the current monsoon season, though reminiscent of 2002 in terms of the deficit, is not
likely to have a similar impact on growth numbers, due to several mitigating factors.

- Four years of a normal monsoon to the rescue: The Current year's drought comes on the
back of four years of a normal monsoon, which are likely to tone down the impact, as compared
to FY2003 drought, which was preceded by two years of poor monsoons.

- Lower dependence on Agriculture to reduce the overall impact: Agriculture had a share of
over 31.4% in FY1991 in the Indian GDP, which declined to 21.4% in FY2003 and to 17%
currently. Hence, we expect the impact on GDP growth to be relatively lower this time, vis-à-vis
FY2003. Moreover, a higher base of Agri growth in FY2002 also magnified the dip, which is not
the case this time around (a mere 1.6% Agri growth in FY2009).

- Lower seasonal dependence and higher Irrigation to support food production: India's
dependence on the monsoon for foodgrains has relatively reduced. Notably, the contribution of
the Kharif crop (Summer Crop, dependant on monsoons) has steadily declined to 50%.
Secondly, the area under irrigation has also increased over the years.

 
 

- Higher Agri-product realisations enrich farmers: The agricultural GDP has performed quite
well since FY2006 (a CAGR of 4.1% over FY2005-09), aided by a normal monsoon. The
benefits were further enlarged for rural India, as the Minimum Support Prices (MSPs) for paddy
and wheat increased substantially during the period. Recently, the government announced a hike
of Rs100/quintal in the MSP of Paddy, to Rs950/quintal.

 
 

- Government initiatives to cap the downside: Measures like the National Rural Employment
Guarantee Scheme (NREGS), which provide an employment fall-back option, have and will
continue to provide considerable support to rural India. According to the latest estimates, 870mn
person days of work have been generated up to July 2009, in 619 districts under NREGS.
Moreover, other initiatives like Farm loan waiver and Pay commission dues are likely to ensure
that the demand from the rural segment does not collapse. The government's spending on
Infrastructure, both rural (Bharat Nirman program) and urban, will also provide the necessary
cushion, in the event of a slowdown in the economy, by supplementing rural incomes.

 
 

 
 

FMCG: Impacted, Yes, but less severe and mixed

Key Takeaways
- The Drought situation carries downside risks to our estimates (both in volumes and in pricing)
- Severity to be lower than FY2003 and mixed, depending on the exposure to rural markets
- Not factoring the same in our numbers, until clear signs of a slowdown emerge
- Study of FY2003 reveals:
- Top-line impacted, particularly volumes
- Categories most impacted - Soaps/Detergents, Toothpaste, Malted Beverages, Coconut Oil and
Tea (for cyclical reasons)
- Companies impacted - HUL, Colgate, GSK Consumer and Dabur
- Companies least impacted - ITC and Nestle
- FMCG stocks underperformed Sensex, particularly in 2HFY2003; ITC, GCPL and Nestle
perform the best in the FMCG pack
- Silver lining - Earnings hold steady as Gross Margins expand, ad spends are cut
- FY2010E Impact - Our take:
- Similar categories could face volume pressure
- Down-trading, Down-pricing, Promotional offers to intensify competition
- Inflation, particularly in Agri-commodities, to rise, posing risks to Margins
- Higher Gross Margins and leeway in Ad spends to sustain Earnings
- VFM (Value for Money) propositions/companies to work best
- Best defensive bets against Monsoons - ITC, Nestle, GCPL and Marico

While a 5-10% deviation from the normal monsoon is not a worry for FMCG companies, an
emerging drought situation carries a downside risk to our estimates (both in volumes and in
pricing), as rural consumption (a key incremental growth driver) takes a hit, albeit with a lag
effect of three to six months. However, the severity will be lower than that in FY2003 and mixed
for companies, depending on their sales mix and the exposure to rural markets. Hence, we have
not factored the same in our numbers, until clear signs of a slowdown emerge.

 
 

FY2003 - A retrospective analysis

To understand the financial implication of the current drought and the possible stock market
behavior of FMCG stocks, we have undertaken a retrospective analysis of the performance of
FMCG companies in FY2003, the most recent major drought year.

