Investors in consumer food firms bet on margins improving

Investors in consumer food firms bet on margins improving

Investors in consumer food product companies appear very optimistic about the future. Even falling profitability, as seen in the September quarter and before, is not shaking their faith. Consider Nestlé India Ltd and Britannia Industries Ltd—both companies reported smart sales growth in the September quarter, but profitability was under pressure.

Britannia’s sales rose by 27% and Nestlé’s sales rose by 26% over the year-ago period. But material costs rose at a much faster rate, compared with revenues. Britannia bore the brunt, with input costs rising by 37% compared with Nestlé’s 29%. Thus, Britannia’s operating profit margin (OPM) fell from 9% to 5% during this period, while Nestlé’s OPM fell by a much lower quantum, from 21% to 20%. Compared with biscuit-maker Britannia, Nestlé operates in segments where competition is relatively low, such as chocolates and infant milk foods, for example. That gives it better pricing power.

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Agricultural products are the main inputs for these companies, and food inflation has meant higher costs. That not only affects margins, but also crimps demand. The challenge is, therefore, to choose between volumes and margins, and choosing margins to protect profit growth is a choice that has been made difficult due to rising competition. Companies such as Britannia and Nestlé have taken a far-sighted approach, and have put volumes first. And they are doing this through new products, expanding geographical reach, aggressive advertising and promotional spend, and keeping price hikes to the minimum. That explains their high sales growth rates, which make it seem like boom years for these companies.

But profits tell a different story. Britannia’s net profit fell by 46% to 32 crore, while Nestlé’s net profit rose by 19%, but partly due to a 40% growth in other income, without which its profit before tax would have risen by 15%. Rising employee costs and the pressure to keep up advertising and promotion leaves little leeway to protect margins. Nestlé though has benefited from a base effect of higher wages.

These companies’ stock valuations do not seem to reflect investor anxiety. Consumer non-durable makers are enjoying high valuations, with the BSE FMCG index itself is trading at a price-earnings multiple of 31 times, based on historical earnings. In comparison, Nestlé trades at 47 times and Britannia trades at 27 times their 2010-11 earnings per share. Their current profit growth levels do not explain this.

Investors appear to be betting on margins eventually improving. Some key commodities have become cheaper: wheat is down by 7% since last year and sugar by around 20%. But edible oil prices are up by 28% since April and milk prices have not eased much, with wholesale milk prices up by 10% in the calendar year so far, compared with a 13% increase last year. Latest government data for October showed inflation in food articles at 14%, compared with 12.5% a year ago. Weekly data does show inflation coming off the 18% levels, however.

There may be a timing effect visible in company results too, as spot prices take some time to become visible in raw material contracts. Therefore, a more benign raw material price situation may become evident in financial results in the coming quarters. If sales growth sustains at these levels, even small improvements in margins will see profits rise handsomely. But if costs don’t fall and profitability does not make a smart recovery in the next few quarters, investors may begin to wonder if their optimism was overdone.

Graphic by Yogesh Kumar/Mint

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