Graphic: Mint
Graphic: Mint

FMCG: September quarter earnings will be the second reality check

September quarter will see sales growth reported without having to adjust for base effect, either for volume due to GST roll-out, or for accounting-related adjustments in value growth

Since early-September, the richly valued BSE Fast Moving Consumer Goods (FMCG) index has fallen by 14.2%. Even after this, it trades at 47 times its trailing 12-month earnings, showing just how expensive it was earlier. Could it get better, or will it get worse?

While the fall in equities has seen the FMCG sector follow suit, the second reality check will be its September quarter results. This quarter will see sales growth reported without having to adjust for base effect, either for volume due to the goods and services tax (GST) roll-out, or for accounting-related adjustments in value growth.

The level at which volume growth settles will be watched. Around 7-8% volume growth will be seen as good. Companies have been cautious with price hikes, both due to the government’s watch on post-GST price levels and relatively soft trends in overall input costs. Although crude oil prices have risen sharply, this will transmit with a lag to intermediates used by the industry. Also, prices of inputs, such as palm oil derivatives, have softened. The rupee depreciation is a damper though.

The interplay of sales and cost increases will determine by how much Ebitda (earnings before interest, tax, depreciation and amortization) margins increase and, therefore, how much earnings increase. An increase of 20%-plus in earnings growth should keep them happy. What investors would like to see is good sales growth with margins sustaining, or going a bit higher, while keeping up healthy investments behind advertising and promotion. This will give them the confidence that earnings growth can continue.

Management comments on outlook will provide useful clues on demand, competition and pricing power. Rural demand has played an important role in sales growth. A recent report by Crisil Ltd gives a post-monsoon assessment. While the overall monsoon was normal, it says the distribution across regions and across the monsoon period was uneven. This has caused deficiency in pockets. Its analysis shows some stress in Maharashtra, Gujarat and Andhra Pradesh.

If that raises fears of what it could do to demand, Crisil also considers how non-farm rural income is doing. It says that real growth in non-agricultural wages has improved in FY18 and it attributed this to the government’s push on rural infrastructure, which has continued in FY19 as well. The extent to which agricultural and non-farm income can support FMCG demand growth is a factor to be watched.

FMCG stocks fell apparently because the broad market declined. If industry-specific factors show that all is well and markets recover, then the sector might recover, too. After all, high valuations and scepticism had coexisted for a fair bit.

But Kotak Institutional Equities offers a cautionary note for investors. It calls this correction a repricing of risk. An increase in Kotak’s assumption of the cost of capital for FMCG companies has resulted in a cut to its target price estimates for a number of stocks. Unless those stocks can demonstrate that their return on capital has also increased, their valuations should correct.

Whether the market takes a saner look at FMCG valuations or turns breathless again, time will tell. For now, investors should keep a watch for Hindustan Unilever Ltd’s results on Friday evening.