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Encore for pharmaceuticals, FMCG outlook cautious

Source : BUSINESS_STANDARD
Last Updated: Thu, Dec 27, 2012 19:01 hrs
FMCG companies want inflation tackled, tax reforms

Pharmaceuticals and fast-moving consumer goods (FMCG), the most defensive sectors, beat the benchmark indices comfortably on the back of strong sales growth as well as expectations of good earnings prospects, going ahead. While the pharma sector managed to beat the Sensex with a 40 per cent return, FMCG did better with 47 per cent. While the gains in the pharma space were led by a turnaround at Wockhardt where investors' wealth multiplied many times over, the gains in the FMCG space were led by UB group companies United Spirits and United Breweries. Among FMCG heavyweights Godrej Consumer Products Ltd (GCPL) stood out with a return of 92 per cent while ITC delivered 43 per cent. Going ahead, the top pick in the pharma space is Dr Reddy's while FMCG analysts are betting on Marico and GCPL.

Pharmaceuticals
Led by a recovery in the domestic market as well as strong momentum in sales in the US, the stocks in this sector continue to be favoured by investors. The sector was one of the top performers again this year and beat the Sensex returns for a third year in a row. The gains were led by pharma heavyweights, especially Sun Pharma, Glenmark (50-86 per cent) while the highest gains were from Wockhardt and Strides Arcolab. Returns are expected to be quite strong this year as well on the back of a 20 per cent growth in top line as well as bottom line, though prices have run up quite a bit. Says Deepak Khetan of Axis Capital, "Most pharma companies trade at either above or close to their own five-year historical median one-year forward PE. While we expect valuations to sustain, companies with potential earnings upgrade are likely to outperform the sector." Most analysts are positive on prospects for Dr Reddy's and Glenmark. While the former is a top pick on the back of market share gains in the US in Metoprolol and expected approval of generic Vidaza in the next quarter and higher US revenue guidance, the latter gets top billing due to diversified geographic presence, product mix and research pipeline.

The gains in the domestic market were driven by new introduction and higher volumes, which helped the sector record 15 per cent sales growth this year and analysts expect a similar number this year as well. What has helped is the good growth in the chronic therapy segment as well as recovery in the anti-infectives category. The pharma pricing policy has been a key overhang on the sector. However, with the government announcing that drugs will now be available at market pricing mechanism as compared to the earlier cost plus methodology, uncertainty is reduced. While the new policy increases the list of drugs to be covered under pricing from 18 per cent to 30 per cent, analysts say impact for most drug firms will be low.

Angel Broking analyst Sarabjit Kour Nangra believes the policy is unlikely to have major negative implications for the sector given adequate price competition. MNCs will be impacted more than domestic firms, according to the firm. Credit Suisse analysts believe that GSK Pharma, Ranbaxy Labs and Cadila Healthcare are the most impacted whereas the impact on most other companies is less than five per cent given their lower exposure to the Indian market as well as the drugs under price control.

Despite the drop in growth opportunities from patent expiries at the end of 2012, pricing pressures and generic penetration, Harith Ahamed of Spark Capital believes that Indian players will gain market share in the US due to investments in complex generics, biosimilars, greater generic adoption driven by Obamacare and faster product approvals. In fact, recent sales growth trends indicate that Indian firms such as Dr Reddy's and Glenmark are gaining market share. Balaji Prasad of Barclays Research estimates that top firms in their coverage are likely to post sales growth of 35 per cent in FY13. Given that US accounts for 25-43 per cent of overall sales of major Indian companies, strong sales growth from this key market as well as a weaker rupee will help boost overall revenues and profitability.

FMCG
If the government had not initiated the reform process and the Reserve Bank of India hinted at rate cuts in calendar year 2013, then BSE FMCG index would have been the best performer instead of rate sensitives like banks and auto. This is because FMCG is the only sector which beat investor expectations both on the top line and bottom line fronts over the past several quarters.