Top-line Impact for real; Volume growth takes a knock

According to ORG-Value data, the FMCG Market (HUL categories) posted a decline of 3.5% in
CY2002, with categories like Personal Wash, Toothpaste and Fabric Wash bearing the
maximum brunt. Shampoo and Skin Products managed to grow in value, but volume pressures
were evident; Packaged Tea was impacted due to the weak commodity cycle.

To further understand the impact on Top-line growth, we have undertaken a study of both
volume and value growth for the core category of each FMCG company. Clearly, the Top-line
takes a hit, both in terms of volumes (more severe) as well as in pricing power (albeit mixed,
company-wise). The most impacted companies were Colgate (both volumes and pricing) and
GSK Consumer (Management re-jig also impacted growth). Among others, while Dabur, GCPL
and HUL faced pressure in terms of volumes, ITC and Nestle clearly emerged as the most
resilient companies to the monsoon (posted volume growth).

 
 

Gross Margins expand, Ad-spends take the brunt

During FY2003, most companies registered a Gross Margin expansion, on account of a fall in
commodity prices (due to weak economic growth for three consecutive years), except for ITC
and Marico (Copra prices benign, Safflower prices hardened). GSK Consumer (Low prices of
Milk/Skimmed Milk Powder), Colgate and HUL were the biggest beneficiaries from lower input
costs.

However, despite modest gains from the Gross Margins, most companies did not reinvest in
higher advertising spends to support their Top-line growth. Apart from GSK Consumer and
HUL, all other companies either maintained or cut their advertising spend, as a % of sales, with
the largest cuts taken by GCPL and Colgate. Hence, the focus clearly shifted from investing
aggressively for Top-line growth, to Top-line growth at reasonable costs (maintaining Margins).

 
 

Stocks Underperformed, but with a lag

During the Monsoon deficient years, FMCG stocks not only underperformed the Sensex, but
they also delivered negative absolute returns, albeit with a lag effect of three to six months. Our
study of the performance of FMCG stocks during FY2003 indicates that while most FMCG
stocks managed a modest performance vis-à-vis the Sensex during the Monsoon period (2Q),
rising concerns over growth starts taking its toll on the stock performance in 2H, when
underperformance magnifies. According to FY2003 data, Dabur, GSK Consumer and HUL
underperformed the most during 2HFY2003, while ITC, GCPL and Nestle emerged as the best
performers.

 
 

The silver lining - Earnings hold steady

While the impact of a deficient Monsoon is generally evident on Top-line growth and stock
market performance, the Earnings growth for most companies was robust. We attribute this trend
to the ability of FMCG companies to shift gears and to focus more on profitability (improve
efficiency, cut costs and leverage on brand strength) during such times. Hence, during FY2003,
most companies, except for GSK Consumer, held their Earnings growth steady, partially aided
by higher Gross Margins and by tinkering with Advertising spends.

 
 

FY2010E: Possible Impact and Reaction - Our Take

Even though it is early to estimate the possible impact of a weak Monsoon, through our
interaction with the Managements/channel checks, coupled with our study of the FY2003
impact, we have jotted down a list of: 1) Categories likely to be impacted; 2) Trends which
could emerge; and 3) The Possible reaction from FMCG companies.

 
 

Stick to Monsoon defensive picks - ITC, Nestle, GCPL and Marico

To conclude the monsoon impact, we believe that the blow on FMCG companies is for real, but
expect the impact to be less severe this time. Moreover, if broader economic growth revives, a
recovery, led by strong urban demand, will be swift. Moreover, while the Top-line is at risk,
Earnings growth is likely to hold steady, due to higher Gross Margins and a leeway in tinkering
with advertising spends.

We believe that HUL, Colgate and Dabur are at a higher risk, whereas ITC, Nestle and Marico
(significant product diversification since FY2003) are likely to show significant resilience to the
monsoon impact. In case of GCPL, while we believe that the Soaps market will be under
pressure, GCPL will outperform, owing to its strong value-for-money portfolio. Moreover,
steady growth in the International business and the recent acquisition of GSL are likely to lend
support to GCPL's growth momentum. We expect GSK Consumer to fare better this time as
compared to FY2003, due to a better management focus, new product launches and a significant
momentum in its core brands.