Inflation is a jinni. Once it’s out of control, it can dent the prospects of any economy. Therefore, it’s important to bottle up this creature before it slips out of control. Recent readings of retail inflation in India aren’t encouraging. It seems the Jinni is out of the bottle already. For a developing country like India, inflation is a double whammy—one it affects investments and, two, it takes away purchasing power from households, causing a slowdown in the real output.
With this backdrop, analyzing companies depending on consumer spending becomes extremely crucial for stock market investors at this juncture. FMCG, Automobile and Consumer Durable sectors bear the brunt of high inflation. From the stock market perspective, lofty valuations and deteriorating business prospects are ominous signs. As far as the Autos and Consumer Durables are concerned, the valuations aren’t alarming, if not comfortable or attractive.
But that’s not the case with FMCG companies. Valuations of the likes of Hindustan Unilever, Nestle and Colgate, among others, are so lofty (with Price-to-Earnings ratios crawling upwards of 50X) that many investors suspect a bubble formation in quality.
When inflation spikes up, the input costs of FMCG companies rise too. Unless companies are able to pass on these increases, their profit margins drop. As inflation starts pinching households, consumer confidence gets shaken and that eventually affects demand.
Over the past few years, low food inflation and relatively high services inflation dragged rural demand. Now that the food inflation rose to 10% in November 2019 and shot up further to 14.1% in December 2019 on a Year-on-Year basis, it remains to be seen how it affects rural wages and therefore, rural demand. On the other hand, urban inflation typically affects urban demand negatively.
Let’s see how these companies have performed in the recent past to gauge how many of them carry the performance pressure.
Most of these companies earn an extremely attractive return (of over 30%) on capital. Their profit margins too are in double-digit and in most cases, in the high teens.
Consensus Bloomberg estimates suggest that top-line growth of the majority of FMCG companies listed above are going to be a single digit. Moreover, the expected rise (which prima facie looks attractive) in the bottom line is chiefly on account of corporate tax rate cuts announced by the government in September 2019. However, slashing corporate tax might be work half-done for FMCG companies, in the absence of incremental demand.
It is believed that large FMCG companies haven’t yet reaped the benefits of formalization of the economy to the fullest, which started soon after demonetization and implementation of GST.
Given the tough economic conditions and rising inflation, large FMCG companies are likely to outplay small regional players that may be constrained by a number of factors such as lack of economies of scale, limited credit access and moderate financial muscle to absorb margin pressure, among others.
Companies such as Hindustan Unilever and Dabur derive almost half of their revenues from rural markets. Their commentary and guidance, if provided any, would be interesting this result season given that food inflation is on the rise.
Companies missing the estimated earnings and those giving weaker guidance may face a downward risk to stock prices. On the contrary, those beating estimates, gaining market share, protecting margins and giving out strong guidance may gallop.
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Disclaimer:
We, Ventura Securities Ltd, (SEBI Registration Number INH000001634) its Analysts & Associates with regard to blog article hereby solemnly declare & disclose that:
We do not have any financial interest of any nature in the company. We do not individually or collectively hold 1% or more of the securities of the company. We do not have any other material conflict of interest in the company. We do not act as a market maker in securities of the company. We do not have any directorships or other material relationships with the company. We do not have any personal interests in the securities of the company. We do not have any past significant relationships with the company such as Investment Banking or other advisory assignments or intermediary relationships. We are not responsible for the risk associated with the investment/disinvestment decision made on the basis of this blog article.
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