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CONSUMER

Research Analysts:

Surviving the 'perfect storm’

Anuj [email protected]: +91 22 3043 3122

January 2017

VENDOR COMPANIES

DISTRIBUTOR

WHOLESALER

VILLAGE SHOP CITY SHOP

TAX

FARMERDISTRESS

WORKERJOBLESS

TAX

Ritesh Vaidya, [email protected]: +91 22 3043 3246

Dhiraj Mistry, [email protected]: +91 22 3043 3264

Consumer

December 16, 2016 Ambit Capital Pvt. Ltd.

CONTENTS

SECTOR

Consumer: Surviving the ‘perfect storm’ …………………………………………..3

Perfect storm brewing ………………………………………………………………..4

Who will emerge the winners? …………………………………………………….14

Rich valuations; wait for emergence of more support …………………………19

A well-implemented GST will make us change our stance ……………………25

COMPANIES

HUL (BUY): ‘Dirt is Good’ ………………………………………………………….31

Nestle (SELL): Waiting for the tide to turn ……………………………………….45

GSK Consumer (SELL): Under-utilising a quality brand ……………………….59

Colgate (SELL): Near-term gain, long-term pain …..………………………….67

Godrej Consumer (SELL): Capital allocation is the key risk …………………..79

Dabur (SELL): Rural skew will cause pain ………………………………………..89

Marico (SELL): Even I am mortal! …………………………………………………99

Britannia (SELL): Not such a sweet story anymore ……………………………111

ITC (BUY): All negatives priced in……………………………………………….. 123

Asian Paints (SELL): Color of the season is red ………………………………..129

Berger Paints (SELL): Can postpone this paint job …………………………….141

Ambit Capital and / or its affiliates do and seek to do business including investment banking with companies covered in its research reports. As a result, investors should be aware that Ambit Capital may have a conflict of interest that could affect the objectivity of this report. Investors should not consider this report as the only factor in making their investment decision.

Surviving the ‘perfect storm’

FMCG sector valuations haven’t priced in the demonetisation/GST disruption. Sales will be hit by: 1) near-term liquidity constraints, 2) stalling of wholesale channel due to cash crunch, 3) weakness in rural demand given job losses and farmer distress, 4) deferment of discretionary spend. Margins are at their peak and face risks from: 1) providing trade/vendors higher margins to offset cost of tax compliance; 2) cost of expanding direct reach; 3) unfavorable crude and INR trends; 4) limited pricing power due to weak demand. We expect earnings growth of 3%/16% vs consensus’ 7%/13% for FY17/18; past earnings multiple averages may be breached on the downside as earnings growth decelerates. HUL and ITC are our top BUYs, given: 1) deeper direct reach; 2) leading brand/product portfolios; 3) focus on staples that will help navigate demand slump, overcome wholesale disruption, and lower impact on margins. Top SELLs are GCPL and GSK.

Disruption in distribution channels to have a longer-term impact We expect near-term demand hit of 10-20% due to: 1) cash crunch and 2) stalling of channel below distributor level. However, recovery should begin by 1QFY18 but will be weak as: 1) impact on cash wealth will hurt discretionary spending (by 5-10%) and 2) job losses in the informal/construction sectors will negate Government stimulus and hurt rural demand (by 3-5%). Distribution will be disrupted until 2HFY18 due to: 1) delay in revival of wholesalers, 2) lower re-stocking by wholesalers due to capital constraints, 3) initial chaos during GST rollout. Demand creation will also be hit as companies postpone product launches and cut A&P spend. Multiple pressures on peak margins indicate sharp dip ahead Risks abound for sector margins, which spiked by 230bps in the past 5 years and are at peak levels: 1) 30-50bps hit from higher supply chain costs as companies compensate trade/vendors for higher tax compliance; 2) 10-80bps hit from rising crude and depreciating INR. Assuming the companies pass on costs to consumers is flawed in the weak demand scenario. Fall in prices of agri-commodities and cut in A&P spend are not sustainable margin drivers. Who are the winners? Just HUL and ITC for now Our framework to identify winners is: 1) deeper direct reach, 2) wide portfolio of market-leading brands, 3) sophisticated IT systems and processes, 4) skew towards staples and low ticket size. These will help companies navigate the demand slump by beating the wholesale disruption and enhancing consumer connect. Wider product portfolio and leading brands will help lower the hit to margins as also gain share as the wholesale channel favours such companies during capital constraints. HUL and ITC fit the bill; GCPL is the weakest. What will make us positive on the sector? Over the next 1-2 years, the perfect storm of weak demand, disrupted distribution, margin declines and peak valuations raise the risk of a material correction in price/valuations. The attributes of strong growth ramp, healthy financials and strong brands do remain intact for the sector. However, we would turn positive only when: 1) distribution revival and its impact are behind, 2) volume growth revives, 3) visibility on interplay of distress from job losses and support from Government stimulus improves, 4) margins stabilise at a lower level and/or 5) valuations shed their peak.

THEMATIC January 03, 2017

ConsumerNEGATIVE

Key Recommendations HUL BUY

Target Price: 930 Upside 12%

Nestle SELL

Target Price: 5,800 Downside: 4%

GSK Consumer SELL


Colgate SELL

Target Price: 825 Downside: 9%

Godrej Consumer SELL


Dabur SELL


Marico SELL


Britannia SELL


ITC BUY

Target Price: 275 Upside: 14%

Asian Paints SELL


Berger Paints SELL


Coverage Map

Source: Ambit Capital Research, Note: Size of the bubble indicates sales (̀ bn) which highlights the difference in scale of HUL and ITC over others

HUL

Dabur

GCPL

Marico

Britannia

Nestle

GSK Cons

ColgateITC

Berger Paints

Asian Paints

2%

4%

6%

8%

10%

12%

14%

16%

18%

20 30 40 50

EPS

CAG

R (F

Y16-1

9E)

CMP FY18 P/E

Research Analysts

Anuj Bansal +91 22 3043 3122

[email protected]

Ritesh Vaidya, CFA +91 22 3043 3246

[email protected]

Dhiraj Mistry, CFA

+91 22 3043 3264

[email protected]

mailto:[email protected]



Consumer

January 03, 2017 Ambit Capital Pvt. Ltd.

Perfect storm brewing Visibility on the earnings of consumer companies over FY17/18 is clouded. There are several negative factors coming together which can materially impact earnings. These are: a) hit to demand from cash crunch, joblessness as the informal sector shrinks, and negative wealth effect at the higher-end consumption, b) supply disruption from stalling of the wholesale channel followed by GST rollout, c) margin hit from rising supply chain costs for both distribution and procurement participants, and d) rise in crude oil prices and INR depreciation. These factors, combined with peak margins, limited pricing power given weak demand, and near peak valuations, increase the possibility of earnings downgrades and sharp correction. Only HUL and ITC with strong product portfolios, market leading brands and superior distribution and scale will emerge stronger and, hence, are our top picks.

Summary of our thesis on the Consumer sector post demonetisation + GST Exhibit 1:

Factors Drivers Company impacted Quantification of impact

Demand Staple is better Low ticket size Habits and necessity

Low: Nestle, Colgate, GSK, ITC Med: HUL, Dabur, Marico High: Asian Paints, Berger, GCPL, Britannia

Sales hit over FY7-18E Staples: 4-7% F&B: 7-10% Paints: 10%+

Supply chain

Wholesale reliance will hurt

Unorganised suppliers become tax compliant

MT/ Urban focus is better

Low: HUL, ITC, Nestle, Asian Paints, Berger, GSK High: GCPL, Britannia, Dabur, Marico, Colgate

30-50% of sales are wholesale based which is hurt

7-15% is MT /eCommerce based which has done better

Margins Channel support Vendor support Crude/ INR impact

Low: Nestle, GSK, ITC Mid: HUL, Colgate, Dabur, GCPL, Britannia, Marico High: Asian Paints, Berger

Supply chain related margin hit of 30-50bps

Crude/ INR impact of 10-80bps

Source: Ambit Capital research

Comparison of earnings growth and valuations Exhibit 2:

Source: Bloomberg, Ambit Capital Research, Note: Size of the bubble indicates sales (` bn) which highlights the difference in scale of HUL and ITC over others

More downside to demand than upside from GST + demonetisation over the next 12 months There are four key impacts that we believe the demonetisation drive will have on the consumer sector in the medium term: a) job losses due to formalisation of the economy and slowdown in real estate construction will impact mass market demand, b) wealth erosion effect will impact demand for discretionary categories, c) near-term inflation in the consumer basket as cashless transactions attract indirect taxes and reduce customers’ wallet size, and d) fiscal stimulus will drive demand. We believe the negative impact of the first three factors will be higher than the positive support from fiscal or monetary stimulus from the Government and, hence, the near-term impact on demand will be negative.

HUL

Dabur

GCPL

Marico

Britannia

Nestle

GSK Cons

ColgateITC

Berger Paints

Asian Paints

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Consumer


Mass market demand to be impacted by job losses: As of 2012, the informal sector accounted for ~48% of India’s GDP but employed ~80% of India’s labour. The clampdown on black economy, suppression of cash-based transactions and implementation of GST will increase the cost of doing business (tax payouts, expenses for maintaining and reporting financial records) in this sector. Inability to pass on higher costs to customers is likely to make some of these businesses unviable. Job losses due to closure of such businesses are likely to impact consumption at the mass end.

Over the last decade, construction has been one of the largest providers of jobs, accounting for ~11% of total employment (vs 4% in 2000). Job losses due to slowdown in the construction sector will also hit demand at the mass end.

Categories which are likely to be impacted more are personal wash, detergents, oral care, skin & hair care and packaged foods.

About 80% of India’s workforce is in the informal sector Exhibit 3:

Source: NSSO, Ambit Capital research

Erosion of wealth will have a higher impact on premium and discretionary segments: We believe there will be a certain section of consumers that will be affected by wealth erosion due to depletion of cash-based wealth. These consumers belong to the affluent class, which has been a driver of premiumisation and discretionary spending. With negative wealth effect playing out, there could be a medium-term impact on discretionary and premium categories like Packaged Foods and Beverages, Paints, and new age FMCG categories like Conditioners, Fabric Softeners, Fragrances and Makeup. Over the longer term, as consumers get used to new wealth levels, most of this consumption should resume but growth will be on a lower base. As a result, we believe FMCG and tobacco companies will face 1-3% sales hit in FY18, F&B companies a 3-5% hit and Paints a 5-10% hit.

Near-term impact of demonetisation and GST could be inflationary: As cashless transactions are gaining traction, sales which went unreported earlier are now getting captured. This is resulting in consumers being charged service tax and VAT, which earlier they were able to avoid by purchasing in cash. Also, post GST there is a high likelihood of services being taxed higher than the current rate. Even if we assume that the Government is able to create tax slabs such that the overall tax incidence on goods does not rise, the net impact on the consumer wallet is likely to be inflationary. Only over a period of time, as the tax net widens and tax collections improve, is there a likelihood of tax slabs being reduced and GST turning deflationary. In the near term, inflationary pressure will hurt demand and limit the pricing power of companies to pass on rising costs to consumers.

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GST will have a one-time impact of ~50bps on headline CPI in FY18 Exhibit 4:

Category Weight Effective tax rate now

Effective tax rate after GST Explanation

Headline CPI 100% ~10.8% ~11.3%

We have taken the weighted average of increase (or decrease) in taxes for various sub-categories in the headline CPI which works out to be an increase of 50bps.

Food and beverages 48.2% ~4% ~4% No change is expected in this

category under GST

Fuel and Light 6.8% ~14% ~14% No change is expected in this category under GST.

Clothing and footwear 6.5% ~9.5% ~12% This category will attract the lower

rate of 12%.

Housing 10.1% NA NA

Miscellaneous 28.3% ~10% ~11.5%

We have taken the weighted average of increase (or decrease) in taxes for various sub-categories in the miscellaneous category which works out to be an increase of 1.5%

Source: CEA’s report on the revenue neutral rate, Ambit Capital research, Note: We assume a GST structure whereby the standard rate is ~22% and the lower rate is ~12%. Furthermore we assume that petroleum products are out of the purview of the GST. The increase/decrease in tax rates for various categories is as taken from the CEA’s report on the revenue neutral rate.

Expected one-time income transfer to drive demand for discretionary categories: Reduction in the RBI’s liability from unreturned `500 and `1,000 notes and tax collected from black money that is now being deposited will provide the Government resources for increased social spending. As shown in the scenario analysis in the exhibit below, we expect the Government to deliver a likely stimulus of `12,000 for 50% of Indian households from the demonetisation windfall. As per NSSO data for 2012, an average rural household had a monthly expenditure of `7,900 (~`10,000 as of 2016 adjusted for inflation). As a result, the stimulus of `12,000 would amount to 1 to 3 months of monthly household expenditure.

Expect a fiscal stimulus of `12,000 for 50% of Indian households in the Exhibit 5:upcoming budget

Expected stimulus/household (̀ ) % Beneficiary Households

33% 50% 67%

Fiscal stimulus (̀ tn)

1.0 12,121 8,000 5,970

1.5 18,182 12,000 8,955

2.0 24,242 16,000 11,940


Given the one-time nature of this stimulus, we expect this income to be mostly spent on small-ticket discretionary products or used to pay down farm loans which have increased following two years of draught. Even if we assume a larger or more sustained or spread-out stimulus package, we believe the impact on consumption will be limited. Evidence suggests that when economic sentiment is low, fiscal stimulus is used by consumers for savings/deleveraging rather than for consumption given low visibility on their future earnings stream.

Overall, we expect consumer demand to be impacted both for staples and discretionary categories over the next 12 months. However, the impact on discretionary categories is expected to be higher than that on staples due to the latter’s smaller ticket size.

Consumer


FMCG to see margin pressure as the supply chain becomes tax-compliant Over the last 5 years, FMCG companies have seen a slowdown in volume growth from 12% in FY11 to 5% in FY16 while input cost deflation has helped EBITDA margin expansion from 15% in FY11 to 18% in FY16.

Sector EBITDA margin has been improving despite weak volume and sales Exhibit 6:growth over FY11-16…

Source: Bloomberg, Ambit Capital research

We see three possible margin impacts on FMCG companies due to supply chain disruptions:

Wholesale channel (35-50% of FMCG sales) will likely demand 30-50bps higher margin as it becomes tax compliant assuming they were under reporting 30-50% of their turnover earning 3% margin which is now taxed making them lose 30-50bps of profit margin,

Increasing direct distribution would increase distribution cost by 10-20bps YoY, and

Raw material procurement cost could increase as vendors become tax-compliant under GST. This impact is lower vs trade margin support due to 1) parts of inputs as agri based which are tax exempt and 2) impact is at COGS and not at Sales level.

FMCG companies could see an overall impact of 100-150bps on their EBITDA margin due to these factors. Add to this potential impact of rising crude oil prices and depreciating rupee in an environment where pricing power is limited due to weak demand. The combined effect would be a strong headwind for margins. Only HUL and ITC (and to some extent Colgate) with deeper direct reach, wide product portfolio with market leading brands, sophisticated IT systems/processes and skew towards staple and low-ticket categories will come out winners. This will help the companies navigate the demand slump, overcome the wholesale channel’s disruption, and enhance consumer connect to drive demand. These companies’ wider product portfolio and market leading brands will help lower the impact on margins and aid market share gains as they have the scale to negotiate and become preferred partners for the capital constrained wholesale channel.

Wholesale channel disruption could keep demand under-served, thereby impacting primary sales

We expect the wholesale channel to be disrupted over the next 6-12 months due to multiple headwinds from demonetisation and GST. Disruption in the wholesale channel, which currently accounts for 30-50% of sales, could mean that some of the end-consumers remain under-served. This would impact primary sales even if end-consumer demand were to recover sooner than expected. Companies more reliant on wholesale will lose share as they will not be able to serve the consumer demand. This would also allow unorganised local players to survive as they would be able to fulfill demand through their local supply chain. Ideally, due to higher cost of doing business

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Consumer


post demonetisation and GST, these unorganised players should have seen a hit to their businesses. But, given they might be crucial in fulfilling demand which organised players are unable to, the unorganised players might be able to pass on increased costs and remain viable.

A snapshot of the distribution channel Exhibit 7:


Revival of the wholesale channel will require giving higher margins to compensate for tax-related costs

After procuring products from the FMCG company, the distributor sells them: a) directly to the retailer (45-70% of distributor sales) or b) to the wholesale channel, which then sells to retailers (30-55% of distributor sales). The transactions in the distributor-wholesale-retailer channel are mostly conducted in cash. Due to the cash transactions, most of the wholesalers are known to under-report their sales by 40-50% to save on taxes. The tax saved on the under-reported sales helps the wholesale operate profitably despite only 3-4% margin offered by the distributor.

As shown in the exhibit below, a wholesaler who till now was reporting 50% of sales in white and 50% in black, will need ~60bps higher wholesale margins if he were to do 100% white business post-demonetisation and still achieve pre-crisis profit levels.

Wholesale would need higher margins to offset the higher tax cost Exhibit 8:Pre-demonetisation White business Black business Total business

Annual Sales 12,000,000 12,000,000 24,000,000

Wholesale net margin 3% 3% 3%

PBT 360,000 360,000 720,000

Tax rate % 30% 0% 15%

PAT 252,000 360,000 612,000

Capital Employed 1,600,000

RoCE 22%

Post-demonetisation Only White business

Annual Sales 24,000,000

Wholesale net margin 3.6%

Annual PBT 874,286

Tax rate % 30%

PAT 612,000

Incremental Wholesale margin 64bps

Capital Employed 1,600,000

RoCE 22%


The wholesaler also benefits from the significantly higher profit margin that he would earn by doing business with unorganised players or by channeling his cash savings into other cash-based businesses. As unorganised businesses are impacted and avenues for deployment of cash savings reduce, the wholesaler’s dependence on profits from organised FMCG companies would increase further.

No disruption

Disruption

Company Distributors

Wholesalers

Retailors

Retailors

MT/ eCommerce

Vendors

Contractors

Suppliers

Others businesses

White label businesses

“Till now I have been under-reporting my sales to pay less tax. The tax savings allows us to do business with these FMCG companies at wafer thin margin.” – Wholesaler based out of Uttar Pradesh

Consumer


Reduced under-reporting of sales and higher compliance costs to increase wholesale operation cost by 50-100bps: We believe that most wholesalers would stop/reduce their under-reported sales to avoid/reduce generation of black money. The higher reported sales would force wholesalers to pay higher taxes and also increase compliance costs due to costs of hiring accountants and filing tax returns. The wholesalers will have to be eventually compensated by the FMCG companies for the higher costs.

Expect 25-50bps margin impact on FMCG companies due to higher margins paid to wholesale: As shown in the exhibit below, companies with a higher proportion of wholesale sales will be more impacted. Due to their international business which will not be impacted by demonetization and GST, the overall impact on margins would be lower for domestic FMCG companies despite having a higher proportion of wholesale sales.

ITC, Britannia and Colgate are most at risk as they would need to offer higher margins to wholesale Exhibit 9:

Company Direct reach outlets (mn)

Indirectly reached outlets (mn)

Total reach (mn)

Direct channel reach %

Direct channel sales %

Overall margin impact (bps))

HUL 3.0 5.5 8.5 35% 70% 30

Dabur 0.9 4.9 5.8 16% 68% 22

GCPL 1.0 4.5 5.5 18% 55% 23

Colgate 1.5 3.1 4.6 33% 65% 35

Marico 0.9 3.7 4.5 19% 65% 27

Nestle 1.0 1.7 2.4 42% 70% 30

GSK CH 0.8 0.5 1.2 63% 90% 10

Britannia 1.0 2.7 3.7 35% 70% 30

ITC 2.0 5.5 7.5 27% 45% 55

Source: Company, Ambit Capital research

Smaller FMCG companies to have lesser bargaining power with wholesalers: Higher tax payout and compliance cost for the wholesaler is expected to reduce the available capital for the wholesaler. We believe this would prompt the wholesaler to get more selective with which company he would deploy his reduced capital on. Companies which currently have higher sales/wholesaler would be better placed to re-negotiate the new terms of trade with the wholesaler. As shown in the exhibit below, ITC and HUL given their huge scale would have more bargaining power with distributors than other FMCG companies.

ITC and HUL deliver the highest throughput per wholesaler Exhibit 10:

Company Estimated sales/wholesaler/year (̀ mn)

ITC 4.6

HUL 2.0

Britannia 1.4

GSK CH 1.1

Nestle 0.9

Colgate 0.6

GCPL 0.6

Marico 0.5

Dabur 0.5


Consumer


Increasing the direct reach will escalate distribution cost

Currently, out of the total outlets where a company’s products are distributed, only 20-35% are serviced directly. The remaining are serviced indirectly mostly by the wholesale channel. The directly serviced outlets contribute 50-65% of the total sales for a FMCG company. The FMCG company’s or distributor’s sales executive visits the direct outlets to take and deliver orders.

In order to overcome supply disruptions in the wholesale channel, most FMCG companies are planning to increase direct distribution. However, reaching an outlet directly requires substantial cost in deploying a sales executive to take and deliver orders and compensating the distributor for the incremental cost in reaching out to these new outlets. Hence, FMCG companies service outlets directly only if the indirectly serviced outlet has a certain minimum throughput and have the potential to increase throughput to cover the direct servicing costs.

ITC and HUL better placed to increase direct distribution due to higher throughput per indirectly serviced store: As shown in the exhibit below, excluding ITC, HUL and Britannia, the throughput (sales/outlet/month) for outlets serviced indirectly reached is substantially lower than that for directly serviced outlets. As a result, we believe that servicing new outlets directly would be less profitable and increase distribution costs for most of the FMCG companies.

Throughput per indirectly serviced outlet is considerably higher for ITC and Exhibit 11:HUL vs peers

Company Sales/store/month (̀ )

Directly serviced Indirectly serviced

HUL 7,241 1,693

Dabur 4,032 349

GCPL 2,548 463

Colgate 1,832 477

Marico 3,467 435

Nestle 5,002 1,531

GSK CH 4,968 920

Britannia 5,196 825

ITC 8,743 3,834


Competition for limited shelf space at retailers would increase trade promotion costs: HUL and ITC already have one of the highest direct distribution reach amongst FMCG companies. As peers such as GCPL, Dabur, Britannia and Marico expand their direct reach, there would be increased competition amongst FMCG companies to capture the limited shelf space at a retailer. This would add to the trade promotion cost for FMCG companies. This would be particularly high for categories such as soaps, detergents, skin creams and packaged foods where HUL and ITC have a wide distribution reach.

