Defensive businesses but not valuations - Sector thematic report on FMCG - HDFC Securities

FMCG sector witnessed growth slowdown in FY20, in-line with nominal GDP moderation. Sector posted 5% revenue growth in 9MFY20 vs. 12% CAGR over the last 10 years. Covid-19 will further delay the macro recovery which was earlier expected in 1HFY21. In the current slowdown, while FMCG cos will be better than other sectors, however, their growth trajectory will also taper down. Staples consumption will see moderation in FY21 particularly with further weakness in income for rural and urban poor households. We believe street is not factoring volume hit and down trading risk in this sector and cos which are more resilient to near term disruption have already seen re-rating. Thereby, risk-reward has become unattractive for most stocks from medium term perspective. We remain selective in sector as extremely stretched valuations keep us on sidelines, esp. on large caps. We downgrade rating on DABUR, BRITANNIA and EMAMI from ADD to REDUCE and UNSP from BUY to ADD. We also initiate coverage on NESTLE and GCPL with REDUCE rating. Within our existing coverage, we remain positive on ITC, UNSP, JUBI, COLGATE and RADICO.

Covid-19 impact: Our conversations with various MGTs reflect that the lock-down will have significant impact of primary growth in 4QFY20. Consumer offtake for essential goods has been strong and trade inventory corrected sharply. Most cos lost 12-15 days of revenue in March which will impact 4QFY20 by 13-15%. That channel filling opportunity will add to FY21 revenue by ~3%. We have done company-wise potential impact of Covid-19 on FY21 revenues (link). We believe HUL, Nestle, Britannia and Colgate will have relatively low impact while Jubilant and Emami will have high impact.

Topline recovery pushed back: Macro support for growth has been lacking, as most indicators (negative real rural wage growth, agricultural growth, MSP rates, job creation and Consumer Confidence Index) are not reflecting a meaningful recovery. Covid-19 induced slowdown will have maximum adverse impact on income growth at bottom of the pyramid, which will hurt non-essential staples consumption with a lag.

Market share gain opportunities for category leaders: In turbulent times, cos with strong distribution, product diversification and superior execution, are expected to gain further market share. Bolt-on acquisitions are likely to gain pace as small players find it difficult to sustain themselves. Cos will focus on cost optimisation, which along with lower input costs and A&P moderation will help mitigate the negative operating leverage.

Category wise analysis: In our category-wise analysis (link), interestingly, even during the economic slowdown of the trailing 12 months, categories like F&B, QSR, Home Care, Cigarettes, Liquor and OTC FMCG grew at 6- 8%. In contrast, laggards like Personal Care and Hair Care grew at ~3%.

Valuation divergence at all-time highs: Given unprecedented times, valuations have also seen sharp polarisation given risk-aversion and flight to safety. Valuation divergence within sector is at an all-time high (P/E range of 10-65x across business models) with preference for large-cap defensives like HUVR, NEST, DABUR and BRIT. We believe valuations for these companies are too rich in comparison to their medium term growth prospects. While sector doesn't offer value bargains yet, we see better opportunities in select stocks where business models are strong and valuations have normalised in the last 12-18 months (e.g. ITC, UNSP, COLGATE) and now more in sync and reflective of their medium term growth potential.

Source : Equity Bulls

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