FMCG: Volumes driven!

From shampoos to skin creams, they're flying off the shop-shelves. Fast moving consumer goods (FMCG) firms had been doing fairly good business in the last few quarters. The trend continued in 2QFY07 too. A combination of increasing incomes, improved marketing and innovation and better price-value equation led to the strong performance of the top tier FMCG companies.

While the topline recorded strong revenue growth on the back of higher volumes, the margins declined, though marginally, due to higher input costs. In this context, let us briefly understand the performance of the top 5 companies (HLL, ITC, Nestle, Britannia and Dabur) as a whole during the September quarter

Rs m	2QFY06	2QFY07	Change
Net sales	64,700	78,001	20.6%
Expenditure	50,330	61,460	22.1%
Operating profit (EBDITA)	14,370	16,541	15.1%
Operating profit margin (%)	22.2%	21.2%
Other income	1,782	1,899	6.6%
Interest (net)	104	140	34.6%
Depreciation	1,445	1,568	8.5%
Profit before tax	14,603	16,732	14.6%
Extraordinary item	(42)	1,350
Tax	3,767	4,145	10.0%
Profit after tax/(loss)	10,794	13,937	29.1%
Net profit margin (%)	16.7%	17.9%

Volume driven: Volume growth has been the front-runner for the 20% YoY growth in the topline for the combined entity. While ITC was a star performer showing a revenue growth of 32 %YoY, HLL managed just under 12% YoY for continuing businesses, while Dabur turned in a top line growth of 21% YoY. Britannia and Nestle also impressed with revenue growth of 19% and 16% YoY.

With economy in good health and disposable incomes on rise, the urban consumers have continued with their buying spree. But in this quarter, even rural demand has kicked in. According to industry sources, rural market is growing at around 11% while both together (urban and rural) are growing at around 8%. In rural areas, small seems to be big as packets and sachets contributed to the topline growth. It should be remembered that growth depends on two structural drivers-increasing penetration and consumption in rural areas and changing aspirational values of the urban markets. Both these factors are on the move.

The large format retail stores in metros have also spurred sales, though a very small percentage of the overall sales, but since the base is low; the growth from the retail formats is very strong.

Mixed operating performance: During the quarter, the companies did witness pressure from rising input costs. The impact was more pronounced on products that require crude and agri-based raw materials. However, the price hikes announced by some FMCG majors indicated some sort of pricing power and they were able to pass on the increase in input costs. Just to give an indication, Hindustan Lever raised prices of its Lux soap (100 gram) by 8 %, Surf Excel Blue (1.5 kg) by 3.5 % and Surf Excel Quick Wash (1 kg) by 3 %). The weighted average price hike across all categories stood at about 1.5 % for the company. At Dabur, the increase has been 3% to 4% on an average over the last nine months. In the quarter, while HLL's OPM was higher by 50 basis points at 13.1 %, Dabur's margins for the quarter remain unchanged at 17.2%.

However, not everyone managed to tide over the cost inflation. Worst hit was Britannia, whose operating profit margin crashed to just over 5 % from 14 % in 2QFY06. In a highly competitive environment, Britannia was not able to pass on the higher input costs. Nestle too saw margins dip albeit marginally by 80 basis points to 19.7%. As far as ITC is concerned, it was also at the receiving end of a rise in input costs, as margins fell by 400 basis points.

One thing that emerges from the operating performance is the fact that, none of the companies enjoy the sort of pricing power that would shield them from rising input costs. Even in cases where the companies were able to hike prices, these instances were few, indicating a fear of loss of market share. This we believe would lead to increased volatility in the performance of the companies. Internal efficiency and efforts at pushing high value added products can be successful only to an extent. Real long-term sustained growth will only come from an ability to pass on the input price hike to the end user.

Bottomline picture: The consolidated net profits (including extraordinary items) grew by 29% YoY in 2QFY07. However excluding the extraordinaries, the bottomline has grown by 16% YoY. The growth in profits was lower than the topline growth due lower operating margins and higher interest costs.

In the end...
At current valuations, most of the growth in the medium term seems to have been factored in. However, to cash in on the long-term growth potential of the sector, which we believe is immense, one should zero in on a company with a strong brand equity, well entrenched distribution network and in the end, an envious ability to pass on the rise in input costs, without losing any sleep over it.