Raw material costs could increase under GST

The third set of factors that is expected to exert gross margin pressure is: a) higher cost of procurement raw material vendors will also become tax compliant as post GST and look to pass on the higher cost of doing business and b) the 12% rise in crude oil prices and 1% INR depreciation over the past month.

Tax compliance by raw material suppliers could increase raw material costs: Once GST is implemented, FMCG companies will be able to claim an input tax credit (ITC) only if their vendors are also paying GST. While most of the vendors for FMCG companies are expected to be organised, we believe some of the raw material suppliers to these vendors are unorganised and possibly evading taxes by under-reporting. Once GST comes into force, all participants in the supply chain will be forced to become tax-compliant. This could increase raw material costs for FMCG companies.

Consumer


Sourcing agri-commodities from farmers could face issues due to the liquidity crunch: For agri-commodities sourced directly from farmers, the farmer is largely paid in cash. Since the demonetisation, companies like Marico which source copra directly from farmers are facing issues as they are unable to do make timely cash payments to farmers. Dabur and Britannia, which also depend on agri-commodities, will also face similar procurement issues. Companies are trying to overcome this issue by paying directly into farmers’ bank accounts. However, this transition could take at least 6-12 months as farmers gradually get their bank accounts.

Non-exclusive converters could demand higher conversion charges as their unorganised businesses get impacted: Most FMCG companies manufacture products through third party manufacturers. Though in many cases the contracts are exclusive, in some instances converters are free to undertake white label or own label manufacturing. This provides scale to the converter and helps subsidise cost of conversion for larger branded players. Under GST, as we expect the unorganised sector to shrink, some of the converters will not be able continue with white/own label. This will make businesses unviable and hit FMCG companies as 1) either some such contract manufacturers will shutdown leading to overall capacity reduction/consolidation or 2)FMCG companies will have to support such contractors with higher margins to make their businesses viable

Rising crude oil price and rupee depreciation are adding fuel to the fire: Paint companies have higher sensitivity to crude oil price movements than FMCG companies as almost half of the raw materials used in paint companies are crude-linked. Amongst FMCG companies, crude-linked derivatives are used for packaging material (HDPE – High Density Poly Ethylene), detergents (LAB – Linear Alkyl Benzene) and soaps (PFAD - Palm oil Fatty Acid Distillate) all of which move in line with crude prices. Hence, HUL, Colgate, Dabur, Marico and GCPL have the highest sensitivity to crude oil. The 50% depreciation in crude oil over the last 24 months has led to an average increase of 310/180bps increase in gross margin and EBITDA margin. We expect the 12% rise in crude oil over the last one month to result in unwinding of some of these margin gains. 1% depreciation in INR vs USD over the last one month will put further pressure on the margin of these companies.

Crude rose by 12% in the past month ($/bbl) Exhibit 12:


INR depreciated by 1% in the past month Exhibit 13:


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Impact of crude oil and INR on company sales Exhibit 14:

RM imported as % of sales

RM dependent on crude oil derivatives

as % of sales

Total Impact due to INR + crude Impact

Staples

HUL 2% 13% 15%

Dabur 0% 13% 13%

Marico 4% 7% 11%

GCPL 3% 11% 14%

GSK CH 1% 7% 7%

Nestle 5% 7% 11%

Colgate 4% 10% 14%

Britannia 0% 5% 5%

ITC 4% 2% 5%

Paints Asian Paints 11% 33% 43%

Berger Paints 12% 34% 46%

Source: Ambit Capital research,

Note: - Strong; - Relatively Strong; - Average; - Relatively weak.

Weak demand scenario limits the ability to take price hikes; reducing A&P spend is not sustainable

The demand disruption and expected job losses would limit a consumer company’s ability to pass on the higher cost pressure to consumers through price hikes. Reduction of A&P spend to counter margin pressure can only be a temporary solution as companies would eventually increase advertising spends to spur consumer demand and maintain brand equity.

Peak valuations and sanguine investors complete the perfect storm Over the past 5 years, FMCG has seen a constant re-rating of valuation multiples. This has been driven by: 1) defensive nature and lack of many other high-quality businesses to invest in and 2) sense of invincibility that investors believe these companies have developed. This is despite earnings fundamentals having moved in downward due to volume growth slowdown (12% in FY11 to 5% in FY16). Profit growth has been maintained (5-year CAGR of 16%) by driving margins higher (up 270bps over FY11-16); however, this is now set to reverse.

Three-year rolling sales and EPS CAGR have been declining Exhibit 15:


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FY10 FY11 FY12 FY13 FY14 FY15 FY16

3 years rolling sales CAGR 3 years rolling EPS CAGR

Consumer


Due to the strong re-rating from April’11 to Jul’15, multiples went up from a reasonable 25x 1-year forward P/E to an astronomical 44x 1-year forward P/E. Since then some rationality has been restored as weak volume growth started weighing down the sector. However, valuations are currently trading at ~1 std. deviation above their last 5 year average 1-year forward P/E. Given our expectations of demand and margin pressure over the next 12 months due to GST/demonetisation, we see the downward pressure on multiples to continue going forward as well.

Sector is trading 12% higher than the historical 5-year average Exhibit 16:


Our DCF-based target prices give an implied multiple of 34x FY18E P/E. This is largely in line with the last 5 years’ average. We believe if the earnings downgrade cycle continues beyond 2HFY18, there could be further downside to valuations.

P/E multiples at CMP vs implied by our DCF-based target prices Exhibit 17:

Company Rating CMP TP PE at CMP (FY18)

Implied PE at TP (FY18)

5 years average 1 year fwd P/E

Staples HUL BUY 826 930 38.9 43.7 36.3

Nestle SELL 6,028 5,800 44.4 42.7 47.3

GSK Consumer SELL 5,003 4,950 27.7 27.4 33.0

Colgate SELL 905 825 35.1 32.0 37.5

Godrej Consumer SELL 1,514 1,025 40.2 27.2 32.7

Dabur SELL 278 240 35.5 30.6 31.9

Marico SELL 260 240 37.1 34.2 31.9

Britannia SELL 2,886 2,600 38.5 34.7 28.0

ITC BUY 242 275 24.2 27.6 26.7

Average 35.7 33.3 33.9

Paints Asian Paints SELL 891 800 45.0 40.4 39.0

Berger Paints SELL 211 180 45.7 39.0 33.5

Average 45.3 39.7 36.2


25

30

35

40

45

Apr

-11

Jul-

11

Oct

-11

Jan-

12

Apr

-12

Jul-

12

Oct

-12

Jan-

13

Apr

-13

Jul-

13

Oct

-13

Jan-

14

Apr

-14

Jul-

14

Oct

-14

Jan-

15

Apr

-15

Jul-

15

Oct

-15

Jan-

16

Apr

-16

Jul-

16

Oct

-16

Sector average 1 year fwd PE 5 years average +1 s.d. -1 s.d.

Consumer


Who will emerge the winners? While we believe the near-term negative impact on demand and the supply chain will be felt by all, in the longer run, reduction in the black economy, monetary/fiscal stimulus by the Government, and weakening of unorganised segment are positives. However, not all categories and companies will be able to gain. Even within organised, we believe there are businesses which can face a negative long-term impact. Growth trajectories hereon could diverge depending on: 1) ability of companies to shift from wholesale to direct distribution, 2) higher sophistication of the supply chain, 3) over-indexation to staples, and 4) shift of share from unorganised to organised.

Framework for categories that would fare better To identify companies which are likely to emerge winners, we first need to assess what are the categories likely to benefit more. Being over-indexed to such categories is one of the key parameters for a company to emerge the winner.

Staples vs discretionary

We prefer staples over discretionary because 1) near-term demand impact has been is lower for staples as customers prioritise purchase of staples over discretionary given limited cash and 2) recovery of staples will also be faster than discretionary as discretionary categories are likely to be negatively impacted by wealth erosion of a certain section of consumers whose cash wealth has been impacted by demonetisation.

Proportion of premiumisation should be lower

As is the case with discretionary categories, premium brands are also impacted more than base brands as the cash crunch can lead to downtrading. Positive wealth effect also tends to be the key driver of premiumisation. Currently, wealth effect in the near to mid term is likely to be negative and, hence, premiumisation trends could decline. There can also be downtrading by consumers whose incomes are impacted due to job losses in the informal sectors.

Higher proportion of the unorganised segment

One key impact of demonetisation and GST would be shrinking of the informal sector due to: 1) liquidity crunch, 2) increase in cost of doing business due to taxes on transactions done through formal channels and not in cash. Most informal businesses price products aggressively and survive on thin margins as they save on taxes. For this, they are dependent on cash transactions so that they do not get captured formally. Once tax incidence goes up, the informal sector will have to either take up prices or struggle for survival as absorbing increased costs is the less likely option. Hence, categories whose size of unorganised is bigger stand to benefit more as they will have higher potential for revenue growth by taking away larger market share from unorganised players.

Ability of customers to move from unorganised to organised also matters

While a large informal sector might provide a bigger opportunity for the organised players, what also matters is the ability to replace unorganised players. The two impediments to this can be:

Higher price gap between the organised and unorganised segments: In this case, consumers might find the gap too steep to bridge. A large gap will provide more room for price hikes to informal players as they might still retain a large enough price advantage over organised players even after taking up prices (eg. in case of hair oil whose price gap is 2-3x vs paints at the other end of spectrum with a price gap of only 20-25%). Even if the informal sector does shrink, we believe in case there is a wide price gap, a large part of this shrunk demand will be left unmet and, thus, the overall category size will shrink instead of market share gains for organised from unorganised.

Consumer


End-to-end supply chain of unorganised players is in cash: Certain categories like biscuits and hair oil run the risk of the informal sector remaining largely unaffected even under GST. This is because the end-to-end supply chain of unorganised is in cash. Purchase of raw material (largely basic agri-products), paying wages to the informal workforce, and selling products to local wholesalers can all be done on cash. This would allow the informal sector to remain unaffected even after GST rollout. The complete cash-based supply chain will be difficult to be captured by GST and, hence, can survive without paying taxes associated under the new regime.

Potential impact on categories from demonetisation and GST Exhibit 18:

Necessity Ticket size Extent of premiumisation

Share of unorganised

Ability to shift to organised

Channel of sales Overall

HPC

Soaps

Detergents

Hair oil

Shampoo

Skin care

Tooth paste

Beauty

Foods and beverages

Biscuits

Juices

Packaged foods

Tea/ Coffee

Health food drinks

Habits

Tobacco

Alcohol

Paints

Paints

Source: Ambit Capital research, Note:


Framework for assessing the chances of winning for a company Having a skew in favor of categories we expect will benefit more is only part of making a business a long-term winner due to demonetisation and GST. The other factors that matter include: 1) contribution of wholesale channel to overall sales and 2) ability to utilise IT systems to benefit from tighter supply chains under GST.

Higher exposure to the direct channel

In a vast country like India with ~10mn retail outlets, wholesale has a critical role to play to act as bridge between a company and smaller retail stores. However, the wholesale channel is currently impacted due to liquidity crunch; post GST, the impact is likely to be from reluctance of the channel to connect to the formal supply chain and disclose their true income levels. Companies which have higher reliance on direct and modern/e-commerce channels will benefit, because of these reasons:

Lower impact to sales as the direct and modern trade channels are working well: The higher the sales contribution from direct and modern trade channels, the lower will be the impact to sales in FY17 and FY18 when channel disruptions due to the liquidity crunch and shift to GST regimes will be high.

Consumer


Chance to gain market share is higher: As demand at the consumer level revives, companies which have a more direct route to market will be able to cater to this demand much better than those who are dependent on wholesale and are therefore unable to cater to the demand. This will lead to market share shifts in favor of companies skewed towards direct and modern trade.

Margin squeeze will be lower: We believe reviving wholesale traders will require companies to support them with higher margins to compensate for increased cost of doing business. Also, companies looking to expand direct distribution in reaction to the current situation will have to incur costs of expansion, which will hurt margins. Hence, a skew towards direct distribution will see a lower hit to margins than companies playing catch up will have to incur.

Exert first-mover advantage to slow expansion by other companies: Companies which already service a higher number of retail outlets will have the advantage of: 1) longer standing relationships, 2) better understanding of requirements of these outlets, 3) better shelf space management experience, and 4) contributing higher to the retailer’s sales. New entrants in these retail stores through expanded direct distribution will find it hard to overcome these barriers.

Quality/sophistication of supply chain should be superior

The key change under GST would be seamless connectivity and transparency across end-to-end supply chains. This would require investments in IT systems to support such seamless integration. Companies like HUL, ITC and Colgate which have invested heavily in IT backbone will have an edge as they are further ahead in being GST ready vs peers which will require more time and investments to catch up and reap the benefits of GST. Some of the initiates taken by these companies are: 1) ERPs and databases linking end-to-end supply chain, 2) handheld devices with sales people to capture MIS at point of sale, 3) centralised procurement, and 4) well-defined process for supply chain management.

Sales forecasting: The biggest benefit of such IT-based integration would be better tracking of tertiary sales and better ability to forecast end-consumer demand. This would enable superior management of inventory levels and reduce working capital. It would also provide better control/feedback loop during new product launches.

Direct procurement and in-house manufacturing: Companies that directly procure raw materials (e.g. HUL has a regional/global procurement system, Nestle and ITC procure directly from farmers) or manufacture the bulk of their products in-house (e.g. Dabur) are better placed than peers as they would already have a tax complaint procurement system and would not be hit by procurement disruption or price inflation under GST.

These advantages are structural in nature and can significantly improve sales throughput (better replenishments, better customer understanding, more successful new launches), profitability (lower transportation costs) and cash flows (lower inventory levels). Therefore, companies which are better prepared for the GST rollout and have made the requisite investments to get IT systems in place to best utilise the advantages offered by GST are preferred over companies which are just tweaking their existing ERPs to become GST-compliant.

Higher skew towards winning categories

As discussed earlier, there are certain categories which will be impacted more due to demonetisation and GST. Companies which have a higher skew towards staples, have low ticket sizes, and a high share of unorganised players are likely to benefit more than companies with a skew towards discretionary, premium, high ticket size items and largely formal categories.

Consumer


Impact on companies on the basis of distribution channel disruption Exhibit 19:

Reach (# of outlets)

Direct/ Indirect

Urban vs rural

MT/ GT/ eCommerce

Geographical region IT system Overall

Staples

HUL

ITC

Marico

Nestle

GSK Consumer

Colgate

GCPL

Dabur

Britannia

Paints

Asian Paints

Berger Paints

Source: Ambit Capital research,


And the winners are… HUL and ITC

Scores of companies to assess winners Exhibit 20:

Distribution impact

Category skew

INR/ Crude impact

Overall Comments

Staples

HUL

Higher direct reach and wide product portfolio benefits HUL Impact of crude and INR depreciation is higher

ITC

Resilience of Cigarettes demand and deep direct distribution will help ITC. Impact of crude is limited while INR depreciation helps

Marico

Higher reliance on wholesale and possible increased cost of procurement will hurt. Staple nature of categories helps. INR/Crude impact is moderate

Nestle

Urban, modern trade focused categories limit impact on Nestle. Impact of crude and INR is moderate

GSK Consumer

Urban and modern trade skew helps but category is highly discretionary. Crude and INR impact are similar as others.

Colgate

Strong direct reach and staple nature of the category helps Colgate. Impact of crude and INR depreciation is also lower

GCPL

Weak direct reach, low market share in soaps, discretionary nature of hair colors will hurt. Crude and INR impact will also be high

Dabur

Higher direct reach and staple / healthcare related categories will limit the impact. Impact of crude in higher.

Britannia

Stalling of wholesale channel, discretionary nature of the category will hurt. Crude/INR dependence is among the lowest.

Paints

Asian Paints

Complete direct distribution will help. Demand suppression is highest and Impact of crude and INR depreciation is high

Berger Paints

Some gaps in distribution will hurt. Demand suppression is higher than Asian Paints and impact of crude and INR depreciation is high



Consumer


Summary of our earnings estimates We believe impact on sales will be higher in FY17 due to near-term impact on demand being much higher (from liquidity crunch), which should lead to double-digit declines for most companies in 2HFY17. Demand should recover in FY18 but it will be back-ended as: 1) wholesale would revive only by 2HFY18 post GST implementation and 2) low base effect of 2HFY17. Margin hit will be higher in FY18 than in FY17 due to: 1) hit to margins for supporting wholesale will be realised only when wholesale revives in FY18, 2) impact of crude and INR will come with a lag as companies work through their low-cost inventories in FY17, and 3) A&P spends which have been cut to support FY17 margins should normalise in FY18. Overall, we expect EPS CAGR of mid to high single digit over FY16-18 for our coverage universe.

Our sales, EBITDA and EPS estimates for FY17-18 Exhibit 21:

Company Sales growth EBITDA growth EBITDA margin EPS growth

Comments FY17 FY18 FY17 FY18 FY17 FY18 FY17 FY18

Staples

HUL -1% 16% -3% 12% 17.6% 17.0% 0% 13% Sales to get impacted for medium term with margin impact in FY18

Dabur -2% 14% -3% 10% 17.8% 17.1% -3% 11% 15% for domestic sales to get impacted with some respite in FY18 as recovery begins in later half of the year

Marico -4% 16% 5% 13% 19.0% 18.6% 9% 15% FY17 sales impact due to raw material deflation and demonetisation; long term benefit by market share gain from unorganised players

GCPL 5% 11% 8% 9% 18.7% 18.3% 5% 5% Soaps category is largely impacted due to higher indexed to wholesale channel; Impact on HI is marginal

GSK Consumer 2% 13% 2% 16% 15.5% 15.8% -3% 14% Less impacted as GSK has high index to evolved channel of chemist and MT

Nestle* 16% 18% 18% 23% 18.9% 19.6% -1% 25% Skew towards Modern trade and urban consumers would cushion impact to sales. Low base due to Maggi re-launch is also a key driver

Colgate 4% 19% 2% 18% 21.9% 21.8% -2% 18% Moderate impact as Colgate present in habit/ health/necessity product category

Britannia 0% 17% 0% 14% 14.0% 13.7% -1% 11% Sales hit is higher vs most Staples as Discretionary and impulse nature of its categories

ITC 5% 16% 6% 15% 38.8% 38.3% 7% 14% Cigarette being a habit category and having small ticket size, we expect cigarettes to have lesser impact than other product categories

Discretionary

Asian Paints -1% 13% 0% 5% 18.3% 17.0% 1% 6%

Highest ticket size and most discretionary category in nature, Asian Paints should suffer most from demand hit; Margin should contract due rise crude price and depreciating INR

Berger Paints -2% 14% 3% 10% 14.8% 14.3% 7% 13% Highest ticket size and most discretionary category in nature, Berger should suffer from demand hit and negative wealth effect

Source: Ambit Capital research; Note: For nestle FY17 is CY16

Consumer


Rich valuations; wait for emergence of more support Given demand and margin headwinds over the next 12 months due to demonetisation and GST, we do not expect the premium sector valuations (36x FY18E EPS, ~12% above 5-year average) to sustain. We have cut our sales and PAT estimates by 8-20% for FY17-18 with a sharper cut for discretionary categories. HUL (12% upside) and ITC (14% upside) are our top picks as they will be less impacted than consensus expects due to the strength of their brands and scale. Although Marico, Asian Paints and Berger Paints remain high-quality franchises, their premium valuations and margin/demand headwinds leave little room for upside; we have SELL rating on these names.

We adopt a DCF-based valuation methodology for valuing FMCG companies due to: (a) high cash generation of these businesses (b) neutralising the impact of cyclicality across different kinds of businesses and (c) valuing companies for their long-term potential and near-term earnings. We break up the DCF model into three stages to capture the different phases of growth:

Phase I - Explicit forecast (until FY20): As we believe that the complete implementation of DBT would be completed by FY20, we have created explicit forecasts for all companies until FY20.

Phase II - Fade period: We differentiate between the longevity of growth of different companies by factoring in different fade periods. The determinants of longevity of growth are described in the following section.

Phase III - Perpetual growth: After the fade period, we assume the same perpetual growth of 5% for every company. We estimate 5% perpetual growth by assuming 3% real GDP growth and 2% long-term inflation.

We assume a cost of equity (Ke) of 13% for all companies.

Relative valuations Exhibit 22:

Relative valuations

CMP Mcap Stance

Target Price

Up / Down

P/E based on CMP

EV/EBITDA ROCE (%) Implied P/E based on TP

Div. Yield

(%)

Rev growth

EPS Growth

(`) (LC bn)

FY17E FY18E FY17E FY18E FY17E FY18E FY17E FY18E FY16 FY16-19 FY16-19

Staples

HUL 826 1,788 BUY 930 12% 44.1 38.9 31.2 27.8 112.7 153.3 49.6 43.7 1.9% 10.2% 12.8%

Nestle 6,028 581 SELL 5,800 -4% 55.4 44.4 31.3 25.5 33.8 39.5 53.3 42.7 0.7% 16.4% 13.5%

GSK Consumer 5,003 210 SELL 4,950 -1% 31.5 27.7 28.0 23.5 26.8 26.6 31.2 27.4 1.4% 9.0% 8.1%

Colgate 905 246 SELL 825 -9% 41.2 35.1 25.6 21.5 53.5 54.9 37.6 32.0 1.1% 12.8% 11.3%

Godrej Consumer 1,514 516 SELL 1,025 -32% 42.2 40.2 30.2 27.3 15.8 14.7 28.5 27.2 0.4% 9.3% 7.9%

Dabur 278 490 SELL 240 -14% 40.1 35.5 31.4 27.8 23.5 24.0 34.7 30.6 0.8% 9.2% 9.4%

Marico 260 336 SELL 240 -8% 42.6 37.1 29.4 25.8 34.3 35.3 39.2 34.2 1.0% 8.3% 13.1%

Britannia 2,886 346 SELL 2,600 -10% 42.9 38.5 27.5 23.9 40.1 37.5 38.6 34.7 0.7% 11.1% 10.6%

ITC 242 2,929 BUY 275 14% 27.5 24.2 18.0 15.5 29.1 30.4 31.3 27.6 2.3% 12.4% 11.7%

Average

-6% 40.8 35.7 28.1 24.3 41.1 46.3 38.2 33.3 1.1% 11.0% 10.9%

Discretionary

Asian Paints 891 855 SELL 800 -10% 47.8 45.0 29.6 28.0 28.9 27.8 42.9 40.4 0.8% 8.7% 8.7%

Berger Paints 211 204 SELL 180 -15% 51.7 45.7 29.9 26.9 21.7 22.4 44.1 39.0 0.6% 9.0% 15.0%

Average

-12% 49.7 45.3 29.8 27.5 25.3 25.1 43.5 39.7 0.7% 8.9% 11.8%


Cost of equity assumptions

Item Value

Risk free rate (%) 8.5

Beta (2-year monthly) 0.5

Equity risk premium (%) 9.0

Cost of equity (%) 13.0


Consumer


HUL and ITC top picks; SELLers on Marico, Asian and Berger paints We are positive only on HUL and ITC within our coverage and have SELL ratings on the rest of the stocks as we believe near-term disruptions might lead to significant earnings cuts and multiples de-rating for these companies. Only HUL and ITC are placed well in the current situation, both in relative and absolute terms. Our high conviction BUY on HUL and ITC stem from:

Higher direct reach: HUL, with over 3mn directly serviced stores, and ITC, with strong control over its distribution network, are placed well to overcome near-term disruption from the wholesale channel faster and better than peers

Ability to expand direct reach: Throughput of stores serviced indirectly by HUL and ITC is significantly higher than for peers. This improves the viability of servicing these stores for HUL and ITC whereas peers will find it unviable to expand direct coverage due to lower throughput.

