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Food companies hit the sweet spot

Food companies hit the sweet spot

If data on industrial production is any indicator, packaged consumer goods companies are having a tough time. In April, the consumer non-durables index was up just 2.1% over a year ago. That could be attributed to the effect that high inflation has on consumer demand.

Publicly traded companies have been reporting good volume growth by keeping price hikes in check and introducing new products. But the impact of limited price hikes on their profit margins has been telling.

Also see | Feeding Margins (PDF)

That appears to be changing now. Investors in food companies are becoming more optimistic. Between 1 April and now, the BSE FMCG index of the Bombay Stock Exchange has gained 7%, but food makers are racing ahead—Nestlé India Ltd is up 13%, Britannia Industries Ltd has risen 20% and GlaxoSmithKline Consumer Healthcare Ltd has gained 11%.

They may be on to something: prices of some raw materials used by food companies have either moderated or are falling. Wheat prices are down by about 11% from their levels in January and by about 8% from a year ago; sugar is down by 10% and 26%, respectively, during the same periods.

Edible oil prices, too, are showing bearish trends. Malaysia’s palm oil stocks in May rose by 15% over the previous month. The country’s palm oil prices have dropped 6% from their recent highs seen in May and 15% lower from the February peak. Rising output from Malaysia and Indonesia is expected to keep a lid on prices in the current year.

But domestic milk prices continue to be stubbornly high. The Wholesale Price Index of milk in end-May was up by 9% from a year ago. Still the rise is moderate compared with the previous year, when it gained 28%.

Thus, the cost environment has turned favourable for consumer packaged food companies. If a good monsoon ensures high agricultural output, then the good feeling may last longer. The only sore point is packaging materials, which have become expensive on the back of rising crude oil prices.

What companies do with the cost savings will determine the impact on their performance. Firms have been holding on to the price line for about two years to ensure that higher prices do not hurt volume growth. Lessons learnt several times in the past years have made companies wiser to the perils of hurting demand growth, as it takes a long time to recover. Growing competition, too, has helped in reining in price increases.

Companies can either choose to keep prices constant, or even raise them by a little so as to not hurt demand. That strategy will see margins rise. Or, they may choose to pass on lower costs to customers to help them cope with inflation, keeping margins constant.

Another option is to hike prices, and make use of the extra sales and cost savings to promote sales further. This could be either through advertising—which fell in the second half of fiscal 2011—or through discounted volume offers. Margins may not increase much, since savings are being ploughed back into marketing, but sales will grow at a faster rate and so will profit. They are most likely to adopt this strategy, as the consumer and company both benefit.

If the trend holds, we will see a period of rising sales growth, accompanied by good growth in margins as well. Barring unforeseen events, investor enthusiasm for consumer goods stocks seems well founded. Apart from the firms mentioned, the foods business of companies such as ITC Ltd and Hindustan Unilever Ltd may also benefit from lower input costs.

Graphic by Yogesh Kumar/Mint

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