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FMCG: Mid-caps take centre stage...

Feb 1, 2006

FMCG results for the December quarter have been splendid in comparison to the same quarter the previous year. Today, we bring you an analysis of the performance of 4 mid-cap FMCG companies and reason as to why these companies are considered as the 'darlings of the markets', with every investor wanting to own them. The analysis comprises of Marico, Essel Propack, Pidilite and GSK Consumers.

Second rung FMCG companies
(Rs m)Dec-04Dec-05Change
Net sales8,151 9,244 13.4%
Expenditure7,069 7,677 8.6%
Operating profit (EBDITA)1,083 1,567 44.7%
Operating profit margin (%)13.3%17.0% 
Other income108 17764.5%
Interest 24 28 17.4%
Depreciation226 388 71.4%
Profit before tax940 1,329 41.3%
Tax212 275 29.7%
Profit after tax729 1,054 44.6%
Net profit margin (%)8.9%11.4% 
Effective tax rate22.5%20.7% 

What does the study say?
The consolidated topline (4 companies combined)) grew by over 13% YoY, although slower than the 2QFY06 consolidated growth. However, the increase in expenditure was at a pace slower than the sales growth, which could be attributed to lower raw material prices like copra, vegetable fats and milk, which these companies have been witnessing for sometime now and is expected to remain on the lower side for at least another quarter, beyond which it is anyone's call as to where the prices are headed. This resulted in operating margins expanding by a strong 370 basis points. Depreciation increased by around 71% YoY, mainly because of Marico's expansion of Kaya Clinics and Essel Propack's twin acquisitions in the UK along with Marico changing its depreciation policy from straight line method to written down value method. Interest costs have increased by around 17% YoY, courtesy Essel Propack and Godrej Consumers, which had raised money to fund their respective acquisitions.

All the above factors, coupled with a considerable increase in other income, resulted in a whooping 45% YoY PAT growth for mid-cap FMCG companies. Also aiding bottomline growth was a lower tax outgo, which reduced as a percentage of PBT by 180 basis points. Mid-cap companies have set up their plants in tax havens like Baddi in Himachal Pradesh, which provide them with tax-free holidays for several years. Large companies like HLL and Britannia have also set up plants there, but not all their plants are located in such zones.

Of the 4 companies, GSK Consumers clearly stole the show with its bottomline bloating by a huge 71% YoY. However, due to rising oil prices and inability to pass on the increased costs to consumers, Essel Propack and Pidilite's margins were hit to some extent.

What to expect?
Mid-cap FMCG stocks are currently in the limelight, which has helped them close the valuation gap with their larger peers (in some cases, even higher than their peers). We believe that selective mid-cap FMCG companies are a good investment option, though their commanding valuations, as compared to the well-established larger companies, make them a somewhat risky investment proposition. Nonetheless, in our view, the smaller FMCG companies have the potential to explore the untapped markets and are already gaining acceptance.

Also, since these companies follow a different strategy by offering higher margins to wholesalers and retailers, it results in their products being pushed more than others. Further, smaller companies have started exploring rural markets, not through their own network as it is an expensive affair, but through other larger companies' networks. For example, Godrej Consumers has tied up with ITC to sell its soaps through the latter's e-Choupal network. However, the only drawback in this strategy is that of marginally lower margins, but then, in such an untapped industry, one has to go for growth, often at the cost of margins.

After having under-performed from 2001 to 2004, the FMCG sector is back on the path to recovery, with an acceleration in rural growth, increased consumer spending and a shift in product preference towards higher-end products in the FMCG sector. Also, with greater possibility of oil prices softening in the medium-term, pressure on operating margins of FMCG companies could ease.

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