Strong market-leading brands: With the wholesales channel likely to be capital constrained, it will be selective in stocking faster moving SKUs from companies with the highest bargaining power (stemming from wider product portfolios). Both HUL and ITC are best placed with market leading brands across key categories.

Direct procurement: HUL benefits from Unilever’s global/regional procurement and ITC has a very strong network for direct procurement from farmers. This gives both the players advantage in terms of navigating procurement-related disruptions and price hikes expected caused by the demonetisation and GST.

Valuations: HUL (38x FY18E P/E) is trading at a marginal premium to sector average (36xFY18E P/E) and its 5year historical average (36x). ITC (23x FY18E P/E) is trading at a discount to both the sector average (36x FY18E P/E) and its last 5year average trading multiple (27x). We believe in case of HUL, premium should be higher given it is unique in benefitting both in near term as well as longer term from demonetization. For ITC, the risk (of higher than expected tax rates post GST) reward ratio at such deep discount is positively skewed.

Nestle and Colgate are better placed among the others

While we have a SELL on Nestle and Colgate, we believe these are reasonably well placed among their peers due to limited impact of demonetisation (Nestle has higher skew towards urban, modern trade/pharmacy and essential categories while Colgate has wider direct reach, lower reliance on wholesale and dominant market share). However, we will await improvement in visibility on their internal growth drivers (new launches for Nestle and share gains for Colgate) before we turn BUY on them.

Nestle: Rich valuations demand a structural turnaround

o We have a SELL on Nestle largely on expensive valuations. Valuations of 45x FY18E P/E are in-line with the last 5 years’ average. However, we also track Nestle’s premium to the sector, which has narrowed.

o We believe Nestle has the potential to beat external factors by carrying out an internal revamp that it has planned. New product/category launches and continued revival of Maggi noodles can help generate market beating growth and share gains.

o Also, higher skew towards urban and modern--centric categories with reasonably small ticket sizes (noodles/ketchup) or essential in nature (Baby Foods) should help Nestle overcome disruptions from demonetisation and GST better than peers. Coffee and confectionary categories are discretionary and might get hit, which is a key risk to Nestle.

o Procurement is also direct and manufacturing is mostly done in-house, providing further cushion from supply side issues.

Consumer


Colgate: Market share stability will be the trigger to turn positive

o With best-in-class distribution (both quantitatively and qualitatively) and dominance in its category, Colgate should be able to overcome disruptions faster and better than peers. Also, its ticket size is reasonably small and category is staple.

o The key risk remains slowdown in premiumisation and share loss to Patanjali, which through its direct distribution can withstand disruptions even better.

o Valuation remains rich and we would prefer either a better entry point or sustained market share gains to convince us that threat of Patanjali is manageable. Trading at 35x FY18E P/E multiple, Colgate is at a 7% discount to the last 5 years’ average. We believe risk of further de-rating remains given Colgate still needs to successfully demonstrate its ability to ward off competition from Patanjali.

SELL ratings on Dabur, Marico, Asian Paints and Berger can reverse

We believe Dabur, Marico, Asian Paints and Berger have built great business franchisees with long-term growth prospects riding on strong sustainable competitive advantages. However, in the current context of demand, supply chain, profitability and valuation, they are relatively weak and likely to be hurt more than HUL, ITC, Nestle and Colgate. We would turn BUYers on any of these names if 1) valuation prices in near-term hit to earnings, 2) revival of demand appears sustainable, 3) action to remove supply chain bottlenecks are demonstrated and/or 4) we are convinced that margins have bottomed out.

Dabur: Will feel the impact of demonetisation and GST

o We like the fact that Dabur has a wide product portfolio and its reliance on wholesale is lower than most peers. Also, for most of its raw materials, Dabur is well integrated at the back end.

o However, over-indexation to North/East and rural markets and entry-level price points could lead to higher demand disruption. Also, one of the key drivers of growth for Dabur is its new product launch pipeline. This has been halted until the demand situation improves.

o Valuation at 35x FY18E P/E is at a 11% premium to last 5 years’ average, which is unjustified under the current circumstances.

Marico: Near-term pressures overshadow strength of franchise

o Marico remains a high-quality franchise as it has implemented several transformational changes in the last 2 years, including: (a) shift in control to professional management; (b) changes to the incentive structure of the management team; (c) prudent capital deployment; and (d) IT-led distribution.

o However, in the near term, Marico is more exposed to margin contraction due to disruption in copra procurement and higher margin for wholesale channel. Moreover, market share gain from unorganised players is likely to be slower due to high price gap.

o Hence, looking at near-term pressure on earnings and margin, current valuations of 37x FY18E, at a 17% premium to last 5 years’ average P/E, leaves little upside.

Asian Paints: High-quality business but highly susceptible to demand disruption and raw material price inflation

o Asian Paints is most immune to supply chain disruptions as it controls its distribution to the last mile. Also, its procurement is mostly formal industrial products, which might benefit under GST through offsetting of input taxes.

o However, Asian Paints is also most exposed to demand hit given it is present in a high-ticket, discretionary spending category.

Consumer


o Also, its exposure to crude prices and INR depreciation is also the highest. Weak demand would limit pricing power and, hence, we expect a hit to both sales and profitability.

o Valuations of 45x FY18E is at a 15% premium to last 5 years’ average, which is unjustified given low visibility of near to mid-term earnings trajectory.

Berger Paints: Internal turnaround will stall given external pressures

o Over the last 2 years, due to several changes made by management across sales, IT and marketing and partially assisted by tailwinds around raw material price, gross/EBITDA margins expanded by ~510/300bps.

o However, with near to mid-term demand destruction in discretionary spending and margin pressure due to headwinds around crude and INR depreciation, we believe current valuation of 46x FY18E (36% premium to last 5 years’ average PE) is unjustified.

GCPL and GSK Consumer: We have a structural SELL rating

GCPL: Capital allocation remains the key risk

o We remain concerned about the company’s capital allocation policy as its vision to grow sales 10x in 10 years (over FY11-21) led to RoCE decline from 24% in FY11 to 18% in FY16 due to several acquisitions during this period.

o Increasing competitive threats in the soaps and hair colours businesses adds to the concerns in the domestic business. We expect 12%/11% sales/PAT CAGR over FY17-20. Given the poor visibility on longevity of growth, we believe GCPL should trade at a discount to the sector’s average valuations.

GSK: Under-utilising a quality brand

o GSK Consumer is less impact by the demonetisation due to: a) lower dependence on wholesale, b) larger portion of its products is sold through much evolved channels of chemists and modern trade, and c) its product is positioned as a health drink for children.

o However, the firm faces headwinds around: a) market share saturation in South and East and intense competition in the North and West and b) ROCE dilution given capital misallocation risks. Given these headwinds, we do not see significant upside from current valuations of 28x FY18E P/E.

Relative valuations vs global peers We compare Indian consumer names with their global peers. The significant premium that Indian companies are trading at (35-180% on P/E) looks unjustified given: 1) gap between growth rates is fairly narrow (in fact staples and paints are expected to grow slower), 2) ROE (ex F&B names) and dividend yields are lower, and 3) risk of exposure to a single country. Structurally, we do believe the growth ramp for Indian companies should be longer and stronger than that of global peers though it does not reflect in current numbers due to near-term hit of demonetisation/GST.

Staples: Indian companies are trading at a 67% premium to global peers on 1-year forward P/E and 50% premium on P/sales basis. ROEs are only marginally better at 52% v 43% while dividend yields are significantly lower (1.1% for Indian names vs 2.6% for global peers). Sales growth is only marginally better at 7% vs 3% for global peers as most of the latter are hurting from the EM slowdown and FX hits. EPS growth is better for global peers. Structurally, we believe this gap should open up post FY18 when Indian companies recover from the demonetisation/GST led slowdown.

Food & Beverages: Indian companies are trading at a 100% premium to global peers on 1-year forward P/E and 120% premium on P/sales basis. The case for premium here is stronger than staples given ROEs are significantly better (50% for Indian names vs 14% for global peers) and growth rates are also materially higher (13% sales growth for Indian companies vs flat for global peers). Structurally, too, we believe F&B is the future growth area in India as penetration levels are quite low (vs staples which is approaching saturation).

Consumer


Paints: Trading at a massive premium of 180% on 1-year forward P/E and at 3x on P/sales to global peers, Indian paints companies look richly valued. With ROEs (29% vs 44%) and dividend yields (0.8% vs 1.6%) being significantly weaker for Indian companies and growth prospects in the near term (till FY18) not looking much better (6% sales growth for Indian companies vs 1% for global peers), this premium appears unjustified.

Tobacco: A premium of only 35% on 1-year forward P/E and 50% on P/sales vs global peers appears justified for ITC as India has the potential for strong cigarette volume growth in the longer run. Even in the medium term, ITC is expected to post 11% sales growth vs flat growth for global peers. ROE (33% for ITC vs 64% for global peers) and dividend yield (1.9% for ITC vs 4% for global peers) are weaker but justified given ITC has significant investments in non-cigarette businesses.

Relative valuations Exhibit 23:

Company name CMP Mcap

(US$mn)

P/E P/ Sales EV/EBITDA ROE % (3 yr avg)

Sales CAGR

EPS CAGR

Div Yld (%)

(LC) FY17E FY18E FY16 FY17E FY18E FY16-18 FY16-18 3 yr avg

HPC

Indian

HUL 826 26,262 44 39 5.6 31 28 111 7% 6% 1.9

GSK Consumer 5,003 3,090 31 28 5.1 28 24 31 7% 5% 1.0

Colgate 905 3,613 41 35 5.9 26 21 79 11% 7% 1.5

Godrej Consumer 1,514 7,572 42 40 5.8 30 27 24 8% 5% 0.5

Dabur 278 7,195 40 35 5.8 31 28 36 6% 5% 0.9

Marico 260 4,935 43 37 5.5 29 26 34 5% 12% 1.1

Average 40 36 5.6 29 26 52 7% 7% 1.1

Global Unilever Plc 3,273 121,831 18 16 1.9 14 13 34 2% 8% 3.3

Procter & Gamble Co/The 85 226,389 23 22 3.2 15 15 15 -4% 25% 3.1

Reckitt Benckiser Group Plc 6,811 58,604 23 20 5.4 17 15 34 11% 17% 2.6

L'Oreal 173 101,596 27 25 3.8 17 16 17 4% 8% 2.0

Colgate-Palmolive Co 66 58,673 23 22 3.7 14 14 113 0% 41% 2.1

Average 23 21 3.6 16 14 43 3% 20% 2.6

F&B Indian Britannia 2,886 5,086 43 39 4.0 28 24 55 8% 5% 1.0

Nestle 6,028 8,535 55 44 7.2 31 25 45 17% 11% 0.9

Average 49 41 5.6 29 25 50 13% 8% 0.9

Global Nestle Sa-Reg 73 221,994 21 20 2.6 14 13 17 2% 12% 3.1

Mondelez International Inc-A 45 69,560 23 21 2.3 18 16 15 -6% -31% 1.5

Mead Johnson Nutrition Co 72 13,276 21 21 3.3 14 14 NA -4% 3% 1.7

Danone 59 40,760 19 18 1.7 12 12 11 5% 26% 2.7

Average 21 20 2.5 14 14 14 0% 2% 2.3

Consumer


Company name CMP Mcap

(US$mn)

P/E P/ Sales EV/EBITDA ROE % (3 yr avg)

Sales CAGR

EPS CAGR

Div Yld (%)

(LC) FY17E FY18E FY16 FY17E FY18E FY16-18 FY16-18 3 yr avg

Paint companies

Indian

Asian Paints 891 12,551 48 45 5.5 30 28 33 6% 3% 0.9

Berger Paints 211 3,002 52 46 4.4 30 27 24 6% 10% 0.7

Average

50 45 5.0 30 27 29 6% 7% 0.8

Global

Akzo Nobel 59 15,693 14 14 1.0 8 7 13 0% 4% 2.5

Ppg Industries Inc 96 25,304 16 15 1.7 10 10 47 -1% 11% 1.3

Sherwin-Williams Co/The 272 25,306 22 20 2.2 13 12 73 5% 9% 1.0

Average

18 16 1.6 10 10 44 1% 8% 1.6

Tobacco companies

ITC 242 43,012 27 24 8.0 18 16 33 11% 10% 1.9

Global

Imperial Brands Plc 3,539 41,705 14 13 2.7 13 11 25 -16% 24% 4.7

British American Tobacco Plc 4,558 104,455 18 16 6.5 17 16 63 12% 10% 4.2

Philip Morris International 91 141,685 20 19 5.3 14 14 NA 1% 4% 4.5

Altria Group Inc 68 132,267 22 20 7.0 15 14 148 3% 12% 4.2

Japan Tobacco Inc 3,838 65,317 17 16 3.4 11 10 20 -1% -7% 2.6

Average

18 17 5.0 14 13 64 0% 9% 4.0


Correction since 8 Nov 2016 is just the beginning; value is yet to emerge Consumer stocks under our coverage have corrected 0-12% since 8 November (demonetisation announcement). While one may see this as a reasonably healthy correction, we believe for most stocks (ex HUL and ITC) value is yet to emerge. We expect more correction. Current prices do not fully factor in the earnings impact and, hence, valuations have become more expensive. We expect earnings downgrades through 2HFY18 as companies disappoint on their earnings due to slower and weaker recovery. This should hurt the investor confidence in resilience of consumer companies in India and create a double whammy of earnings miss as well as potential de-rating.

Correction in stock prices since 8 Nov 2016 Exhibit 24:

Company Price at 8th Nov CMP Change TP Up/ Down

from CMP Staples HUL 845 826 -2% 930 12%

Nestle 6,452 6,028 -7% 5,800 -4%

GSK Consumer 5,714 5,003 -12% 4,950 -1%

Colgate 979 905 -8% 825 -9%

Godrej Consumer 1,531 1,514 -1% 1,025 -32%

Dabur 298 278 -7% 240 -14%

Marico 260 260 0% 240 -8%

Britannia 3,236 2,886 -11% 2,600 -10%

ITC 256 242 -5% 275 14%

Paints Asian Paints 1,057 891 -16% 800 -10%

Berger Paints 246 211 -14% 180 -15%


Consumer


A well-implemented GST will make us change our stance The FMCG ecosystem will be disrupted in the near term as several participants, who have hitherto conducted business in an unorganised manner, are forced to migrate to the GST era. However, over the longer term, we see benefits to consumer companies from: a) reduction in logistics costs and working capital due to setting up of cost-efficient supply chains, b) lowering of indirect tax on FMCG goods under GST could bring down prices and drive volume growth, and 3) higher cost of doing business could make local unorganised players unviable, leading to share gains for branded players. However, given lack of visibility on GST in terms of implementation timelines, rate slabs and readiness of various companies, we are not building in any positive from GST.

GST will reduce logistics cost and working capital requirement Distribution consolidation could reduce distribution costs

The current distribution networks of consumer companies have been built to be tax-efficient. However, under GST, as free movement of goods across states would be possible, networks would be built to be cost-efficient. As shown in the exhibit below, consumer companies currently spend ~5% of their sales on logistics. Consolidation of warehouses and use of larger commercial vehicles to transport goods under GST could help bring down distribution costs for consumer companies.

According to our interaction with a logistics expert, GST would be less beneficial for low value (`150-200/kg goods) and extremely high value goods (e.g. mobile phones) but beneficial for mid-priced goods. The low value goods will continue to need production facilities near the end-market to keep costs low while logistics costs will be immaterial for high value goods. By evaluating the product portfolio of individual companies in our coverage, we believe ITC and Colgate will see the maximum savings in distribution costs under GST. Dabur, Marico, Nestle and GSK Consumer could see moderate benefits.

Colgate and ITC could see maximum benefit from consolidation of distribution under GST Exhibit 25:

Company

Freight and Forwarding cost Benefit from GST Comments

FY15 FY16

Berger Paints 6.2% 6.4% Low Savings from distribution consolidation would be less as paint is a low value density product due to voluminous nature Asian Paints 5.0% 5.2% Low

Britannia 5.4% 5.0% Low Low consolidation led gains as biscuits is a low value density product

Nestle 4.9% 4.8% Moderate Less benefit in packaged foods and dairy products which has low value density but possible in baby foods and chocolates

GSK Consumer 5.0% 4.7% Moderate Despite high value density, savings will be moderate as HLX and Boost have very concentrated demand

HUL 4.6% 4.6% Low Less benefit in soaps, detergents and packaged foods (70% of sales) due to low value density

Marico 3.8% 4.1% Moderate High benefit in hair oil but low benefit in edible oils

Colgate 3.5% 3.3% High High benefit for Colgate as toothpaste is a high value density product

GCPL 3.1% 2.9% Low Less benefit as soaps is low value density; India sales contribute only 50% of total sales

ITC 2.4% 2.3% High High benefit as cigarettes is a high value density product

Dabur 2.0% 2.1% Moderate Moderate benefit as logistics are already lowest; most of the portfolio has moderate value density

Median 4.6% 4.6% Source: Company, Ambit Capital research

Consumer


Decline in finished goods inventory would cut WC requirements

Warehouse consolidation is expected to bring down finished goods inventory for consumer companies. We believe this will help bring down finished goods inventory and not raw material inventory. The latter is held by companies depending on seasonal availability and as a strategic advantage. As shown in the exhibit below, most companies hold 12-20 days of finished goods inventory. Companies benefiting from GST-led reduction in finished goods inventory will be similar to those which can benefit from reduced distribution costs mentioned above.

Most consumer companies hold 12-20 days of finished goods inventory Exhibit 26:Company Finished goods inventory days (FY16)

HUL 13

Dabur 12

GCPL 21

Colgate 13

Marico 22

Nestle 18

GSK CH 21

Britannia 8

ITC 19

Asian Paints 19

Berger Paints 31


Lack of ecosystem readiness could result in near-term business disruption

Implementation of GST for FMCG companies entails getting the entire ecosystem of vendors, service providers and distributors ready for a GST-compliant world. These stakeholders have to get their business partners ready for GST. Considering that some of these participants have been conducting business in an unorganised manner for last several decades, business disruption is possible once GST is implemented. FMCG distributors might even resort to down-stocking ahead of GST implementation to avoid confusion over tax credits during transition from existing indirect tax system to GST.

Lowering of tax rates should support demand According to media reports, the GST slabs for FMCG products could be set at a lower level than that being already paid by FMCG companies. Under the anti-profiteering clause included in the draft GST law, companies will have to share the benefit of lower taxation with consumers. This should lead to lower prices for certain FMCG products and increase demand for organised sector products.

Consumers to benefit from lower tax burden

As shown in the exhibit below, assuming most FMCG products are taxed at the proposed revenue neutral rate of 18%, we believe Colgate, GSK Consumer and HUL could be beneficiaries. The Finance Ministry has also proposed taxing some essential FMCG products like soaps and toothpaste at 12% GST, which could benefit HUL and GCPL the most. The lower tax burden will have to be passed on to consumers through price cuts which could help drive volume growth in these categories.

Consumer


HUL, Colgate and GSK Consumer could benefit from implementation of Exhibit 27:GST

Company Effective indirect tax rate Applicable GST Rate (assumed)

Benefit / (impact) due to GST

HUL 19.7% 18.0% 1.7%

Marico 12.7% 12.0% 0.7%

Dabur 13.9% 12.0% 1.9%

GCPL 18.5% 18.0% 0.5%

Britannia 15.3% 18.0% -2.7%

Nestle 16.1% 18.0% -1.9%

GSK Consumer 21.2% 18.0% 3.2%

Colgate 22.9% 18.0% 4.9%

Gillette 13.1% 18.0% -4.9%

Asian Paints 23.5% 28.0% -4.5%

Berger Paints 22.3% 28.0% -5.7%


While GST is likely to be inflationary to the overall consumer basket initially (mainly due to services getting taxed at a higher rate), over a period of time this should reverse. As the tax net widens and tax compliance levels improve, overall tax collection for the Government should improve significantly. This should encourage the Government to rationalise tax slabs and ensure GST becomes deflationary over the longer term.

Input tax credits could aid profitability too

While price cuts might offset the advantage of lower tax rates, we believe large part of the benefit from ability to take input tax credit would still flow through to the companies. This should help improve profitability in the longer run once

Shift from unorganised to organised segment One of the key positives expected from the demonetisation and GST is shifting of economic activities from the informal to the formal sector. This bodes well for consumer companies as well as this will provide them an opportunity to gain share from local unbranded unorganised players which constitute 10-40% of sales (proportion based on category).