BANKING ON VOLUME GROWTH
FY14E in Rs crore HUL ITC Godrej Cons Tata Global Colgate
Returns YTD (%) 28.3 44.1 93.8 77.6 52.3
Revenues 30,229 34,677 7,797 8,437 3,697
% change y-o-y 15.7 16.0 22.8 10.5 17.0
Operating Profit 4,452 12,618 1,439 912 835
% change y-o-y 16.1 18.5 25.4 21.7 18.1
Net profit 3,702 8,665 958 518 619
% change y-o-y 12.5 17.8 26.1 21.1 15.4
P/E (x) 30.6 26.2 26.4 19.1 33.2
E: Estimates Source: Analyst reports

Majority of the companies namely Hindustan Unilever Ltd (HUL), Dabur and GCPL did not significantly disappoint on volume growth despite price hikes, which came as the biggest positive surprise and belied fears of slowdown impact on consumption. Nevertheless, superior financial performance was largely supported by price hikes and contribution of volume growth was relatively less.

For instance, ITC's cigarettes volumes remained flat in September 2012 quarter as prices were 17 per cent higher year-on-year but the company still exceeded analysts' expectations with growth of 19 per cent and 21.3 per cent in sales and net profit, respectively. Similarly, Nestle witnessed pressure on volumes and reported a single digit sales growth but price hikes helped maintain its operating profit margin.

With almost stable volume growth and price hikes, most companies managed to maintain or improve margins. "Consumption of organised brands continued to be strong and competitive intensity, to an extent, reduced compared to last year," points out an analyst. The next two quarters would more or less reflect a similar picture of steady volume growth and price hikes leading to strong sales growth and improved margins.

From an investment perspective, the overall mood for the FMCG sector is cautious in calendar 2013 or financial year 2014 not only on the valuation front but also from the volume growth perspective. Downtrading is a major risk to most players especially in price-sensitive categories like personal care (soaps, detergents and toothpaste) and biscuits. Investors thus, need to keep a watch on volume growth, believe analysts, as premium valuation does not leave any room for disappointment. Stocks like GCPL, Colgate and ITC rallied while others have retained their price levels partly also due to uncertainty and downturn witnessed by other sectors. However, analysts now feel most companies, namely HUL, Colgate, GCPL and Nestle, are trading at near peak valuations.

Says an FMCG analyst, "FMCG companies commanded premium valuation for reporting quality of growth (read volume growth), which now does not look sustainable for a lot of players, though not all of them." He prefers to wait and watch for the next two quarters before recommending a buy to see any trend of downtrading by consumers. Adds Abneesh Roy, analyst, Edelweiss Securities, "FMCG may underperform, going ahead, as valuations are currently expensive and beta stocks will be in favour due to the slew of reforms and interest rate cycle reversing."

However, with the scenario for prices of key raw materials like palm oil, copra and crude being favourable or benign, companies would channelise the savings in input costs to advertising and launch new products. This will prevent price hikes and help the companies to at least maintain or sustain their volume growth. For instance, correction of palm oil prices will not only help HUL and GCPL in terms of margin improvement but also prevent any further price hikes, which would have hit volume growth. Soaps business contributes 20 per cent and 35 per cent (standalone) of the companies' revenues, respectively.

Favourable crude prices will help Colgate sustain its double digit volume growth as any savings in input costs (more than 60 per cent crude based) will be used for advertising. Lower copra prices will help Marico sustain volume growth of Parachute and value-added hair oils.

Overall, HUL is expected to be the biggest beneficiary of softer raw material prices, thanks to its diversified product portfolio. ITC is favoured at all times as it is the undisputed market leader in the price inelastic cigarettes category. Analysts advise to accumulate HUL and ITC but advise to buy -Marico and GCPL as they see many positive triggers. Besides sustained volume growth in Parachute and other hair oils, Marico is likely to witness recovery in Saffola's volume growth and near break-even of Kaya. Better synergies from Paras acquisition will be the icing on the cake. Besides correction in palm oil prices, success from the new launch of Creme Hair colour and relaunch of Cinthol are other positives for GCPL's domestic business. International business will see support from strong momentum in Indonesia and Darling acquisition.


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