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The Defensive Nature of FMCG

The inherent character of this sector gives it a high capacity to withstand shocks from the external environment which acts as a good defense says Sohini Andani, fund manager, SBI Mutual Fund

In the second part of the three part interview; Sohini Andani, fund manager at SBI Mutual Fund shares her investing experience in the FMCG sector with Sanjay Kumar Singh

Could you elaborate on the factors that make this sector defensive in nature?
Several factors are responsible. One, growth visibility is high in this sector. Moreover, what you get here is stable growth. If in the past a company has been growing at the rate of 15 per cent, then year-to-year growth rate may rise to 17 per cent or decline to 13 per cent. Thus, growth rate moves within a narrow band. You get this regular and stable growth scenario year after year, which makes the sector stable. Two, companies within this sector are also able to protect their margins across cycles. Margins don’t vary in a big band. At most they could rise or dip by 100-200 basis points. You don’t see the sharp expansion or compression in margins as you do in some other sectors. And three, the level of leverage in this sector is low. This gives it a high capacity to withstand shocks from the external environment.

What has been your past experience: do FMCG companies do well in a high-inflation environment? How do they manage to overcome the impact of high input costs and high interest costs on their bottom line?
As said earlier, high inflation definitely affects the spending capacity of the mid- to low-income population. Hence to some extent we will see an impact on the volume growth of these companies compared to what is built into expectations. This is what happened earlier also, say, in the cycle of 2000-2001. However, the cyclicality of their business is relatively lower than the cyclicality that you see, say, in auto companies. So these companies do get impacted in a high-inflation scenario, but to a lesser extent.
As said, the impact of high interest cost on these companies is low because they don’t borrow and spend. They generally don’t have huge capex programmes. But an inflationary environment does impact their margins because raw materials costs go up. Besides, the ability to pass on costs to consumers will vary from company to company. If the increase in costs is sharp, many of them may not be able to fully pass on costs, and so their margins could be affected in the short term.
At the same time, some of them will have the additional lever of being able to curtail some of their ad spends. In the last one-two years these companies have spent heavily on their ad budgets. So they can afford to go slow on ad spending when they see a slowdown. This will help them protect their bottomlines. So I think the impact on their bottom lines will not be very sharp. But vis-à-vis current expectations, there could definitely be some disappointment.

In Q2FY11 many FMCG companies showed volume-led growth whereas earlier most of their revenue growth came from price increases. What was responsible for this volume growth?
Volume growth was low the year before last. Earlier, when raw material price inflation had happened, companies had cut their grammage instead of increasing prices. Later, when raw material prices started to soften, companies brought back the grammage. This led to some volume growth.
Income growth has been fairly significant, especially in rural India. That has led to good volume growth. Structurally I think volume growth at that higher level will sustain going forward as the overall income level has been going up.

What are your expectations from Q3 results (for the FMCG companies that you cover) on criteria such as revenue growth, profit growth, and margins?
I think Q3 will not be very different from what we have seen in the past. We are expecting 15-16 per cent revenue growth, but slightly lower EBITDA and bottomline growth, say, around 13-14 per cent. So Q3 will be in line with the broad trends that these companies have followed historically.
However, greater impact may be seen in the next quarter. In Q4 FY11, the true impact of raw material price inflation will show up.
The impact will vary from stock to stock. ITC, which is a heavyweight in the index, is fairly insulated. But in case of companies that produce hair oil, or soaps and detergents, the impact of raw material price inflation has been significant. There we are likely to see an impact on margins. Though these companies have raised prices, this is not commensurate with the increase in raw material prices.
Some segments, where demand was very low during Q1 and Q2 due to the long-drawn monsoon season, are now expected to do well, such as paint.

So the reason here is seasonal impact?
Normally, the pre-Diwali period, which is the second quarter, is a very good quarter for paint companies. This time Diwali was postponed and the rains also lasted much longer. So the second quarter saw muted growth. That demand has got postponed to the third quarter. So in the third quarter we could see paint companies register good volume growth. This is one segment we are positive about.

Tell us about the demand scenario from the rural and urban markets for the coming year.
Last year was very good for the rural consumer because we saw the employment guarantee scheme as well as MSP increases. To get further growth on a higher base would be difficult this year. So, in case of rural India, the capacity to spend may not increase significantly in the current year.
For the urban poor the capacity to spend may actually decline because of high inflation. Income levels have not risen commensurately because construction activity is not happening in a big way. Not much labour demand has come from construction. This is likely to affect volume growth in the next couple of quarters. The urban markets could deliver a negative surprise.
On the rural side we are not so negative. But whether it can deliver big incremental growth in demand or whether it will consolidate around the same level remains to be seen.

Competitive pressures appear to be increasing within the FMCG sector. Why?
Market players can see that the Indian market has the potential to deliver high growth. Double-digit volume growth in the last couple of years underlines this potential. That has encouraged many companies to enter this market.
Rising competitive pressures will affect the entire industry. New MNC players entering the market, which don’t have a domestic production base, are selling imported products here. Existing MNCs in India are ramping up their production capacity and distribution networks, and are introducing new products from their global portfolio. P&G, L’Oreal and Nivea are all getting aggressive. Lever has introduced a range of products in the last one or two years that it had not in the last 20 years. For instance, it has introduced many products under brands such as Ponds, Fair & Lovely and Dove.
Deep-pocketed companies that can sacrifice a part of their margins in the short term in order to maintain their market share will win in the long term.

To read the first part of this interview click on

Read the last part of this interview on March 18, 2011