Rising cost of doing business likely to price out unbranded players

By unorganised businesses we refer to those which sell unbranded products or products under local brands. By avoiding taxes, having very low advertising expenses and focusing on local distribution, these businesses usually sell their products at a 40-50% discount to the branded players. Under GST, those unorganised businesses which purchase any of their raw materials from an organised/tax-paying vendor will be tracked on the GST Network (GSTN) and penalised. This could increase the cost of doing business and reduce profitability, making these businesses unviable. In this scenario, we expect one of the following scenarios to play out:

Closure of unorganised players shifts consumers to organised players: As certain unorganised players close down, supply within the category will reduce. Some of this supply will be filled in by organised players which will gain share.

Lower price gap between organised and unorganised will lead to uptrading: As price hikes close the value gap between organised and unorganised players, part of the demand (where affordability allows moving to branded players) will shift towards organised players.

Demand shrinkage: The remaining demand which is now unable to afford hiked prices of unorganised players or entry-level pricing of branded players will vanish, leading to shrinkage of the category.

Consumer


However, the shift might not be as high or rapid as expected

One factor which might prevent faster shift from unorganised to organised is the inability of organised players to service demand, which is currently fulfilled by wholesalers. As discussed earlier, with the wholesale channel likely to be disrupted, unorganised players which supply through their own localised chains would fulfill the demand left unserviced by organised players. This will allow them to exert pricing power and operate profitably, which would keep them viable till such time as organised players revive their supplies.

There are some other factors which might prevent or delay the shift in share:

Entire supply chain is in cash: Businesses where the entire supply chain from procurement of raw material to sale of finished product is in cash would continue to remain outside the GSTN and, hence, continue operating.

Operating in niche, natural/herbal segments: These businesses will also find it easier to survive as larger organised players might not be present in their categories due to small size or inability to compete effectively.

Price gap between branded and unbranded is large: In such cases, unbranded player would find it easier to exert pricing power to cover increased costs as, despite its price hikes, the value gap is likely to remain large enough to prevent consumer migration from unbranded to branded players (e.g. in the case of hair oil, where the price gap is 2-3x, vs paints at the other end of the spectrum, which has a price gap of only 20-25%).

Certain categories will benefit more than others

Based on the factors discussed above, we believe certain categories are more conducive to a share shift from unorganised to organised.

Packaged foods like biscuits, loose tea/coffee, fruit juices and hair oil, in which most unorganised businesses have entire supply chains in cash, will continue to operate unscathed even under GST.

In soaps, detergents, hair colour, toothpastes and paints, in which some of the raw materials are either imported or manufactured by an organised player, the unorganised sector could shrink gradually over the next 2-3 years.

Metrics that may spring surprises We believe neither of the two events – Demonetisation and GST – have been implemented by any economy as large and diversified as India. A combination of the two is certainly unprecedented. This disruption combined with low level of economic development, low internet penetration, technological challenges and high dependence on cash (14% of GDP) make it difficult to predict accurately the impact of these events. So, we have created a list of metrics that we will closely track and report periodically. This will help us track the impacts of these two events and how they diverge from our initial hypothesis and estimates.

What would we watch closely and how do we track it?

Given the uncertainty arising out of demonetisation and GST rollout, it is imperative that certain metrics are tracked closely to understand if our investment thesis is holding up or if it needs to be modified.

Total deposits of `500 and `1000 notes: It is estimated `15.5tn worth of `500 and `1000 notes were circulating in the economy before they were demonetised. As of 10th December (last reported data), only `12.6tn have been deposited in the banks. The difference between `15.5tn and amount deposited back by 30th December will largely be the black money which could not be placed in the banking system. Larger the gap higher will be the fiscal room available to the Government to provide stimulus (assuming benefit from reduction in RBI’s liabilities will be passed on to the Government).

Consumer


Level of re-monetisation: As of 10th December only 39% of cash has been recirculated in the economy. This is a key metric as it will determine the level of liquidity easing in the economy. Faster the rise of this number higher will be the demand recovery.

GST tax slabs: These are expected to be announced by end of the year. The impact of these tax slabs is expected to be moderate. In case companies have a net lowering of taxes, these would mostly be passed on to the consumers due to the anti-profiteering clause in the GST. Higher tax rates are also likely to be passed on to the consumers. However, a lower tax rate enabling price cuts will boost demand and would be a positive.

Volume growth: As companies report earnings, we will monitor the trajectory of volume growth and assess if it is improving faster or slower than expected.

Share of wholesale in FMCG sales: Given wholesale is the key channel which will be a bottleneck for revival of growth, we will monitor progress being made by companies in either reviving this segment or finding alternate delivery mechanisms.

Number of stores with direct reach: This will be a parameter which will guide us on how rapidly companies are following up on their strategy of enhanced focus on direct distribution post demonetisation and GST rollout.

Gross margin: Several companies will be forced to provide higher trade margin to support wholesale. Also, several companies will witness increased cost of procurement as the suppliers of their vendors move to formal channels and incur higher cost of doing business.

A&P spending: As a near-term profitability measure, most companies have scaled back ad spending given demand is constrained due to cash crunch and advertising will not help revive it. We need to track how A&P spending is revived as it will help us assess who is managing the fine balance of retaining profitability while investing enough on A&P to defend market share.

Key metrics and their timelines to watch out for Exhibit 28:

Timeline Key events Key developments

Q3FY17 Demonetisation

Demand hit for staples and discretionary companies due to demonetisation of high value currency notes Wholesalers channel completely stalled due to liquidity crunch Consumer companies cut A&P to protect margins Farmers distress sells perishable crops due to lack of liquidity in the system Initial job losses at unorganised market

Q4FY17 Budget + Remonetisation

Staples companies recovers as liquidity comes back in system Expect stimulus flow starts post budget session Job losses to further accelerate in unorganised market Negative wealth effects to further affect discretionary companies Wholesale channel partially recovers on back of remonetisation and pick up staples demand

Q1FY18 GST tax slabs

Sales normalises for consumer staples companies Discretionary companies still under stress Euphoria around government stimulus subsides Consumer staples companies resumes A&P expenditure Margin hit from channel disruption begins and increased A&P expenditure Wholesale channel recovers but with lower stock

Q2FY18 GST run up

Wholesale channel stablise to normal level Channel destocking begins before GST implementation System disruption due to GST implementation Margin hits exacerbates further due to destocking and higher margin demand in the wholesale channel

Q3FY18 GST rollout

Channel restocking begins post GST rollout but at lower levels Early inflation kicks in due to GST rollout Base effect supportive (demonetisation comes in base) Margin hits bottom post GST implementation

Q4FY18 Budget + GST stablising

New normal is established for consumer staples companies Economy recovery begins as GST stabilises Discretionary starts recovering Some benefit for Consumer company due shift from unorganised to organised market kicks in

Source: Ambit Capital Research

Consumer


What can surprise us and how will it impact our view?

We believe there are certain unknown factors which can have a significant impact on our long-term expectations for category evolution (slower premiumisation, share gain for organised), channel evolution (shift from wholesale to direct) and demand trajectory (impact of job losses to be offset by fiscal/monetary stimulus). These factors are:

Market share gains from unorganised may be lower: While our base case assumption remains that organised branded players will gain share from unorganised players, there is a possibility in certain categories that we might witness a reverse phenomenon. In several categories (biscuits, hair oil, edible oil etc.) raw materials are largely agri-commodities and, hence, the supply chain tends to be informal and cash-based. Such supply chains can remain cash-based under GST too and hence the unorganised player can continue to operate without coming under the ambit of GST.

Demand shrinkage can be more than expected: We expect demand destruction at the lower end of the consumption basket. This will be driven by lower-end unorganised players either taking sharp prices hikes or closing down as the cost of doing business rises. We expect a large part of consumers to migrate upward. However, the proportion of consumers for which affordability becomes an issue can be higher than expected, leading to shrinkage in overall category size. While there will be no immediate impact of this on our earnings estimates for listed players, the pace of penetration growth will slow, which will slow the eventual addition of new customers for listed players.

Nature of stimulus and job losses: Political and economic rationale suggests that the nature of economic stimulus will be such that transmission to the end-consumer is rapid. Fiscal stimulus can, therefore, take the form of increased MNREGA outlay or Universal Basic Income (UBI) or a one-time pay-off to Below Poverty Line families. This should also help to cushion the impact of potential job losses from closure of SME/unorganised businesses or a slowdown in certain sectors like real estate. However, demand would be adversely impacted if: 1) the Government uses fiscal room for increased investment in infrastructure building, which will delay the transmission of benefits or 2) if job losses are higher than anticipated.

Longer impact of wealth effect: We are assuming a slowdown in premumisation and higher impact to discretionary/high-ticket categories due to negative wealth effect for certain sections of consumers whose black money savings are getting impacted. However, whatever cash wealth they are able to channel through formal means (either by paying taxes or laundering) will now be freely available for use and need not be stashed away. This could lead to positive wealth effect, increased consumption and a positive multiplier effect on the economy as cash which was lying unproductively will now rotate through the formal economy.

Faster adoption of non-cash payment methods can drive higher consumption growth: Cash is a cumbersome method of payment and also limits consumption to its actual value. Non-cash payment methods would bring more convenience and also easier leverage, which can drive higher consumption. Demonetisation has accelerated the adoption of non-cash payment methods and a higher-than-expected adoption rate might create a demand push.


‘Dirt is Good’

In line with Unilever’s ad, the mess created by demonetisation and eventual GST rollout is good for HUL. Wider direct reach, leading market share/scale, and wide, staples-focused product/brand portfolio will enable a faster sales recovery. HUL will gain market share by servicing demand as others struggle due to stalling of the wholesale channel. HUL would tackle margin hit from supply chain issues better than peers, but crude inflation and INR depreciation will hurt profitability. At 39x FY18E P/E, HUL trades at an 8% premium over peers justified by superior business model. Key risks: Hit to margins and a weak sales recovery.

Competitive position: STRONG Changes to this position: POSITIVE Superior supply chain will ensure HUL outshines peers

Its staples-focused category mix should help HUL limit the hit from weak demand. HUL has a wider direct reach (3mn outlets vs <1mn for peers), lower reliance on wholesale (at the lower end of 30-50% for the industry), superior point-of-sale management, and sophisticated IT support. These will help HUL overcome supply disruption from stalling of the wholesale channel and use MIS well to ease bottlenecks better than peers and grow faster than industry. Wide product portfolio and leading brands will help gain share The wholesale trade will be capital constrained due to demonetisation-led losses even after it revives and will restock at a lower level. To make up for lower capital, wholesalers will prefer SKUs with faster churn. Hence, HUL stands to gain share as a preferred partner for wholesalers given its larger throughput, leading brands and wide portfolio catering to staples categories. Margin pressure is the key negative to track While HUL will outperform industry on topline growth, we perceive risks to margins. HUL would not be impacted much by the need to give higher margins to wholesalers and suppliers to compensate for increased cost of doing business post demonetisation + GST. However, higher sensitivity to rising crude and INR depreciation (5-27% of COGS) would hurt margins. We build in a 90bps drop in margins over FY16-18E. Low valuation premium vs peers provides comfort

HUL is trading at 39x FY18E P/E (8% premium to FMCG sector). At our DCF-based TP of `930, HUL would be trading at 43.7x FY18E P/E, a 31% premium to the sector. We believe this is justified given: 1) superior scale and market share, wider product/brand portfolios; and 2) a resilient business model that would benefit from demonetisation/GST in the long term.

COMPANY INSIGHT HUVR IN EQUITY January 03, 2017

Hindustan Unilever

BUY

Consumer Staples

Recommendation Mcap (bn): `1,788/US$26.3 6M ADV (mn): `1,143/US$16.8 CMP: `826 TP (12 mths): `930 Upside (%): 13

Flags Accounting: GREEEN Predictability: AMBER Earnings Momentum: RED

Catalysts

Revival in sales growth from FY18E

Market-share gains in key categories of HPC

Performance (%)

Source: Bloomberg, Ambit Capital Research

70 80 90

100 110 120

Dec

15

Feb

16

Apr

16

Jun

16

Aug

16

Oct

16

Dec

16

HUL Sensex

Research Analysts

Anuj Bansal

+91 22 3043 3122

[email protected]

Ritesh Vaidya, CFA

+91 22 3043 3246

[email protected]

Dhiraj Mistry, CFA

+91 22 3043 3264

[email protected]

Key financials

Year to March FY15 FY16 FY17E FY18E FY19E

Operating income (` mn) 308,056 319,872 316,481 367,497 427,793

EBITDA (` mn) 52,082 57,299 55,635 62,294 76,792

EBITDA Margin (%) 16.9% 17.9% 17.6% 17.0% 18.0%

Adjusted PAT (` mn) 37,611 40,143 40,544 45,984 58,410

Adjusted EPS (`) 17.2 18.8 18.7 21.3 27.0

RoE (%) 105.2% 109.8% 112.7% 153.3% 258.7%

P/E (x) 47.9 43.9 44.1 38.9 30.6


Hindustan Unilever


Best-in-class supply chain and wide portfolio are key advantages We believe the resilience of HUL’s business model is based on superior distribution (deeper and direct), wider product and brand portfolio (straddling the price ladder), and use of systems and process (IT backbone, centralised and systemic procurement). This will help HUL recover sales growth faster vs peers, gain market share and face lesser margin loss despite being more sensitive to crude oil price rise.

Widest and more directly serviced distribution will help HUL gain market share With relentless focus on creating a best-in-class distribution ecosystem, HUL has been able to create an ever widening advantage over peers not only in terms of depth of distribution but also quality of distribution. Given HUL is the market leader with significant share across most FMCG categories, potential loss of share to peers from a high base has been a recurrent concern. However, we believe the disruption created by the demonetisation and GST will allow HUL to gain share across most categories.

Both quantity and quality are high for HUL…

Of the 9.5mn retail outlets in India (source: AC Nielsen), HUL is present through one or more of its products in 8-8.5mn outlets. This coverage is unmatched, with Dabur being the second best with 6-6.5mn outlets. Besides the coverage, HUL is also way ahead of peers in terms of quality of distribution. ‘Quality of distribution’ is defined as the number of outlets directly serviced by either the company or through its distributors. HUL is also a leader in this regard with over 3mn outlets serviced directly. The next in line are Dabur and Colgate with 1-1.5mn outlets. This has enabled HUL to limit its reliance on the wholesale channel to 30-35% of sales, which is lower than that of peers.

Direct channel contributes ~70% of HUL sales Exhibit 1:


Key distribution data for HUL Exhibit 2:

HUL

Direct reach (mn) 3.0

Indirect reach (mn) 5.5

Total reach (mn) 8.5

Direct channel reach (%) 35%

Direct channel sales (%) 70%

Sales/store/month (`) Directly serviced 7,241

Indirectly serviced 1,693

Sales/wholesaler/year (`) 2,031,335

Overall expected margin impact (bps) 30

Indirect outlet sales as % of direct outlet 23%

EBITDA margin 18%

Impact on EBITDA margin (%) 2%


Distributors, 50%

MT/ eCommerce,

10%

Wholesalers, 30%

CSD, 10%

Hindustan Unilever


…which will drive significant market-share gains in current environment

HUL’s distribution advantages are magnified by the disruption in the wholesale channel given:

Lower loss of sales from wholesale: Lower dependence on wholesale implies HUL will be affected to a lesser extent by the disruption in this channel. Also, it will be easier for HUL to service more stores directly through its wide distribution network.

Better reach than peers will help HUL gain share: Peers who have limited reach will lose share to HUL as it continues to service those stores/geographies better through its wide presence of 3mn outlets. Peers would also lose out here as they are dependent on the wholesale channel to service most of these stores.

HUL will gain share amid capital constraints: We expect the wholesale channel to face capital constraints even when it starts functioning normally again. In this scenario, wholesalers would prefer to deal with brands with the highest market share. HUL, with its market leading brands and maximum contribution to a wholesaler’s turnover, has the requisite brand and bargaining power to increase its share with wholesalers once they return to the trade.

Expanding the direct reach will be easier: Given its wide product portfolio and high per-store throughput, HUL will be able to expand its direct reach more viably than peers. Also, given HUL has the benefits of scale and first-mover advantage in terms of direct reach, it can create entry barriers for peers when they try to expand their direct reach.

Formalised procurement to ease transition to GST Margins of most companies will be hit due to rising raw material costs on two fronts: 1) as supply chain comes within the scope of GST, suppliers would look to pass on increased cost of doing business; and 2) the combined impact of the rise in crude prices and INR depreciation. While HUL’s globally integrated procurement is likely to limit the impact of formalisation of suppliers, the hit from crude oil price inflation and INR depreciation could be higher due to its category mix skewed towards soaps and detergents which have crude derivatives as key ingredients.

Margin impact from formalisation of procurement will be limited

HUL should benefit from its globally as well as regionally integrated purchase process. This would limit the impact of supplier formalisation within India post demonetisation and GST rollout. Also, HUL tends to have exclusive contractors for its third-party manufacturing. These are already formally linked to the economy and are unlikely to witness a rise in the cost of doing business post-demonetisation or GST. In fact, HUL might be a net beneficiary of GST if it is able to take more input tax credits versus what it is able to do now.

Impact of crude price inflation and INR depreciation will be high

Given high contribution of home and personal care categories that have crude oil and its derivatives as key input materials, the impact of rising crude and INR depreciation will be reasonably high on HUL. Despite strong brands and the potential of gaining market share, HUL will not be able to pass on increased raw material cost given the weak demand environment. This should impact HUL’s profit margins in the near term.

Hindustan Unilever


HUL’s 5% COGS is sensitive to currency Exhibit 3:fluctuation


HUL’s 27% COGS is sensitive to crude oil price Exhibit 4:


Wider, market-leading portfolio provides muscle HUL has a higher exposure to preferable categories in the post-demonetisation and GST environment which should help it lower the impact on sales from demand suppression.

Staples vs discretionary: The bulk of the home and personal care portfolio of HUL is staples. The contribution from new age categories like conditioners, fabric softeners, deodorants, makeup and surface cleaners is limited to less than 10% of sales. The beverages segment, which mainly consists of tea and coffee, is also largely staples. Only ice cream is a predominantly discretionary and impulse-driven category for HUL.

Premiumisation potential: Overall premium brands account for 20-25% of sales for HUL. The sales contribution of premium brands to home and personal care (Surf Excel, Dove, Pears, Pond’s and Lakme) is limited (less than 25%). Within beverages, premium brands like Taj and Bru Gold contribute only 10-15% of sales. Ice creams are largely premium in nature.

Shift from unorganised to organised: The size of the unorganised segment of personal care is limited. However, the narrow price gap can help the shift from unorganised to organised. Home care categories tend to have larger unorganised markets. However, the price gap here is generally large enough for unorganised players to exert pricing power without getting close enough to branded players. Tea and coffee are likely to remain large unorganised markets as both might not witness disruptions even post GST as they are agri-based commodities. In ice creams, unorganised players can survive on end-to-end cash-based supply chains while remaining unscathed by GST.

Channel of sales: Despite lower reliance on wholesale, HUL remains over-indexed to the rural channel due to its wide reach. However, over the last few years, HUL has invested significantly in developing the modern trade channel, where it is marginally over-exposed (10-12% of sales) compared to the industry (8-10% of sales).

Imported, 5%

Indigenous, 95%

Crude linked, 27%

Non-crude linked, 73%

Hindustan Unilever


Category-wise details of HUL Exhibit 5:

Category Key brands Key Competitors Market share

% of turnover

Soaps Lifebuoy, Lux, Dove, Pears, Hamam, Liril, Breeze, Rexona

Godrej Consumer, Reckitt Benckiser, Wipro ~48% 19%

Detergents Surf Excel, Rin, Wheel, Comfort, Vim, Domex, Cif

P&G, Rohit Surfactants, Nirma ~40% 24%

Oral care Pepsodent, Close-up Colgate, Dabur ~20%

31% Skin care Fair & Lovely, Vaseline, Dove, Ponds, Lakme, Aviance

L'Oreal, Marico, Beiersdorf, Emami ~58%

Hair care Clear, Clinic Plus, Tresemme, Dove, Sunsilk

P&G, CavinCare, Dabur, L'Oreal ~44%

Tea 3 Roses, Red Label, Taj Mahal, Taaza, Lipton Tata Tea, Wagh Bakri ~29%

10% Coffee Bru Nestle ~51%

Ice Creams Kwality Walls Amul, Vadilal, Mother Dairy ~13%

17% Branded Staples Annapurna Aashirvaad NA

Culinary Products Knorr, Kissan Maggi NA


Hindustan Unilever


Earnings will be more resilient vs peers We expect HUL to show resilience in earnings growth vs peers, with a lower impact in FY17, faster recovery in FY18 and stronger growth from FY19. We are building in no EPS growth in FY17 due to the near-term headwinds of the demonetisation. EPS growth should recover to 13% YoY in FY18 and normalise at 27% YoY from FY19.

HUL’s EPS growth trends and estimates for FY11-19 Exhibit 6:


Impact on sales growth will be limited Sales grew by 3% YoY in 1HFY17. However, we build in a 1% YoY sales decline in FY17 given the impact of an 8-10% YoY decline in 3Q and flat sales YoY in 4Q due to the demonetisation. Recovery would be rapid due to the reasons discussed earlier; we expect sales CAGR of 16% over FY18-19.

Disruption to supply from wholesale channel will be lower

Sales in FY17 are being affected by near-term demand headwinds due to the liquidity constraints. For the consumer sector, we expect sales growth to be affected by supply disruptions caused by the stalling of the wholesale channel. However, we believe that given HUL has higher direct coverage than peers, it would be less affected by supply disruptions. Also, we believe HUL will be able to recover faster within the wholesale channel as well given it would be a preferred partner and can exert higher bargaining power by riding on its high throughput, wider product portfolio and market leadership.

Larger contribution from staples categories a key advantage

Contribution of staples categories is 80%+ for HUL (with ice creams and some new-age categories like hair conditioners, fabric softeners and deodorants being discretionary in nature). This makes it relatively immune to the hit on demand post-demonetisation. Smaller ticket sizes and the essential nature of most of its products would help HUL overcome any structural slowdown in demand or counter it better than peers.

Higher rural exposure and non-premium categories could pose risks

The key risk to our sales growth assumptions for HUL is the possibility of weak demand in rural India due to: 1) farmers’ distress; and 2) job losses in the informal sector. Also, HUL has a fairly large entry-level portfolio (40% of sales). Even within the mid- to high-end portfolio, a large part of sales (20%+) comes from low unit price packs. These products are largely consumed by those with low purchasing power and, hence, could be affected by job losses and weak economic activity.

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Hindustan Unilever


HUL’s sales growth trends for FY11-19 Exhibit 7:


HUL’s sales estimates split by segments Exhibit 8:


There are risks to near-peak margins While HUL should recover well from the near-term impact of demonetisation and GST on the top line, its near peak margins could take a hit. We are building in EBITDA margin of 17.6%, 17% and 18% for FY17, FY18 and FY19 respectively with a hit of 30bps/60 bps in FY17/18 and 100bps expansion in FY19. EBITDA margin contraction in FY17/18 will be led by lower gross margins (down 60bps/50bps in FY17/18) due to higher trade discounts and impact of higher raw material prices. Some cushion will be provided by lower A&P spends as HUL and others in the sector are looking to moderate A&P spend in light of the weak demand scenario.

Scale will provide bargaining power with wholesale channel

While we do build in pressure on gross margin, we believe the impact will be limited due to increased trade margin. HUL has the scale to provide it enough bargaining power so as to avoid granting higher margins to the wholesale channel when it revives. Also, the impact from increased procurement cost due to suppliers moving to GST will also be limited as HUL’s supply chain is already formalised to a large extent.

Impact of crude inflation more than negate potential A&P savings

The major part of the impact on HUL’s gross margin will come from the rise in crude prices and INR depreciation. HUL is more sensitive to these trends (~20bps impact on EBITDA margin for every 1% rise in crude prices and INR depreciation) than peers given higher exposure to soaps, detergents and other crude and crude derivative-based categories.

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Hindustan Unilever


HUL’s EBITDA and EBITDA growth trends Exhibit 9:


GM, A&P/sales and EBITDA margin trends Exhibit 10:


Summary of our key earnings estimates Key assumptions and estimates (` mn) Exhibit 11:

FY15 FY16 FY17E FY18E FY19E Comments

Profit and loss Net sales 308,056 319,872 316,481 367,497 427,793 Expect HUL’s sales to decline by 2% in FY17 due to

demonetisation and recover from FY18 onwards; we expect 10% sales CAGR over FY16-19 Growth (%) 9.9% 3.8% -1.1% 16.1% 16.4%

Gross Profit 151,821 166,742 163,012 187,452 220,346 Lack of premiumisation to drive gross margin contraction for FY17-18 Gross margin (%) 49.3% 52.1% 51.5% 51.0% 51.5%

Employee cost (% of sale) 5.1% 5.0% 5.3% 5.2% 5.1% Expect employee costs to remain stable

Advertising (% of sale) 12.6% 14.1% 12.8% 13.2% 13.1% Expect A&P spends to reduce in FY17 due to demonetisation and recover from FY18

EBITDA 52,082 57,299 55,635 62,294 76,792 Expect EBITDA margin contraction of 30bps/60bps in FY17/18 and expansion of 100bps in FY19 EBITDA Margin 16.9% 17.9% 17.6% 17.0% 18.0%

Consol PAT 37,299 40,679 40,544 45,984 58,410 Expect PAT to grow at 12.5% CAGR over FY16-19

Growth (%) 5.8% 10.5% -2.6% 13.4% 27.3%

Balance Sheet Capex 2,785 6,574 3,000 3,000 3,000 Expect no material capex requirements over FY15-20

Working Capital days (62) (64) (64) (64) (64) Expect working capital days to remain stable

Cash flows (` mn) Operating cash flows 42,162 47,001 42,509 57,258 71,111 Expect free cash flows to grow strongly given low capex

requirements and negative working capital Free cash flows 37,348 40,152 39,509 54,258 68,111


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Hindustan Unilever


Long-term benefits of demonetisation/GST We believe the advantage that HUL will derive from demonetisation and GST will be sustainable. Some of the advantages that HUL has over peers are structural and are likely to get strengthened by the demonetisation and GST. Even in the absence of demonetisation and GST-related benefits, we are structurally positive on HUL given:

Leadership role in developing categories for the future: HUL has been most active when it comes to developing categories for the future like hair conditioners, fabric softeners, fragrances etc. This would provide HUL a first-mover advantage as and when these categories become sizable in India.

Highest focus on channel development with peers playing catch-up: Irrespective of the type of channel (direct reach, modern trade, e-commerce), HUL has been most focused on widening and deepening its reach. This to some extent is possible given HUL’s scale, which provides it enough throughput to justify investment in channel development.

Route to premiumisation is strong: Through a well-crafted brand and pricing ladder, HUL has created a route for customers to constantly keep upgrading as and when their affordability and willingness to pay improve. This would be key to HUL’s sales growth and profitability improvement in the longer run as focus shifts from deeper penetration to a more premium portfolio.

Market-share gains should sustain

One of the key benefits of the demonetisation and GST would be market-share gain as HUL moves in to fill the gap created by the disruption in the wholesale channel for peers. We believe these share gains should sustain beyond FY18 as well when the market returns to a new normal.

Share gains would happen through structural drivers: We believe that there will be a permanent reduction in stock carried by the wholesale channel as destruction of capital for wholesalers during demonetisation is permanent. The gains made by HUL as a company with the highest throughput and maximum market leading brands in an environment of reduced capital and stock level would also be a long-term phenomenon.

Shift from unorganised to organised would be limited: HUL would gain share in categories like soaps, detergents and shampoos from unorganised as it has entry-level brands which would help migrate customers as unorganised players increase prices. However, the size of the unorganised segment is not large in these categories. Also, most F&B categories like tea, coffee and ketchups would probably not see significant share gain given: 1) the price gap between branded and unbranded is large; and 2) the end-to-end supply chain for unorganised players can work on cash as these are agri-based commodities.

Product portfolio gap should open up further

HUL already has a significant advantage over peers in terms of the width of its portfolio. We believe the scale and product portfolio advantage should open up further as HUL gains share and launches new products/brands/categories.

R&D is driven globally; new product launches should be easier for HUL: Having a global FMCG company as a parent gives HUL the advantage of R&D for new products being carried out globally. Though new product launches have been put on hold in India in the near term, the global launch pipeline should remain unaffected and, hence, backend work on new launches would continue.

Hindustan Unilever


HUL’s low premium to sector valuations provide comfort Valuation premium is justified given growth longevity We expect HUL to deliver 11%/16% sales/EPS CAGR over FY16-20. However, given the competitive strengths of existing brands, diverse portfolio, capability to enter new categories, process-oriented operations, and superior capital allocation (>100% RoCE in FY16), HUL has higher longevity of growth than most of its peers. This is complemented by relatively better positioning to weather the impact and potentially gain market share from demonetisation and GST. This combination of near-term resilience and business model supporting longer-term growth is unique for HUL and warrants a valuation premium. Our DCF-based TP of `930 (13% upside) implies FY18E P/E of 44x vs a sector average of 33x (premium of 28%).

Our WACC assumptions for the DCF model are summarised in the exhibit alongside. The cash flow and return profiles generated by our model are shown in the exhibits below.

HUL’s cash flow profile Exhibit 12:


HUL’s return profile Exhibit 13:


HUL’s one-year forward P/E Exhibit 14:


HUL’s one-year forward EV/EBITDA Exhibit 15:


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Item Value


Beta (2-year monthly; %) 0.50



Cost of debt (%) 12.0

Debt/Equity ratio (%) 0%

Tax rate (%) 28.0

WACC (%) 13.0

Terminal growth rate (%) 5.0


Hindustan Unilever


Risks Higher-than-expected impact of demonetisation: We expect sales to largely

recover by FY18. We also expect HUL to gain market share given lower reliance on wholesale and wider direct reach. However, weaker demand and weaker-than-expected share gains might affect our earnings estimates for HUL.

Margin impact might be higher: If HUL is not able to exert its scale to provide lower margin support to the wholesale channel or if crude inflation is higher than expected, HUL’s margins may be affected more severely than we currently expect.

Catalysts Revival in sales growth: We expect FY18 sales to recover sharply for HUL. If

HUL is able to report healthy double-digit sales growth in FY18, it could see earnings upgrades with the stock re-rating on improved earnings visibility.

Market-share gains: We will track management commentary on market share, which we expect to start improving from 4QFY17. If the market-share gains are in line or higher than our expectations, we could see earnings upgrades and stock re-rating.

Ambit vs consensus

Our FY17/18/19 estimates vs consensus Exhibit 16:

Ambit v/s Consensus Ambit Consensus Divergence from consensus Comments

FY17E

Net Sales (` mn) 316,481 334,346 -5% We build in higher impact of demonetisation than consensus

EBITDA (` mn) 55,635 62,240 -11% We factor in margin impact due to change in product mix, channel support and headwinds around raw material prices

EPS (`/share) 18.3 20.7 -12% EBITDA flows through PAT

FY18E

Net Sales (` mn) 367,497 370,953 -1% We are marginally behind consensus

EBITDA (` mn) 62,294 70,204 -11% We factor in margin impact due to change in product mix and channel support

EPS (`/share) 20.8 23.6 -12% EBITDA flows through PAT

FY19E

Net Sales (` mn) 427,793 416,333 3% We expect HUL sales to lead due to premiumisation of product portfolio

EBITDA (` mn) 76,792 79,865 -4% Build in higher advertising expense for premium portfolio

EPS (`/share) 26.4 26.4 0% In line with consensus


Explanation of our forensic accounting scores Explanation of our forensic accounting scores Exhibit 17:

Segment Score Comments

Accounting GREEN In the past, HUL has reported excellent cash conversion, efficient management of working capital, and low levels of loans & advances and contingent liabilities. Consequently, we give a high rating to its accounting quality.

Predictability AMBER Whilst HUL’s revenue growth has been stable, the company’s bottom-line has seen some volatility due to the recent input cost volatility.

Earnings momentum RED Consensus has cut earnings estimates since last reported results to factor in impact of the demonetisation.


Hindustan Unilever


Balance Sheet

Year to March (` mn) FY15 FY16 FY17E FY18E FY19E

Shareholders' equity 2,164 2,164 2,164 2,164 2,164

Reserves & surpluses 35,084 34,709 31,277 23,015 16,888

Total networth 37,248 36,873 33,440 25,179 19,052

Minority Interest - - - - -

Debt - - - - -

Deferred tax liability (1,960) (2,309) (2,309) (2,309) (2,309)

Total liabilities 35,288 34,564 31,132 22,870 16,744

Gross block 47,214 53,787 56,787 59,787 62,787

Net block 24,575 29,147 28,680 28,240 27,832

CWIP 4,790 3,860 3,860 3,860 3,860

Investments 32,779 29,666 41,666 56,666 71,666

Cash & equivalents 25,376 27,588 12,033 (1,906) (12,125)

Debtors 7,829 10,645 10,532 12,230 14,237

Inventory 26,027 25,284 25,016 29,048 33,814

Loans & advances 12,407 12,546 12,413 14,414 16,779

Other current assets 597 626 620 720 838

Total current assets 72,236 76,689 60,613 54,505 53,542

Current liabilities 63,671 65,699 65,002 75,481 87,865

Provisions 35,422 39,099 38,684 44,920 52,290

Total current liabilities 99,093 104,797 103,686 120,400 140,155

Net current assets (26,857) (28,108) (43,073) (65,895) (86,613)

Total assets 35,288 34,564 31,132 22,870 16,744


Income statement


Operating income 308,056 319,872 316,481 367,497 427,793

Growth (%) 9.9% 3.8% -1.1% 16.1% 16.4%

Operating expenditure 255,974 262,573 260,845 305,203 351,000

EBITDA 52,082 57,299 55,635 62,294 76,792

Growth (%) 16.4% 10.0% -2.9% 12.0% 23.3%

Depreciation 2,867 3,208 3,467 3,440 3,409

EBIT 49,216 54,092 52,168 58,854 73,384

Interest expenditure 168 2 - - -

Non-operating income 6,184 5,006 5,270 6,270 9,521

Adjusted PBT 55,231 59,096 57,438 65,124 82,904

Tax 18,410 18,418 17,806 20,189 25,700

Adjusted PAT/ Net profit 36,821 40,678 39,632 44,936 57,204

Growth (%) 5.8% 10.5% -2.6% 13.4% 27.3%

Extraordinaries (312) 536 - - -

Reported PAT/Net profit 37,133 40,142 39,632 44,936 57,204


Share of associates 478 1 912 1,048 1,206

Adjusted Consolidated net profit 37,611 40,143 40,544 45,984 58,410

Reported Consolidated net profit 37,611 40,143 40,544 45,984 58,410


Hindustan Unilever


Cash Flow statement


EBIT 55,399 59,098 57,438 65,124 82,904

Depreciation 2,867 3,208 3,467 3,440 3,409

Others (511) (351) - - -

Tax (18,410) (18,418) (17,806) (20,189) (25,700)

(Incr) / decr in net working capital 2,816 3,464 (590) 8,883 10,499

Cash flow from operations 42,162 47,001 42,509 57,258 71,111

Capex (4,814) (6,849) (3,000) (3,000) (3,000)

(Incr) / decr in investments (1,838) 3,114 (12,000) (15,000) (15,000)

Others - - - - -

Cash flow from investments (6,652) (3,735) (15,000) (18,000) (18,000)

Net borrowings - - - - -

Issuance of equity - - - - -

Interest paid (168) (2) - - -

Dividend paid (38,812) (41,395) (43,065) (53,197) (63,330)

Others 6,636 344 - - -

Cash flow from financing (32,344) (41,053) (43,065) (53,197) (63,330)

Net change in cash 3,166 2,213 (15,556) (13,939) (10,219)

Closing cash balance 25,376 27,588 12,033 (1,906) (12,125)

Free cash flow 37,348 40,152 39,509 54,258 68,111


Ratio Analysis


Gross margin (%) 49.3% 52.1% 51.5% 51.0% 51.5%

EBITDA margin (%) 16.9% 17.9% 17.6% 17.0% 18.0%

EBIT margin (%) 18.0% 18.5% 18.1% 17.7% 19.4%

Net profit margin (%) 12.1% 12.7% 12.8% 12.5% 13.7%

Dividend payout ratio (%) 89.9% 101.4% 108.7% 118.4% 110.7%

Net debt: equity (x) (1.4) (1.4) (1.4) (1.9) (2.8)

Working capital turnover (x) (5.9) (5.7) (5.7) (5.7) (5.7)

Gross block turnover (x) 6.5 5.9 5.6 6.1 6.8

RoCE (%) 105.5% 109.8% 112.7% 153.3% 258.7%

RoE (%) 105.2% 109.8% 112.7% 153.3% 258.7%


Valuation Parameter


EPS (`) 17.2 18.8 18.7 21.3 27.0

Diluted EPS (`) 17.2 18.8 18.7 21.3 27.0

Book value per share (`) 17.2 17.1 15.5 11.6 8.8

Dividend per share (`) 15.0 16.0 17.0 21.0 25.0

P/E (x) 47.9 43.9 44.1 38.9 30.6

P/BV (x) 48.0 48.4 53.4 70.9 93.8

EV/EBITDA (x) 33.8 30.7 31.9 28.7 23.4

Price/Sales (x) 5.8 5.6 5.6 4.9 4.2


Hindustan Unilever


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Waiting for the tide to turn

Impact of demonetisation on Nestle would be limited given low base, staple-like categories and focus on urban/middle-class/modern-trade customers. Margins should improve led by premiumisation, scale efficiency from Maggi ramp-up, and low impact of crude/INR. Given premium valuations (44x CY17E P/E; 24% premium to FMCG sector), we would monitor: 1) recovery of Maggi and 2) impact of new launch pipeline. While Maggi recovery seems on track, impact of new product pipeline is doubtful give poor track record. We remain SELLers until a structural turnaround or valuation correction emerges. Key risks: Faster recovery by Maggi, stronger margin gains and more new launches.

Competitive position: STRONG Changes to this position: POSITIVE Nestle would be least impacted by near-term disruptions

Nestle is largely immune to near-term disruptions of demonetisation/GST unlike other consumer companies. This is led by (i) largely staple nature of its categories (ex chocolates; 15% of sales); (ii) focus on urban, middle class; and (iii) low base of Maggi. Higher reliance on modern trade/pharmacies (>20% of sales) and lower rural exposure (<30% of sales) provide added comfort. Revival of Maggi and success of new product launches are crucial

Maggi has recovered strongly since its re-launch in Nov’15 (market share up 56% vs 77% pre-withdrawal). Sales should hit 80% of pre-withdrawal levels in CY16; we expect double-digit growth as Maggi continues to recover lost ground. Maggi should contribute 29% of growth for Nestle in CY17, supporting overall sales growth through the current disruption. Strongest margin trajectory in our coverage universe

One of the positives of the Maggi fiasco was that Nestle was able to abandon the `10 price point which was dragging down Maggi’s profitability. Since re-launch at `12, Maggi has become margin-accretive. Unlike peers, Nestle would expand margins (40-50bps p.a.) driven by: 1) premiumisation, 2) scale benefits due to Maggi ramp-up, and 3) benign raw material prices and strong pricing power (only 16/11% of COGS are linked to crude/FX). Valuation is pricing in more than what Nestle can deliver

Nestle is trading at 44x CY17E P/E, a 24% premium to the FMCG sector and 6% discount to last 5-year average. Nestle does deserve the premium given long and strong growth ramp for its underpenetrated categories, strong margins and premium positioning. But current multiples appear rich given limited visibility on Maggi recovery and ability of new launches to boost growth.

COMPANY INSIGHT NEST IN EQUITY January 03, 2017

Nestle

SELL

Consumer Staples

Recommendation Mcap (bn): `581/US$8.5 6M ADV (mn): `244/US$3.6 CMP: `6,029 TP (12 mths): `5,800 Downside (%): 4

Flags Accounting: GREEN Predictability: RED Earnings Momentum: RED

Catalyst

Weaker-than-expected performance of new product launches

Earnings miss in CY17 due to high competition

Performance (%)


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Nestle Sensex

Research Analysts

Anuj Bansal

+91 22 3043 3122

[email protected]

Ritesh Vaidya, CFA

+91 22 3043 3246

[email protected]

Dhiraj Mistry, CFA

+91 22 3043 3264

[email protected]

Key financials

Year to December CY14 CY15 CY16E CY17E CY18E


EBITDA (` mn) 19,832 15,029 17,716 21,751 25,589

EBITDA Margin (%) 20.2% 18.5% 18.9% 19.6% 20.0%

Adjusted PAT (` mn) 11,777 10,641 10,493 13,083 15,538

Adjusted EPS (`) 122.1 110.4 108.8 135.7 161.2

RoE (%) 45.2% 37.6% 35.9% 41.7% 45.5%

P/E (x) 49.4 54.6 55.4 44.4 37.4


Nestle


Demonetisation + GST is just noise for Nestle Nestle would be largely immune from disruptions caused by demonetisation and GST. Key reasons are: 1) predominant focus on urban markets; 2) lower contribution from wholesale as Nestle is over-indexed to modern trade; 3) categories are fairly staple (except chocolates) though they appear discretionary; and 4) low base effect (withdrawal of Maggi noodles last year) will support strong growth during the ongoing period of disruption.

Favourable base effect will support earnings growth

Nestle’s earnings growth will be supported by a favourable base for the next two quarters as sales and earnings had declined by 16% and 28% respectively in 4QCY15 and 1QCY16 due to withdrawal of Maggi noodles. Sales and earnings would grow by of 25-27% over the next two quarters. This should make Nestle the company clocking the highest growth in our coverage in the near term. The timing matches with the period of disruption. By the time the base effect wears off, the impact of demonetisation and GST is likely to subside to a certain extent, providing Nestle a healthy and consistent growth trajectory.

Nestle to report 25-27% sales and PAT growth over the next 2 quarters as Exhibit 1:the Maggi fiasco enters the base


Product portfolio is largely skewed to urban market

Nestle’s product positioning is such that it caters mainly to the young, urban, mid-to-high class consumers section. This provides Nestle an edge on two counts:

Lower impact on demand: Most of the demand suppression would be due to job losses in the informal sector and farmers’ distress at the rural consumer level.

Lower impact on the supply chain: Most wholesalers cater to smaller towns and rural markets, which are too remote for FMCG companies to service directly. Hence, stalling of the wholesale channel would have a higher impact on supply to rural stores. Given Nestle has very low exposure to the rural market, it should be largely immune from any disruption in the wholesale channel.

Over-indexation to modern trade and pharmacy should help Nestle

Given its urban focus and nature of its products, Nestle is over-indexed to modern trade in all its categories and pharmacies for baby food and confectionary compared to peers. Our channel checks suggest that modern trade has gained share during demonetisation as this channel was most geared towards cashless transactions. Also, pharmacies gained share as well given the channel was allowed to accept old notes for an extended period of time. Nestle, therefore, would have gained from its higher reliance on modern trade and pharmacies during the demonetisation drive.

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Nestle


Direct channel contributes 70% of Nestle sales Exhibit 2:


Details of distribution channels for Nestle Exhibit 3:




Direct channel reach (%) 42

Direct channel sales (%) 70


Indirectly serviced 1,531

Sales/wholesaler/year (`) 1,837,372


Indirect outlet sales as % of direct outlet 19

EBITDA margin (%) 15

Impact on EBITDA margin (%) 2


Categories appear discretionary at first look, but the difference in target audience needs to be appreciated

The key categories of Nestle, baby foods, beverages, prepared dishes and confectionary, appear discretionary at first sight as they belong to the packaged foods and beverages segment and have home-based substitutes. However, on a closer look, the categories other than confectionary would not have been impacted much due to the following reasons:

Baby foods: These would not have been impacted much as most parents use baby foods on a need basis and, therefore, keep it high on their priority list; i.e. consumers would not look to substitute it just because of the demonetisation.

Prepared dishes: Given Maggi noodles (bulk of the prepared dishes category) are on a comeback trail, the low base effect would ensure healthy growth (though lower than what it could have been if not for the ban).

Beverages: Instant coffee is the main product of Nestle in this category. Drinking tea/coffee is a fairly routine and habit forming activity for most consumers. Giving up the habit of drinking coffee appears difficult. There is a risk of downtrading given Nestle’s premium positioning. However, as Nestle’s consumers typically belong to the affluent class, their monthly spend on coffee would not be large enough to motivate them to downtrade.

Confectionary: This is the most discretionary, impulse-based category for Nestle. There may have been some impact on Nestle due to the demonetisation in this category. However, this category forms only 12% of sales and is over-indexed to modern trade and pharmacies. Hence, the overall impact on the segment’s sales would be limited.

Nestle’s product mix Exhibit 4:

Category Key brands Key competitors Market share

% of domestic turnover

Milk Products & Nutrition

Cerelac, Nanm Lactogen, A+ Milk, Milkmaid, Everyday

Danone, Amul, Britannia

Lactogen 42%; Cerelac 97%; Everyday 45% 51%

Beverages Nescafe Classic, Nescafe Sunrise, Nestea HUL Nescafe 50% 14%

Prepared Dishes & Cooking Aids

Maggi Noodles, Maggi Sauces ITC, HUL, Ching

Maggi Noodles 57%, Ketchups 24%, Pasta 57%

22%

Chocolate and Confectionery

Kit Kat, Munch, Bar One, Polo Cadbury Kit Kat + Munch +

Milkybar 64% 13%


Distributors, 50%

MT/ Chemist/

eCommerce, 20%

Wholesalers, 30%

Nestle


Margin impact will be limited for Nestle

Nestle would continue to add 40-50bps each year to its profitability, helped by the fact that the demonetisation and GST will not impact it significantly for the following reasons:

Nestle has a well-integrated supplier and manufacturing set-up in place. Even the milk that it procures is through contract farming with cattle owners in Moga, Punjab. Nestle’s margins would not be materially impacted by increased cost of doing business for suppliers as the chain already largely transacts formally and there is not much scope for under-reporting or tax evasion.

Nestle’s sensitivity to crude prices is fairly low because other than packaging (which is also to a large extent cardboard- or glass-based) there are not many crude-based raw materials being used. Sensitivity to INR is slightly higher as skimmed milk powder is imported to some extent by Nestle.

Impact on margins from providing higher support to the trade could be tangible. Wholesale channel will require support. However, the lower contribution of wholesale to sales and bargaining power accorded by market leadership in noodles and baby food would limit the impact.

11% of COGS is sensitive to currency fluctuations Exhibit 5:


16% of COGS is sensitive to crude Exhibit 6:


Imported, 11%

Indigenous, 89%

Crude linked, 16%


Nestle


Ability to drive structural growth is crucial Nestle is in a unique position in the Indian consumer space as it can drive earnings growth while overcoming the challenges posed by near-term disruptions through internal actions. However, we are still awaiting actions on the ground like new product launches, enhanced distribution and margin gains before turning positive.

Continued ramp-up of Maggi noodles remains the primary catalyst

Re-launch of Maggi noodles should get into the base by the end of Q1CY17. Maggi noodles’ full-year sales would be 80% of pre-withdrawal levels. This is a reflection of the resilience of the brand. Not only has Maggi overcome a reputational hit but has also managed to regain a large proportion of the market share it had lost (now 56% vs 77% pre-withdrawal). Nestle should regain most of its earlier share over the next few quarters.

Maggi noodles sales and market share have revived since the re-launch in Exhibit 7:November 2015

Source: Company, Ambit Capital research; sales is based to 100 for Nov’15

Maggi would be able to recover most of the lost base by growing faster than the average run-rate over CY17-18. In our view, an overall CAGR of 10% over CY14-19E should be maintained, indicating growth of 20% over CY17-19E. This accelerated growth of Maggi will account for ~45% of overall sales growth for Nestle and, hence, is crucial for its medium-term earnings growth.

Margins should be able to break free from historical peg

Noodles had traditionally been a drag on profitability as Nestle was stuck at the `10 price point. They did try to pass on the impact of inflation to customers by: 1) reducing grammage; 2) introducing larger variants at higher price points; and 3) launching brand extensions. However, the `10 pack remained the bellwether and none of the actions yielded any results.

Since its re-launch, Maggi has abandoned the `10 price point. This has helped it maintain healthy profitability even after Maggi was reintroduced. The other long-term benefit of abandoning the `10 price point is that Nestle will not be tied down to a psychologically important price point and will have more freedom to exert its pricing power. The new profitability level of Nestle is now the new normal and premiumisation-driven margin gains each year hereon should sustain.

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Nestle


Nestle is maintaining its gross margins post Exhibit 8:Maggi noodles launch


List of pricing actions taken by Nestle on Maggi Exhibit 9:noodles

Pack price

(`) Weight

(gm) Price/gm Price inflation

Pre-2010 10 90 0.11 2010 10 85 0.12 6%

2011 10 80 0.13 6%

2013 10 75 0.13 7%

2014 10 70 0.14 7%

2016 12 70 0.17 20%


Pace and success of new product launches is crucial

One of the key benefits of the Maggi issue was a change in management personnel and mindset. Nestle has historically been content with driving growth within its four key categories, with the last major launch being chocolates 26 years ago and the last major brand launch being Kit Kat 21 years ago. However, after the Maggi noodles issue, the management realised that it needs to actively diversify its product portfolio. A pipeline of 20-25 products has been created for the launch over the next few quarters. The other key change in mindset has been the shortening of launch window; a product is now brought to the shelves within 4-6 months vs 12-15 months previously.

Dairy is expected to be a key focus category for growth with packaged milk, UHT milk and yoghurt being the key products under the ‘a+’ brand. Some of the new launches announced by Nestle since 2015 are:

Nestle a+ Grekyo: This is a Greek yoghurt product in several flavours like strawberry, mango, pineapple and orange.

Pro-Gro: Protein-based drink.

Nescafe RTD: Three variants in RTD version have been launched.

Some brand extensions that have been launched include Nestle Choco Mocha (coffee), Kit Kat Duo (chocolates) and Nescafe 3-in-1 (coffee).

While we appreciate the new-found aggression, Nestle is still doing things incrementally and not radically. Also, Nestle’s track record has not been very good in terms of new launches. Some of the key failures it has faced in the past are:

Bottled water was launched in 2000-01 and then withdrawn.

Entry into malted food drinks through Milo in 1996 did not work well and the product was withdrawn after a decade.

Milk has been in and out of Nestle’s product offerings since 2000.

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Timeline of new product launches by Nestle in India – failure to scale up Exhibit 10:many of them has been an issue

Year Products launched Comments

1990 Nestle Premium chocolate Succeeded; Nestle is now #2 player

1991 Soya based products in JV with BM Khaitan Failed to ramp up

1995 Kitkat Succeeded; Nestle is now #2 player

1995 Milo Withdrew; Nestle could not gain share

1999 Nestle growing up Milk Surviving; has not scaled up well

2000 UHT milk Surviving; has not scaled up well

2001 Nestle Pure Life bottled water Withdrew; Nestle could not gain share

2008 Nesvita Pro-Heart Milk and Omega-3 Withdrew; Nestle could not gain share

2009 Nestle Masala Succeeded; impact is limited by category size

2009 Maggi Nutri-Licious Pazzta Succeeded; Nestle is now #1 player

2013 Alpino – Premium chocolate Surviving; has not scaled up well


Management implementing its stated strategy of aggressive new product launch strategy is the key

As highlighted earlier, we are encouraged by Nestle’s management’s stated intent of accelerating new product launches to drive faster growth in the Indian FMCG space. However, there are several factors which need to play out before Nestle is on a structural growth path. Some of the parameters that we will track are:

Recovery in volumes for Maggi noodles: While Maggi noodles will recover most of the lost volumes, a key variable to watch out for is the impact on margins. Given the new price point, Maggi noodles will not be margin-dilutive but we would still need to track this parameter closely.

Success rate of new launches: Nestle has a reasonably strong pipeline in terms of new product launches. However, on the ground implementation has been weak as there have not been any major launches. Also, given the patchy track record of past launches (see exhibit 10), we need to monitor the success of recent launches before we build them into our estimates.

Further investment in enhancing distribution capability: One key area where Nestle needs to enhance focus is supply chain. Modern trade and e-commerce are important channels for Nestle given its focus on the urban, young, mid-to-high class consumers. Fulfillment rates, shelf space management, and point of sale activation would become important and Nestle has room for improvement on all those fronts. Also, for dairy and dairy-based products to become a large category for Nestle, procurement of fresh milk will be critical. While Nestle does have backward linkages for this, it needs to expand its coverage beyond just the few sourcing arrangements that it now has.

Nestle


Summary of our key assumptions and estimates

Key assumptions and estimates (` mn) Exhibit 11: CY14 CY15 CY16E CY17E CY18E CY19E Comments

Profit and loss

Total Sales 101,295 84,304 97,054 114,894 132,459 151,586 We expect low impact of demonetisation on Nestle as sales being skewed toward urban areas Growth YoY (%) 8.0% -16.8% 15.1% 18.4% 15.3% 14.4%

Gross Profit 52,823 46,544 54,748 65,145 75,489 86,830 Expect modest gross margin improvement led by premiumisation and new product launch Gross margin (%) 53.9% 57.6% 58.3% 58.6% 58.9% 58.9%

Employee cost (% of sale) 8.4% 11.2% 11.2% 11.0% 11.0% 11.0% Expect employee costs to remain stable

Advertising (% of sale) 4.5% 6.5% 6.5% 6.0% 5.9% 5.8% Expect advertising spends to be high for CY16 but normalise over CY17-18E

Carriage & freight (% of sale) 4.9% 4.8% 4.7% 4.8% 4.8% 4.8% Expect carriage and freight expenses to remain stable

Other expenses (% of sale) 15.0% 15.0% 15.0% 15.0% 15.0% 15.0% Expect other expenses to remain stable

EBITDA 19,832 15,029 17,716 21,751 25,589 29,871 Expect EBITDA margin to improve due to premiumisation and new product launch EBITDA Margin 20.2% 18.5% 18.9% 19.6% 20.0% 20.4%

PAT 11,777 10,641 10,493 13,083 15,538 18,294 Expect PAT growth of CY16 to be affected due to demonetisation Growth YoY (%) 6.7% -9.6% -1.4% 24.7% 18.8% 17.7%

Balance Sheet

Capex 1,058 1,084 750 750 750 750 Expect no material capex

Capital Work in Progress 2,448 2,308 2,308 2,308 2,308 2,308

Working Capital days (60) (87) (88) (60) (60) (60) Expect working capital to improve post GST implementation

Cash flows (` mn)

Operating cash flows 16,313 17,066 17,251 12,601 22,620 26,052 Expect free cash flows to grow strongly as no material capex Free cash flows 15,364 16,522 16,501 11,851 21,870 25,302


Nestle’s revenues and revenue growth trends Exhibit 12:


Nestle’s segmental sales growth trends Exhibit 13:


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Nestle


Nestle’s EBITDA and EBITDA growth trends Exhibit 14:


Nestle’s GM and EBITDA margin trends Exhibit 15:


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Nestle


Stretched valuations with limited visibility of a turnaround Nestle will be among the least impacted companies in our coverage universe by near-term disruptions as most of its products are premium with an urban focus. Nestle deserves to trade at a premium to sector valuations due to the following factors:

Longer-term growth potential due to the low penetration of its categories and economic and lifestyle related changes working in its favour. As income levels rise spend on discretionary items like packaged foods tends to rise at a faster pace. As more women enter workforce, they prefer convenience of packaged foods and drive their demand.

Market domination in cash cow categories like baby foods and nutrition, where Government regulation against advertising prevents high competitive intensity.

Potential to launch new products by leveraging parent’s product portfolio.

Efficient working capital management vs peers.

Lack of significant capital misallocation risk unlike GSK Consumer or domestic FMCG peers.

These qualities would ensure longevity of growth for Nestle, warranting premium valuations vs peers. However, at CMP of `6,029, the stock is trading at 44x CY17E P/E. At a 24% premium to sector FY18E P/E of 44x, this multiple seems very expensive even on factoring in depressed earnings due to the Maggi fiasco. Our DCF-based TP of `5,800/share (4% downside) implies CY17E P/E of 43x, a 28% premium to the implied multiple of overall sector at 33xFY18E P/E. We expect earnings downgrades (we are 3-7% below street for CY16-17) and any weakness due to earnings disappointment might provide valuation comfort.

The cash flow and return profiles generated in our model are shown in the exhibits below.

Nestle


Nestle’s cash flow profile Exhibit 16:


Nestle’s return profile Exhibit 17:


Nestle’s one-year forward P/E Exhibit 18:


Nestle’s one-year forward EV/EBITDA Exhibit 19:


Risks Strong recovery in Maggi sales: While we expect a steady improvement, an accelerated recovery could lead to positive earnings surprise.

Higher-than-expected success of new product launches: Nestle is yet to demonstrate a new launch that can move the earnings trajectory. A faster-than-expected rollout schedule or higher-than-expected success in variants launched till date could pose upside surprises.

Higher-than-expected margin gains: We are building in a healthy 80-90bps margin gain each year for Nestle driven by recovery in Maggi noodles, premiumisation and internal efficiency programmes. If the margin trajectory is steeper than expected, there could be positive surprises to our estimates.

Catalysts Underwhelming new product launches: Expectations from the new Nestle India management are high, especially given a more aggressive new product pipeline. As of now, there is not much evidence that these expectations would be met.

Earnings miss: We are in line with the Street on sales but at a 3% discount on CY17 EPS estimates. Nestle would not be able to meet the Street’s expectations and will lag on both sales and margins growth. A series of earnings downgrades could lead to a correction in the stock price.

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Ambit vs consensus Our CY16/17/18 estimates vs consensus Exhibit 20:

Ambit Consensus Divergence from consensus Comments

CY16E

Net Sales (` mn) 93,957 93,512 0% In line with consensus

EBITDA (` mn) 17,716 19,196 -8% We factor in high cost of new product launches

EPS (`/share) 109 117 -7% EBITDA flow through PAT

CY17E

Net Sales (` mn) 111,228 111,228 0% In line with consensus

EBITDA (` mn) 21,751 22,703 -4% We factor in high cost of new product launches


CY18E

Net Sales (` mn) 128,232 122,282 5% New products launches to drive higher sales

EBITDA (` mn) 25,589 26,375 -3% Lower EBITDA margin due to high cost of new products





Accounting GREEN In the past, Nestlé reported excellent cash conversion, efficient management of working capital, and low levels of loans & advances and contingent liabilities. Consequently, we give a high rating to its accounting quality.

Predictability RED Following the ban on Maggi noodles in Jun’15, Nestle’s financials have shown high volatility.

Earnings momentum RED We have cut our FY17-18 estimates by more than 5% due to the demonetisation.


Nestle


Balance Sheet (` mn)


Shareholders' equity 964 964 964 964 964


Total networth 28,372 28,178 30,211 32,577 35,707


Debt 196 177 - - -

Deferred tax liability 2,227 1,729 1,729 1,729 1,729


Gross block 50,090 51,174 51,924 52,674 53,424

Net block 31,766 28,979 26,186 23,040 19,504

CWIP 2,448 2,308 2,308 2,308 2,308

Goodwill - - - - -

Investments 8,118 13,249 13,249 13,249 13,249

Cash & equivalents 4,458 4,996 12,859 13,993 23,454

Debtors 991 784 907 1,219 1,405

Inventory 8,441 8,208 9,494 9,447 10,891

Loans & advances 1,820 2,134 2,468 2,438 2,811

Other current assets 152 147 - - -



Provisions 16,017 18,625 21,542 16,760 19,323


Net current assets (11,537) (14,451) (9,803) (4,291) 2,375

Total assets 30,795 30,085 31,940 34,307 37,436


Income statement (` mn)



Growth (%) 8.2% -17.2% 15.7% 18.4% 15.3%


EBITDA 19,832 15,029 17,716 21,751 25,589

Growth (%) 3.9% -24.2% 17.9% 22.8% 17.6%

Depreciation 3,375 3,473 3,542 3,896 4,286

EBIT 16,457 11,556 14,174 17,855 21,303

Interest expenditure 142 33 3 - -


Adjusted PBT 17,674 13,145 15,661 19,527 23,192

Tax 5,897 2,504 5,168 6,444 7,653

Adjusted PAT/Net profit 11,777 10,641 10,493 13,083 15,538

Growth (%) 6.7% -9.6% -1.4% 24.7% 18.8%

Extraordinaries 70 (5,008) - - -



Share of associates - - - - -




Nestle


Cash Flow statement (` mn)


EBIT 17,816 13,178 15,664 19,527 23,192

Depreciation 3,375 3,473 3,542 3,896 4,286

Others (70) (531) (3) - -

Tax (5,897) (2,504) (5,168) (6,444) (7,653)

(Incr)/decr in net working capital 1,088 3,451 3,216 (4,378) 2,795


Capex (949) (545) (750) (750) (750)

(Incr)/decr in investments 393 (5,131) - - -

Others - - - - 3

Cash flow from investments (557) (5,676) (750) (750) (750)

Net borrowings (11,699) (18) (177) - -

Interest paid 142 33 3 - -

Dividend paid (7,107) (4,794) (8,460) (10,717) (12,409)

Others (128) (6,073) (3) - -


Net change in cash (3,035) 537 7,864 1,134 9,461

Closing cash balance 4,458 4,996 12,859 13,993 23,454

Free cash flow 15,364 16,522 16,501 11,851 21,870


Ratio Analysis


Gross margin (%) 53.9% 57.3% 58.3% 58.6% 58.9%

EBITDA margin (%) 20.2% 18.5% 18.9% 19.6% 20.0%

EBIT margin (%) 18.2% 16.2% 16.7% 17.6% 18.1%



Net debt: equity (x) (0.2) (0.2) (0.4) (0.4) (0.7)



RoCE (%) 34.6% 35.0% 33.8% 39.5% 43.3%

RoE (%) 45.2% 37.6% 35.9% 41.7% 45.5%


Valuation Parameter


EPS (`) 122.1 110.4 108.8 135.7 161.2

Diluted EPS (`) 122.1 110.4 108.8 135.7 161.2



P/E (x) 49.4 54.6 55.4 44.4 37.4

P/BV (x) 20.5 20.6 19.2 17.8 16.3

EV/EBITDA (x) 29.1 38.4 32.1 26.1 21.8

Price/Sales (x) 5.9 7.2 6.2 5.2 4.5



Under-utilising a quality brand

GSK Consumer will be less impacted by demonetisation than peers given: a) lower dependence on the wholesale channel; b) most of its products are sold through chemists and modern trade; and c) its products are positioned as health drinks for children. The GST rollout would not benefit GSK’s market share as the Health Food Drinks (HFD) category already lacks unorganised players. Meanwhile, the underlying issues of (i) market-share saturation in South/East and intense competition in North/West and (ii) RoCE dilution given capital misallocation risks remain an overhang. We expect GSK to deliver sales/EPS CAGR of 10%/9% over FY16-20. Our DCF-based TP of `4,950 (1% downside) implies 27x FY19E P/E. Key risks: Market share gain in North/West and margin expansion from premiumisation.

Competitive position: MODERATE Changes to this position: NONE Limited impact of demonetisation and GST

GSK derives only ~10% of revenue from the wholesale channel, which is severely impacted by the demonetisation. It is highly dependent on chemists and modern trade channel. GSK’s market leadership (~66% volume share) in HFD should help it limit sales slowdown better than competitors. With lack of unorganised players in HFD and GSK’s higher reach of direct distribution, we see no material benefit for the company from GST implementation. Headwinds from growth saturation and competition

GSK derives >80% of sales from South/East India, where it holds ~75% market share (vs ~30% in North/West) in the Malt-based Food Drinks (MFD) category. GSK faces growth moderation due to: (a) market-share saturation in MFD in South/East; (b) weak presence in premium MFD due to rising competition from peers like Abbott; and (c) inability to counter Complan’s threat in the brown powder MFD category in North/West. `27bn surplus cash could drive capital allocation misadventures

GSK has accumulated `27bn cash on its balance sheet by maintaining a low dividend payout ratio. Given unsuccessful attempts at diversifying beyond MFD, the surplus cash would either remain unutilised or be deployed for M&A, which could lead to material dilution in RoCE for the firm. Retain SELL with TP of `4,950

We appreciate GSK’s sales growth potential due to increased rural spending. But, given headwinds of category growth moderation and RoCE dilution, we expect no significant upside from current valuation of 27x FY18E P/E. We factor in sales/EPS CAGR of 10%/9% over FY16-20E with a DCF-based TP of `4,950, implying FY18E P/E of 27x and at 18% discount to sector average.

COMPANY INSIGHT SKB IN EQUITY January 03, 2017

GSK Consumer

SELL

Consumer Staples


Flags Accounting: GREEN Predictability: RED Earnings Momentum: RED

Catalysts

• Lack of market-share gains in North and West India

• Weak top-line and profit growth in 2HFY17E

Performance (%)


70 80 90

100 110 120

Dec

15

Feb

16

Apr

16

Jun

16

Aug

16

Oct

16

Dec

16

SKB Sensex

Research Analysts

Ritesh Vaidya, CFA

+91 22 3043 3246

[email protected]

Anuj Bansal

+91 22 3043 3122

[email protected]

Dhiraj Mistry, CFA

+91 22 3043 3264

[email protected]

Key financials



EBITDA (` mn) 5,589 6,328 6,460 7,473 8,443

EBITDA Margin (%) 13.5% 15.4% 15.5% 15.8% 15.9%

Adjusted PAT (` mn) 5,836 6,869 6,683 7,600 8,671

Adjusted EPS (`) 138.8 163.3 158.9 180.7 206.2

RoE (%) 29.7% 30.1% 25.6% 25.6% 25.7%

P/E (x) 36.1 30.6 31.5 27.7 24.3


GSK Consumer


Limited impact of GST + demonetisation GSK Consumer derives only ~10% of revenue from the wholesale channel, which is severely impacted by demonetisation. It uses the more evolved channel of chemists, which was allowed to accept old currency notes for a longer period during November, and modern trade, which has a higher proportion of digital transactions. GSK’s market leadership (~67% volume share) in the HFD category should help it limit sales slowdown, better than competitors. GSK’s sales/PAT would be flat YoY over the next 6 months due to the demonetisation disruption while peers would post a decline. GSK will not benefit much from GST rollout as there are hardly any unorganised players in the HFD category.

HFD is only moderately affected by the disruption We expect moderate impact of demonetisation on GSK due to following reasons:

Higher focus on direct distribution: GSK derives only 10% of sales from the wholesale channel compared to 40-50% for other FMCG companies. Moreover, the chemists channel was allowed to accept old currency notes for a longer period in November (the month in which demonetisation was announced). Also, GSK derives ~70% of sales from urban areas, which were less impacted by demonetisation.

Faster recovery due to market leadership in HFD: GSK should be less impacted by channel disruption than competitors due to its market leadership (66% volume share in HFD) with strong brands like Horlicks and Boost. Market leadership would help it negotiate better terms with channel partners (demanding higher margin post demonetisation) than peers.

Exhibit 1: GSK Consumer has a volume market share of ~66% in HFD


Children focus should limit category decline: Sales of Horlicks and Boost will be less impacted as HFD is endorsed as a children’s and women’s health supplement and is treated as priority in the household budget. Also, GSK’s in-house resources (sales representatives) reach out to Health Care Professionals (HCPs) and chemists to increase awareness, which helps in driving prescription-based sales. Recent launch of `10 SKU should also help increase the penetration of this category.

Limited benefit from GST Given lack of unorganised players in the HFD category and a higher share of sales already coming from direct distribution, we see no material benefit for GSK post GST rollout.

GSK Consumer, 66%

Heinz, 19%

Cadbury, 12%

Others, 3%

GSK Consumer


Concerns over sustainability of growth persist GSK Consumer benefits from its strong foothold in milk food drink in south and East. However, underlying issues of (i) market-share saturation in South/East and intense competition in North/West and (ii) RoCE dilution given capital misallocation risks remain an overhang. We expect GSK to deliver sales/EPS CAGR of 10%/9% over FY16-20 with DCF-based TP of `4,950 implies FY19E P/E of 27x, which is at 18% discount to sector average.

Beyond the near-term disruption, GSK continues to grapple with these underlying issues, namely:

GSK is yet to prove its capability to expand auxiliary income: Auxiliary income does offer GSK a healthy revenue stream with zero capital employed. However, given a history of unsuccessful auxiliary launches (Lucozade, Nutribars, Foodles, Aquafresh and Horlicks Chilled Doodh), it is premature to attach significant value to the parent’s (GSK) ability to introduce OTC products through GSK’s distribution network.

Limited room for penetration-led growth in MFD; increased consumption to drive growth: GSK derives ~80% of its sales from South and East India, where it has ~75% market share (vs ~30% in North and West India) in MFD. Growth could moderate due to: (a) market-share saturation in MFD in South and East India; (b) weak presence in premium MFD compounded by rising competitive intensity from peers, such as Abbott; and (c) GSK’s inability to counter Complan’s threat in the brown powder MFD category in North and West India.

Risks around capital misallocation given >`27bn surplus cash: GSK has accumulated `27bn cash on its balance sheet by maintaining a low dividend payout ratio. Given unsuccessful attempts at diversifying beyond the MFD segment, the surplus cash would either remain unutilised or be deployed for M&A. This could result in a meaningful dilution in RoCE.

We appreciate GSK’s revenue growth potential from increased rural spending due to programmes like Horlicks Swasthya Abhiyan (HSA) and Village Level Entrepreneurs (VLE). However, given the headwinds pertaining to category growth moderation and possible RoCE dilution, we do not see significant upside from the current valuation of 27x FY18E P/E. We expect GSK to deliver sales/EPS CAGR of 10%/9% over FY16-20, which is lower than the sector average of 12%/13%. Our DCF-based TP of `4,950 (1% downside) implies FY19E P/E of 27x, which is at 18% discount to the sector average.

The cash flow and return profiles generated by our model are shown in the exhibits below.

Exhibit 2: GSK’s cash flow profile


Exhibit 3: GSK’s returns profile


2

4

6

8

10

12

14

CY0

9

CY1

0

CY1

1

CY1

2

FY14

FY15

FY16

FY17E

FY18E

FY19E

FY20E

Operating Cashflow (Rs bn) Free cash flow (Rs bn)

-10%

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40%

CY0

9

CY1

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CY1

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FY14

FY15

FY16

FY17E

FY18E

FY19E

FY20E

YoY EPS Growth (%) ROE (%)

YoY Sales growth (%) EBIT Margin (%)

GSK Consumer


Exhibit 4: GSK’s one–year forward P/E band


Exhibit 5: GSK’s one-year forward EV/EBITDA band


20 25 30 35 40 45 50

Jan-

12

May

-12

Sep-

12

Jan-

13

May

-13

Sep-

13

Jan-

14

May

-14

Sep-

14

Jan-

15

May

-15

Sep-

15

Jan-

16

May

-16

Sep-

16


5

15

25

35

45

Jan-

12

May

-12

Sep-

12

Jan-

13

May

-13

Sep-

13

Jan-

14

May

-14

Sep-

14

Jan-

15

May

-15

Sep-

15

Jan-

16

May

-16

Sep-

16


+1 s.d. -1 s.d.

GSK Consumer


Summary of our key assumptions and estimates Exhibit 6: Key assumptions and estimates (` mn)

FY15 FY16 FY17E FY18E FY19E FY20E Comments

Profit and loss Net revenues 41,364 41,066 41,789 47,425 53,241 59,361 Expect GSK to deliver 10% sales CAGR over FY16-

20 Growth (%) 10.4% -0.7% 1.8% 13.5% 12.3% 11.5% Gross Profit 26,373 27,631 27,772 31,613 35,542 39,688 Minimal gross margin expansion due to very slow

premiumisation in the MFD category and rise in SMP prices Gross margin (%) 63.8% 67.3% 66.5% 66.7% 66.8% 66.9%

Employee cost (% of sale) 10.4% 12.4% 11.0% 11.0% 11.0% 11.0%

Expect costs to remain stable

Advertising (% of sale) 17.3% 16.9% 17.2% 17.2% 17.2% 17.2% Carriage & Freight (% of sale) 5.0% 4.7% 5.0% 5.0% 5.0% 5.0%

Royalty (% of sale) 3.2% 3.5% 3.4% 3.4% 3.4% 3.4% Other expenses (% of sale) 14.3% 14.3% 14.4% 14.3% 14.3% 14.3%

EBITDA 5,589 6,328 6,460 7,473 8,443 9,473 Gross margin gains flow into EBITDA

EBITDA Margin 13.5% 15.4% 15.5% 15.8% 15.9% 16.0%

Other Income 3,930 4,809 4,373 4,826 5,545 6,349 Other income growth to be led by a CAGR of 15% in auxiliary commissions Growth (%) 0.1% 22.3% -9.1% 10.3% 14.9% 14.5%

PAT 5,836 6,869 6,683 7,600 8,671 9,837 Expect PAT CAGR of 9% over FY16-20

Growth (%) 8.1% 17.7% -2.7% 13.7% 14.1% 13.5%

Balance Sheet Capex 2,047 607 1,500 1,000 1,000 1,000 No material capex planned over FY16-20

Working Capital days (73) (81) (81) (81) (81) (81) Expect working capital days to be stable

Cash flows (` mn) Operating cash flows 9,589 8,308 7,467 9,546 10,710 11,998 FCF to materially improve over FY16-20 due to no

material capex Free cash flows 7,411 7,700 5,967 8,546 9,710 10,998


GSK Consumer


Risks Strong urban and rural recovery: Stronger- and faster-than-expected urban and rural recovery over the next 12 months could lead to robust sales growth for GSK.

Margin gains from premiumisation: Premiumisation in the MFD category will boost margins, which would reduce the downside to the stock implied by our valuation.

Catalysts Lack of market-share gains in North and West India: GSK faces high competitive intensity from brown powder MFD drinks, such as Complan in North and West India. Also, it faces competition from Abbott at the premium end of the MFD category. These factors would limit market-share gains for GSK in North and West India.

Weak top-line and profit growth in 2HFY17: Flat sales growth over 2HFY17 due to demonetisation instead of an expectation of a mid-single digit sales growth would support our thesis.

Ambit vs consensus Exhibit 7: Our FY17/18/19 estimates vs our estimates (` mn)


FY17E

Net Sales (` mn) 41,789 42,814 -2% We build in impact of demonetisation

EBITDA (` mn) 6,460 8,045 -20% Difference may be due to our exclusion of auxiliary income

EPS (`/share) 158.9 168.2 -6% We expect rising SMP price will impact GSK margin

FY18E

Net Sales (` mn) 47,425 47,837 -1% We are marginally behind consensus


EPS (`/share) 180.7 188.9 -4% We build in high competition from Heinz and Cadbury will impact profitability

FY19E

Net Sales (` mn) 53,241 52,125 2% We are marginally ahead of consensus


EPS (`/share) 206.2 212.8 -3% Profitability to impact to due to high competition


Explanation of our forensic accounting scores Exhibit 8: Explanation of our forensic accounting scores


Accounting GREEN In the past, GSK has reported excellent cash conversion, efficient management of working capital, and low levels of loans & advances and contingent liabilities. Consequently, we give a high rating to its accounting quality.

Predictability RED Following volatility in input costs and weak macro environment, the predictability of GSK Consumer’s profit margins has reduced

Earnings momentum RED GSK’s estimates have been trimmed by more than 5% over the past month.


GSK Consumer






Total networth 21,130 24,456 27,788 31,578 35,901


Debt - - - - -

Deferred tax liability (1,043) (1,125) (1,125) (1,125) (1,125)


Gross block 10,593 10,995 12,495 13,495 14,495

Net block 4,917 4,860 5,737 6,049 6,307

CWIP 423 514 514 514 514

Investments - - - - -


Debtors 3,134 3,542 3,604 4,090 4,592

Inventory 4,663 4,616 4,697 5,331 5,985

Loans & advances 1,610 1,754 1,785 2,026 2,274

Other current assets 1,440 1,455 1,481 1,680 1,886



Provisions 6,027 6,843 6,963 7,902 8,871


Net current assets 14,746 17,958 20,413 23,891 27,956

Miscellaneous - - - - -

Total assets 20,087 23,332 26,664 30,453 34,777





% growth 10.4% -0.7% 1.8% 13.5% 12.3%


EBITDA 5,589 6,328 6,460 7,473 8,443

% growth -18.7% 13.2% 2.1% 15.7% 13.0%

Depreciation 621 574 622 689 742

EBIT 4,968 5,753 5,837 6,785 7,701

Interest expenditure 7 8 8 8 8


Adjusted PBT 8,891 10,554 10,203 11,602 13,238

Tax 3,055 3,685 3,520 4,003 4,567


% growth -13.5% 17.7% -2.7% 13.7% 14.1%

Extraordinaries - - - - -

Reported PAT / Net profit 5,836 6,869 6,683 7,600 8,671






GSK Consumer




EBIT 8,899 10,562 10,211 11,610 13,246

Depreciation 621 574 622 689 742

Others (148) (90) (8) (8) (8)

Tax (3,055) (3,685) (3,520) (4,003) (4,567)

(Incr) / decr in net working capital 3,273 946 161 1,258 1,298


Capex (2,178) (607) (1,500) (1,000) (1,000)

(Incr) / decr in investments - - - - -

Others - - - - -

Cash flow from investments (2,178) (607) (1,500) (1,000) (1,000)



Interest paid 7 8 8 8 8

Dividend paid (2,697) (3,543) (3,351) (3,810) (4,347)

Others (145) (8) (8) (8) (8)


Net change in cash 4,577 4,157 2,616 4,736 5,363


Free cash flow 7,411 7,700 5,967 8,546 9,710


Ratio Analysis


Gross margin (%) 63.8% 67.3% 66.5% 66.7% 66.8%

EBITDA margin (%) 13.5% 15.4% 15.5% 15.8% 15.9%

EBIT margin (%) 21.5% 25.7% 24.4% 24.5% 24.9%



Net debt: equity (x) (1.1) (1.1) (1.1) (1.1) (1.1)



RoCE (%) 31.3% 31.7% 26.8% 26.6% 26.6%

RoE (%) 29.7% 30.1% 25.6% 25.6% 25.7%


Valuation Parameter


EPS (`) 138.8 163.3 158.9 180.7 206.2

Diluted EPS (`) 138.8 163.3 158.9 180.7 206.2



P/E (x) 36.1 30.6 31.5 27.7 24.3

P/BV (x) 10.0 8.6 7.6 6.7 5.9

EV/EBITDA (x) 33.5 29.0 28.0 23.5 20.2

Price/Sales (x) 5.1 5.1 5.0 4.4 4.0



Near-term gain, long-term pain

Colgate should emerge unscathed from near-term disruption given its focus on strong distribution (wholesale forms only 30% of sales), staple nature of the category and low ticket size of the product. However, the long-term growth trajectory has limited visibility. Inability to counter Patanjali’s inroads and penetration levels nearing saturation have been pressuring earnings growth. Stabilisation of market share and successful entry into new categories are likely drivers of long-term growth. We await improved visibility or lower valuations (currently 35x FY18E; in-line with peers) before turning positive. Key risks: Sharp recovery in market shares; acceleration in new product launches.

Competitive position: STRONG Changes to this position: NEGATIVE Staple category, strong distribution to limit impact of demonetisation Demonetisation would not depress demand as oral care is a staple, low-ticket category. Colgate, given lower reliance on wholesalers and best-in-class point of sale (PoS) management, should be even less impacted by the stalling of the wholesale channel due to demonetisation. Despite being a single-category player, Colgate will be able to defend market share as the wholesale channel would prefer Colgate over peers in oral care due to its dominant share (55%). Competitive intensity is high; market share stabilisation is the key Colgate has lost 1.5% volume share since the advent of Patanjali. Its template of wider distribution, better PoS management, high A&P spend and increased doctor scoping has failed against Patanjali given the latter’s non-traditional distribution, differentiated positioning (Ayurvedic) and limited impact of dentists on purchase decisions. Margins will be stressed until market share stabilises as Colgate will need to increase A&P spend to defend its market share. Long-term growth trajectory hinges on new launches

Colgate’s sales CAGR of over 10% in the past 20 years was driven by rising penetration of toothpaste (now 92%/74% in urban/rural markets). Globally, oral care accounts for only 46% of Colgate’s sales (vs 95% in India). In India, introduction of new categories (personal wash, skin care, fabric care, surface cleaners, pet food) from the parent’s stable is the way forward for strong growth as rising penetration levels are reducing growth potential of oral care. De-rating can continue until earnings growth visibility improves Given weakness in earnings growth and market share erosion, Colgate has de-rated from 47x to 35x in the past two years. Risk of further de-rating remains high until Colgate turns around the current decline in market share or supplements growth by entering new categories. Our DCF-based TP of `825 (9% downside) implies FY18E P/E of 32x, marginally lower than average multiple for our coverage due to weaker long-term growth visibility.

COMPANY INSIGHT CLGT IN EQUITY January 03, 2017

Colgate Palmolive

SELL

Consumer Staples

Recommendation Mcap (bn): `246/US$3.6 6M ADV (mn): `299/US$4.4 CMP: `905 TP (12 mths): `825 Downside (%): 9

Flags Accounting: GREEN Predictability: AMBER Earnings Momentum: RED

Catalysts

Weakness in rural demand for the next two quarters

Price cuts and increased competitive intensity from HUL, Dabur, Oral B and Patanjali

Performance (%)


70 80 90

100 110 120

Dec

15

Feb

16

Apr

16

Jun

16

Aug

16

Oct

16

Dec

16

CLGT Sensex

Research Analysts

Anuj Bansal

+91 22 3043 3122

[email protected]

Ritesh Vaidya, CFA

+91 22 3043 3246

[email protected]

Dhiraj Mistry, CFA

+91 22 3043 3264

[email protected]

Key financials



EBITDA (` mn) 8,222 9,313 9,509 11,241 12,980

EBITDA Margin (%) 20.6% 22.4% 21.9% 21.8% 21.7%

Adjusted PAT (` mn) 5,590 6,392 5,970 7,018 8,383

Adjusted EPS (`) 20.6 22.3 21.9 25.8 30.8

RoE (%) 81.6% 67.9% 54.6% 55.9% 57.9%

P/E (x) 43.8 40.3 41.0 34.9 29.2


Colgate Palmolive


Strong enough to weather near-term turbulence… Colgate dominates the oral care category with a volume market share of 55% through its: (i) focus on distribution (1.5mn directly covered outlets); and (ii) investment in brand; Colgate’s A&P spend of 17% is higher than that of peers. This combined with the staple nature of oral care would help Colgate tackle the near-term disruptions caused by demonetisation and GST. Also, the impact on margins from crude oil price rise and INR depreciation should be low given only 11% of COGS is imported and 28% of COGS is crude linked.

Moderate impact on sales growth Sales would be largely affected in the near term by the cash crunch and stalling of the wholesale channel. While the staple nature of the category should help in a quick revival once the cash crunch eases, the revival of the wholesale channel might extend into 2HFY18 once the GST rollout is also behind. We are building in 4.2% sales growth in FY17 and a reasonably quick recovery in FY18 with a sales growth of 19.1%. We estimate sales CAGR of 13.5% over FY16-20E.

Sales trends for Colgate Exhibit 1:


Distribution strength should help overcome near-term disruptions

Colgate is a single category company with limited per-store throughput (`1,832 vs industry average ex-HUL of `3,547). However, it has an industry-leading distribution network both numerically and qualitatively. Numerically, it covers 4.6mn stores. Qualitatively, it directly services 1.5mn stores and the contribution from the wholesale channel is only 26%. The stronger distribution network should help Colgate minimise the impact of the stalling of the wholesale channel. Also, Colgate would be able to gain share and record higher growth by tapping demand that is under-served by peers that have limited direct distribution.

0%

5%

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25%

20,000

40,000

60,000

80,000

FY12 FY13 FY14 FY15 FY16 FY17E FY18E FY19E FY20E

Sales (Rs mn) Sales growth (RHS)

Colgate Palmolive


The direct channel contributes ~65% of Colgate’s Exhibit 2:sales


Key distribution data for Colgate Exhibit 3:

Colgate




Direct channel reach (%) 33

Direct channel sales (%) 65

Sales/store/month (`.) Directly serviced 1,832

Indirectly serviced 477

Sales/wholesaler/year (`.) 572,915


Indirect outlet sales as % of direct outlet 26

EBITDA margin (%) 22

Impact on EBITDA margin (%) 2


Colgate will retain its share in the wholesale basket

When the wholesale channel revives, it will face capital constraints as most wholesalers used to deal in cash and are likely to have lost part of their undisclosed wealth or capital during the demonetisation drive. In this scenario, when the channel revives, it will prefer companies with higher throughputs and brands with faster churn. Colgate lags on throughput but given the dominance it has in oral care, it is unlikely that the wholesale channel will reduce Colgate stocks once they re-enter the market.

Category dynamics are also favourable for Colgate

Oral care is now a fairly staple category with very high urban penetration (92%). Rural penetration is limited (74%) and, hence, the impact of job losses and farmers’ distress is likely to be lower. Having said that, we expect distressed consumers in rural areas to downtrade or return to traditional oral care habits. Colgate does have a complete price point ladder (Cibaca at the entry level) and strong presence through low unit packs of higher-end brands, which could help prevent downtrading by consumers.

Shift from unorganised to organised is not material

The unorganised segment in toothpastes is fairly small, hence the shift from unorganised to organised is not relevant. Within the toothbrush segment, the unorganised segment is larger. Given toothbrushes require raw materials that are crude derivatives, unorganised players are likely to get registered on the GST Network. This might increase their cost of doing business, which could hasten the shift from unorganised to organised. However, we do not consider this to be material for Colgate because: 1) toothbrushes contribute only 16% of sales; 2) the product portfolio within toothbrushes for Colgate is skewed towards the higher end, which remains unaffected by the unorganised segment; and 3) the price gap between organised and unorganised players is wide enough (2-3x at entry level price point) that the unorganised segment may survive even if it has to take steep price hikes.

Profitability might not be hurt as much as peers We expect a 50-60bps margin impact on Colgate over FY17-18E vs 100-150bps for the sector. This will be led by a 20-40bps hit to gross margin, impact of operating deleveraging as sales slowdown and increased cost of distribution. The A&P spend to sales ratio would dip (40bps in FY17) before recovering from FY18. In the longer run, the benefit of GST should lower logistics costs. However, heightened competitive intensity will maintain pressure on margins due to declining gross margins and rising A&P spend.

Distributors, 57%

MT/ Chemist/

eCommerce, 8%

Wholesalers, 35%

Colgate Palmolive


Colgate’s EBITDA growth trends Exhibit 4:


Colgate’s GM, A&P/sales and EBITDA margin Exhibit 5:


Procurement is centralised and formal – impact should be minimal

While we are building in a steady decline in gross margin trend for Colgate, it is largely due to high competitive intensity that would limit pricing power. The impact from rising cost of procurement due to GST would not be high as Colgate’s supply chain is fairly formalised and, hence, already tax complaint. Colgate’s contract manufacturers are largely exclusive and are unlikely to be affected by the GST.

Sensitivity to crude oil prices and INR depreciation is low; cut in A&P spends to be short lived

Only 11% of COGS are imported for Colgate implying 1% INR depreciation will hurt margins by only 4bps for Colgate. Linkage to crude oil is limited to packaging which accounts for 28% of COGS. A 10% move in crude oil will hurt margins by ~1% for Colgate. In the near term, given disruptions from demonetisation, Colgate has decided to cut back A&P spends for the rest of FY17. We are building in a 40bps margin saving in FY17 on this account. However, given competitive intensity from Patanjali remains high, we expect A&P spending to start rising again from FY18 onwards.

Colgate’s 11% COGS is sensitive to currency Exhibit 6:fluctuations


Colgate’s 28% COGS is sensitive to crude price Exhibit 7:trends


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17,000FY

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EBITDA (Rs mn) EBITDA growth

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Gross margin A&P as % of sales (RHS)

EBITDA margin (RHS)

Imported, 11%

Indigenous, 89%

Crude linked, 28%


Colgate Palmolive


…but long-term case is still clouded We like Colgate’s single-minded focus on oral care through aggressive branding, active new product development, well-managed distribution and scoping of dentists. The impact of these on sales growth and market-share gains have been positive and vindicate Colgate’s strategy. However, sustaining the gains from this high base with category reaching high penetration levels (92% in urban, 74% in rural) would be difficult. For a sustained double-digit growth, Colgate will have to ramp up investments (we build in higher A&P spends) and explore entry into non-oral care categories.

The Patanjali threat has not yet been fully managed

Colgate has an impressive market share within the oral care category which it has been continuously improving. However, the launch of Patanjali’s focused herbal/Ayurvedic platform has challenged Colgate’s market-share gain trends. It has lost 1.5% volume share over FY15-16. Colgate has a strong template (wider distribution, better point of sale management, high A&P spend, increased doctor scoping and referrals) to counter global oral care brands like it did with Oral B. However, taking on Patanjali has proved difficult because: 1) Patanjali is distributed through non-traditional channels; 2) product positioning is not comparable; and 3) western medicine trained dentists which are scoped by Colgate are not able to influence Ayurveda consumers targeted by Patanjali. Colgate will have to continue to invest aggressively in channel development, branding and new product launches to counter Patanjali; these will require additional R&D effort as direct pick-up of western products from the parent’s global R&D lab will not be possible.

Toothpaste volume market-share trends for Colgate in India Exhibit 8:


Moving beyond oral care will become important

Colgate resisted the temptation to aggressively expand its product portfolio in India beyond oral care for several decades. The justification for this strategy has been the ample growth opportunity accorded by low penetration and consumption levels of oral care products in India. Given the high competitive intensity and strong/long growth ramp offered by oral care, this strategy worked as Colgate achieved high growth (FY94-16 sales CAGR of 10%) and market-share gains. However, penetration is now reaching a level where sustaining such growth will become difficult.

Globally, oral care accounts for only 46% of sales for Colgate. Larger categories in which Colgate operates are personal wash, home care and pet foods. All these categories (except maybe pet foods) have a sizable market and strong growth potential in India. However, other global leaders like HUL, P&G and Reckitt Benckiser are already working hard to develop these categories. Colgate will have to move beyond oral care to maintain its growth trajectory. This will require increased investments in new launches (capacity expansion and branding) in the increasingly competitive industry.

48.8% 49.4%

52.2% 53.3%

52.7%

54.5%

56.1% 56.8% 57.2%

55.7%

45.0%

47.0%

49.0%

51.0%

53.0%

55.0%

57.0%

59.0%

FY07 FY08 FY09 FY10 FY11 FY12 FY13 FY14 FY15 FY16

Toothpaste volume market share

Colgate Palmolive


Toothpaste penetration in India is now 92% in Exhibit 9:urban areas and 74% in rural areas

Source: Industry, Ambit Capital research

Colgate derives ~46% of its global sales from Exhibit 10:oral care


Managing margins by moving around A&P spends is not a strategy

Colgate has been investing aggressively in branding. Given it is a single-category company, this strategy has led to high negative impact on margins. However, we also observe that when Colgate faces margin pressures from other sources like raw material prices, employee costs, manufacturing and distribution expenses, it tends to use reduction in A&P spends to manage overall margins; there is a negative correlation of 61% between EBITDA margin and A&P spends since FY01. We prefer companies exerting pricing power and relying on internal efficiencies rather than using A&P spends as a cushion for managing margins. Given the rising competitive intensity which Colgate is struggling to overcome, Colgate may have to keep A&P spends elevated, which would hit margins.

EBITDA margin and A&P/Sales show diverging trends =>A&P spends are Exhibit 11:used as key levers to manage EBITDA margins


Attempts at premiumisation have not succeeded

In toothpastes, premiumisation trends in India have not played out well as rising penetration has meant volume growth at the entry level price points has been high. This has prevented an increase in the share of premium brands. One key example of the tardy pace of premiumisation is that despite the launch of Colgate Total in 1993, Colgate has not been able to significantly premiumise consumers from the CDC (`42/100gm), a basic dental cream, to Colgate Total (`81/100gm). Even after two decades since launch, Colgate Total contributes less than 5% to total sales. The recent launch of functional, need-based premium offerings like sensitivity management toothpastes have shown higher acceptance. However, GSK, with its Sensodyne brand, has done much better than Colgate in developing this category.

75% 80%

90% 91% 92%

38% 46%

61%

73% 74%

30%

40%

50%

60%

70%

80%

90%

100%

2005 2008 2011 2013 2015

Urban Rural

Oral Care 46%

Personal Care 21%

Home Care 20%

Pet Foods 13%

0%

10%

20%

30%

FY01

FY02

FY03

FY04

FY05

FY06

FY07

FY08

FY09

FY10

FY11

FY12

FY13

FY14

FY15

FY16

EBITDA Margins A&P Spends

Colgate Palmolive


Summary of our key assumptions and estimates

Key assumptions and estimates Exhibit 12:(` mn) FY15 FY16 FY17E FY18E FY19E Comments

Profit and loss Total revenues 39,819 41,623 43,368 51,641 59,767 We expect moderate impact on revenue in FY17 due to

impact of demonetisation Growth (%) 11.3% 4.5% 4.2% 19.1% 15.7%

Gross Profit 25,142 26,670 27,730 32,916 37,976 Expect only marginal GM contraction due to limited premiumisation of portfolio Gross margin (%) 63.1% 64.1% 63.9% 63.7% 63.5%

Employee cost (% of sale) 6.5% 6.5% 6.9% 6.5% 6.5% Expect employee costs to remain flat

Advertising (% of sale) 17.9% 17.4% 17.0% 17.2% 17.5% Expect A&P spends to be elevated again from FY18 due to heightened competitive intensity from Dabur and Patanjali

Royalty (% of sale) 5.6% 5.3% 5.6% 5.6% 5.6% Expect royalty payment rate to remain stable Other expenses (% of sale) 12.5% 12.5% 12.5% 12.4% 12.3% Expect other expenses to reduce marginally over FY17-19

EBITDA 8,222 9,313 9,509 11,396 12,980 EBITDA margin to contract marginally due to limited premiumisation and increasing competition EBITDA Margin 20.6% 22.4% 21.9% 22.1% 21.7%

Tax rate 28.4% 29.3% 31.0% 33.0% 33.0% Tax rate is expected to increase towards 33% due to end of tax benefits at its Baddi plant

PAT 5,590 6,079 5,970 7,121 8,383 Expect PAT growth to be impacted in FY17 due to demonetisation Growth (%) 17.6% 8.7% -1.8% 19.3% 17.7%

Balance Sheet Capex 2,902 2,944 3,750 1,500 1,500 Capex intensity is expected to moderate as the AP and

Gujarat facilities are now commissioned Working Capital days (40) (32) (35) (35) (35) Do not expect material changes in working capital days

Cash flows (` mn) Operating cash flows 6,564 6,607 7,750 9,291 10,636 We expect Colgate to continue to report strong FCF driven by

stable WC and capex Free cash flows 3,560 3,856 3,784 7,791 9,136


Valuation: De-rating trends might continue Whilst Colgate has a dominant market share in toothpastes, efficient working capital management and high RoCE vs peers, we perceive the following risks:

Limited volume growth potential for the toothpaste category given ~85% penetration and slower-than-expected premiumisation leaves increasing usage/consumer as the key growth driver for the category.

The company has not diversified beyond toothpaste, which limits growth potential.

Risk of market-share loss in urban areas due to increased competitive intensity from GSK Pharma, Dabur and Patanjali and potential threat from Oral B.

Recent decline in market shares have not yet shown signs of stabilisation. This has led to a de-rating of the stock from 47x to 37x in the last two years. The de-rating could continue unless there is reversal of some of the above-mentioned structural issues.

Our DCF-based TP of `825/share (9% downside) implies FY18E P/E of 32x, which is marginally below the sector multiple (33xFY18E) implied by our target price. This discount is justified given Colgate has single category risk and lower long term growth visibility vs peers.

Our WACC assumptions for the DCF-model are summarised in the exhibit alongside. The cash flow and return profiles generated from our model are shown in the exhibits below.

WACC assumptions

Item Value






Debt/Equity ratio (%) 0

Tax rate (%) 28.0

WACC (%) 13.0



Colgate Palmolive


Colgate’s cash flow profile (` mn) Exhibit 13:


Colgate’s returns profile (%) Exhibit 14:


Colgate’s one-year forward P/E Exhibit 15:


Colgate’s one-year forward EV/EBITDA Exhibit 16:


Risks Lower competitive intensity in the segment: Any reduction in competitive

intensity in the oral care segment will ease the pressure on A&P spends and positively impact margins.

Lower-than-expected impact of demonetisation: While Colgate would remain largely immune from demonetisation, even a low impact will pose a risk to our estimates in the near term.

Acceleration in new product launches: While there is no visibility or guidance from management on shifting focus to non-oral care categories, any such move would be a positive surprise for earnings.

Catalysts Weakness in rural demand: Continued weakness in rural demand and

disruption in supply due to stalling of wholesale channel for the next 9-12 months would significantly moderate Colgate’s volume growth.

Increased competitive intensity from Oral B, Dabur, HUL and Patanjali: Colgate is yet to stabilise its market shares that it has been losing to Patanjali. This will entail continued A&P spends at an elevated level and impact margins.

2,000

4,000

6,000

8,000

10,000

12,000

14,000FY

11

FY12

FY13

FY14

FY15

FY16

FY17E

FY18E

FY19E

FY20E


0%

40%

80%

120%

160%

0%

10%

20%

30%

FY11

FY12

FY13

FY14

FY15

FY16

FY17E

FY18E

FY19E

FY20E

ROE (%), RHS EPS Growth (YoY)EBIT Margin (%) YoY growth in sales

20

30

40

50

Jan-

12

May

-12

Sep-

12

Jan-

13

May

-13

Sep-

13

Jan-

14

May

-14

Sep-

14

Jan-

15

May

-15

Sep-

15

Jan-

16

May

-16

Sep-

16


15

20

25

30

35

Jan-

12

May

-12

Sep-

12

Jan-

13

May

-13

Sep-

13

Jan-

14

May

-14

Sep-

14

Jan-

15

May

-15

Sep-

15

Jan-

16

May

-16

Sep-

16

1 year fwd EV/ EBITDA 5 yrs average EV/EBITDA+1 s.d. -1 s.d.

Colgate Palmolive


Ambit vs consensus Our FY17/18/19 estimates vs consensus Exhibit 17:


FY17E

Net Sales (` mn) 43,368 45,155 -4% We expect high impact on demonetisation in FY17 compared to consensus

EBITDA (` mn) 9,509 10,082 -6% We expect higher margin contraction

EPS (`/share) 21.9 23.3 -6% EBITDA margin contraction to flow to PAT

FY18E

Net Sales (` mn) 51,641 50,871 2% We expect faster sales recovery post demonetisation for Colgate compared to consensus

EBITDA (` mn) 11,241 11,645 -3% Margin to remain under pressure due to high competition intensity

EPS (`/share) 25.8 27.0 -4% EBITDA growth flow through PAT

FY19E

Net Sales (` mn) 59,767 57,490 4% We build in higher growth and market-share gain than consensus

EBITDA (` mn) 12,980 13,540 -4% Margin to remain under pressure due to high competition intensity

EPS (`/share) 30.8 31.4 -2% EBITDA growth flow through PAT




Accounting GREEN Colgate has reported excellent cash conversion, efficient management of working capital, and low levels of loans & advances and contingent liabilities. Consequently, we give a high rating to its accounting quality.

Predictability AMBER Colgate has shown volatility in earnings in the last 6 quarters as its margins are strongly influenced by the timing of its advertising and marketing campaigns and increased competition from Patanjali and Dabur.

Earnings momentum RED We have cut our EPS estimates by more than 5% for FY17/18 due to the impact of the demonetisation.


Colgate Palmolive


Balance Sheet




Total networth 7,703 10,195 11,687 13,442 15,537


Preference share capital - - - - -

Debt - - - - -

Deferred tax liability 26 217 217 217 217


Gross block 12,829 15,773 19,523 21,023 22,523

Net block 7,816 10,081 12,548 12,667 12,689

CWIP 1,412 784 1,000 1,000 1,000

Investments 371 301 301 301 301


Debtors 696 1,015 713 849 982

Inventory 2,522 2,927 3,049 3,631 4,202

Loans & advances 1,585 1,363 1,420 1,691 1,958




Provisions 1,272 1,106 1,153 1,373 1,589


Net current assets (1,870) (755) (1,945) (310) 1,764


Total assets 7,729 10,412 11,904 13,659 15,754


Income statement



Growth (%) 11.3% 4.5% 4.2% 19.1% 15.7%


EBITDA 8,222 9,313 9,509 11,241 12,980

Growth (%) 23.8% 13.3% 2.1% 18.2% 15.5%

Depreciation 750 1,114 1,283 1,381 1,478

EBIT 7,472 8,199 8,226 9,860 11,501

Interest expenditure - - - - -

Non-operating income 332 396 426 614 1,011

Adjusted PBT 7,804 8,595 8,652 10,474 12,512

Tax 2,214 2,516 2,682 3,456 4,129


Growth (%) 17.6% 8.7% -1.8% 17.6% 19.5%

Extraordinaries - (313) - - -







Colgate Palmolive


Cash Flow Statement


EBIT 7,804 8,595 8,652 10,474 12,512

Depreciation 750 1,114 1,283 1,381 1,478

Others 204 191 - - -

Tax (2,214) (2,516) (2,682) (3,456) (4,129)

(Incr)/decr in net working capital 20 (777) 498 789 775


Capex (3,004) (2,752) (3,966) (1,500) (1,500)

(Incr)/decr in investments - 70 - - -

Others - - - - -




Interest paid - - - - -

Dividend paid (3,819) (3,274) (4,477) (5,263) (6,287)

Others (67) (313) - - -


Net change in cash (325) 339 (693) 2,424 2,849


Free cash flow 3,560 3,856 3,784 7,687 9,136


Ratio Analysis


Gross margin (%) 63.1% 64.1% 63.9% 63.7% 63.5%

EBITDA margin (%) 20.6% 22.4% 21.9% 21.8% 21.7%

EBIT margin (%) 16.7% 18.7% 19.8% 16.8% 17.5%



Net debt: equity (x) (0.3) (0.3) (0.2) (0.3) (0.5)



RoCE (%) 82.5% 67.0% 53.5% 54.9% 57.0%

RoE (%) 81.6% 67.9% 54.6% 55.9% 57.9%


Valuation Parameter


EPS (`) 20.6 22.3 21.9 25.8 30.8

Diluted EPS (`) 20.6 22.3 21.9 25.8 30.8



P/E (x) 43.8 40.3 41.0 34.9 29.2

P/BV (x) 31.8 24.0 20.9 18.2 15.8

EV/EBITDA (x) 29.5 26.0 25.5 21.4 18.3

Price/Sales (x) 6.1 5.9 5.6 4.7 4.1


Colgate Palmolive


This page has been left intemtionally


Capital allocation is the key risk

Demonetisation/GST will hit GCPL’s soaps business (16% of sales) the hardest among its categories due to higher dependence on wholesale. Margin headwinds from formalisation of the channel/vendors would negatively impact EBITDA margin by 40bps YoY in FY18E. In the longer term, we remain concerned about capital allocation as GCPL’s vision to grow sales 10x in 10 years (FY11-21) has led to RoCE decline from 24% to 18% over FY11-16 due to several acquisitions during this period. Increasing competitive threats in soaps and hair colour add to the concerns in the domestic business. We expect 10%/9% CAGR in sales/PAT over FY16-20, lower than sector average of 12%/13%. Risk: Higher-than-expected Government stimulus.

Competitive position: MODERATE Changes to this position: NONE The soaps portfolio would be hit the hardest by demonetisation

GCPL derives ~45% of its India sales from the wholesale channel and soaps are particularly exposed to this channel. Disruption of the wholesale channel and, hence, preference for the market leader’s brands could impact GCPL. GCPL should perform better than peers in Household Insecticides, where it is the leader. We expect limited benefit for GCPL from GST. Demonetisation/GST could negatively impact GCPL’s EBITDA margin by 30-35bps YoY in FY18. Domestic headwinds and overhang from Africa and LatAm business In the domestic business, hair colour (7% of sales) faces increasing competition as MNC peers replicate GCPL’s low-cost crème format (no market share gain over FY17-20). In a highly penetrated category like soaps (16% of sales), lack of a premium offering will limit sales growth (10% sales CAGR in FY17-20E). International business faces supply chain challenges in Africa (15% of sales; 13% sales CAGR over FY17-20E), resulting in delayed business integration, and MNC competition in LatAm (7% of sales; 9% sales CAGR over FY17-20E). ‘10x10’ target presents more risks than rewards

As GCPL pursues its target sales CAGR of 26% over FY11-21, we expect substantial capital allocation for M&A in emerging markets. However, the international portfolio’s RoCE declined from 16% in FY08 to 9% in FY16. Thus, there exist the risk of a sustained drag on return ratios due to the challenges of management bandwidth, integration expertise, and incentive to consolidate the existing portfolio before pursuing more acquisitions. Valuations do NOT adequately factor in growth limitations Our DCF-based TP of `1,025 (32% downside) implies FY18E P/E of 27x (18% discount to sector average. Given concerns around GCPL’s capital allocation and international growth potential, this discount is warranted.

COMPANY INSIGHT GCPL IN EQUITY January 03, 2017

Godrej Consumer

SELL

Consumer Staples

Recommendation Mcap (bn): Rs516/US$7.6 6M ADV (mn): Rs346/US$5.1 CMP: Rs1,514 TP (12 mths): Rs1,025 Downside (%): 32

Flags Accounting: AMBER Predictability: AMBER Earnings Momentum: RED

Catalysts

Increasing competitive intensity from MNCs in hair colour and soaps

Delay in integration of the African business

Continuation of poor sales growth even in 4QFY17

Performance (%)


70

90

110

130

150D

ec 1

5

Feb

16

Apr

16

Jun

16

Aug

16

Oct

16

Dec

16

GCPL Sensex

Research Analysts

Ritesh Vaidya, CFA

+91 22 3043 3246

[email protected]

Anuj Bansal

+91 22 3043 3122

[email protected]

Dhiraj Mistry, CFA

+91 22 3043 3264

[email protected]

Key financials


Operating income (Rs mn) 82,764 89,678 93,788 104,286 117,186

EBITDA (Rs mn) 13,653 16,242 17,507 19,049 21,427

Adjusted PAT (Rs mn) 9,071 11,406 12,228 12,812 14,656

Adjusted EPS (Rs) 27.1 34.3 35.9 37.6 43.0

RoCE (%) 17.4% 17.8% 15.8% 14.7% 15.4%

P/E (x) 55.8 44.2 42.2 40.2 35.2

P/B (x) 12.0 10.1 8.5 7.3 6.3


Godrej Consumer


Skew toward wholesale will impact sales over the next 12 months GCPL derives ~45% of its India sales from the wholesale channel. The soap category is over-indexed to this channel. The discretionary nature of the hair colour portfolio implies that demand would take longer to recover than most consumer staples categories. Given market leadership in the Household Insecticide category, GCPL should fare better than peers in this category. GCPL (10% sales CAGR for soaps over FY17-20) could see possible market-share loss to market leader HUL (15% sales CAGR for soaps over FY17-20) in soaps as the wholesale channel rationalises its product range to optimally allocate limited capital. GCPL would face margin headwinds due to formalisation of the wholesale channel, increase in crude prices and INR depreciation. However, INR depreciation could help reduce translation losses for its African business. We expect consolidated sales and PAT CAGR of 9% over FY17-20 with EBITDA margin being almost flat.

Soaps will be most impacted by the demonetisation GCPL derives ~45% of its India sales through the wholesale channel, which is one of the highest levels amongst the Indian FMCG peers. The impact on various product categories is discussed below:

Soaps will be impacted the most given higher dependence on wholesale: The category (~16% of total sales) derives majority of its sales from the wholesale channel. Also, Godrej No.1, which is the biggest soap brand for GCPL, derives most of its sales from North India, which has been worst affected by the demonetisation. As GCPL is a distant #2 in the soaps category, it could also lose market share in this category if in the light of capital constraints the channel partners decide to stock more of HUL’s soaps. Withdrawal of consumer promotions could further slowdown the volume growth in this category.

Household insecticides should do better due to market leadership: Fear of dengue and chikungunya epidemics could sustain demand for the category (~23% of sales). Given market leadership in this category through Good Knight and HIT, GCPL would grow ahead of competition. Postponement of discretionary purchases may have affected the performance of GCPL’s recent out-of-home insecticide launches.

Hair colour could see postponement of demand: Given the discretionary nature of hair colour (~6% of sales), this category should post a slower recovery in demand than other staples categories. GCPL has also been facing increasing competitive intensity from L’Oreal and other brands, which have copied its crème hair colour format.

Overall, GCPL’s India sales would decline by 5% YoY over 2HFY17 due to the impact of demonetisation.

EBITDA margin to contract by ~40bps YoY in FY18 due to higher input cost and GST/demonetisation

Formalisation of the wholesale channel and vendor base could impact margins by 30-35bps: The wholesale channel would at least partially formalise operations after the demonetisation. Given GCPL’s high dependence on this channel for India sales, we expect a possible impact of 30-35bps at the consolidated gross margin level as GCPL will have to partially compensate the wholesale channel for higher compliance costs. Although GCPL procures raw material and some finished products from organised vendors, these vendors depend on the unorganised sector for raw materials. Formalisation of this channel post GST could also impact GCPL’s gross margin.

Crude oil appreciation and INR depreciation to impact GM by 20-25bps: GCPL’s gross margin expanded by ~300bps over FY14-16 due to more than 50% fall in crude prices. The recent ~10% increase in crude prices and ~3% INR depreciation would impact gross margin by ~25bps. There could be translation benefits for the overseas business due to INR depreciation.

Godrej Consumer


Limited potential to gain market share from unorganised players post GST

Amongst GCPL’s product categories, only hair colour has a sizable unorganised component. However, unorganised hair colours sell at less than half the price of GCPL’s product. Given this wide price differential, there is limited potential for market-share gains for GCPL in this category after the implementation of GST.

Given these sales and margin headwinds over the next 9-12 months, GCPL would deliver sales/PAT CAGR of 10%/9% over FY17-20.

Godrej Consumer


Focus on M&A increases capital misallocation risk The core businesses of most Indian FMCG companies do not need incremental capital to grow due to their highly cash-generative nature. However, one of the important factors of growth longevity is the company’s ability to continuously pursue new organic or inorganic growth opportunities, which require capital. These new opportunities, in turn, need to generate RoCE equivalent to at least the cost of capital to provide capital for the next opportunity and, hence, ensure growth longevity. However, an analysis of RoCE of GCPL’s international business (non-standalone; built largely inorganically) indicates that it has failed to generate over 8% RoCE in the last 5 years. Given the poor track record with acquisitions, GCPL’s ambitions of achieving 10x growth in 10 years by using inorganic growth raises risk of capital misallocation and risk to growth longevity.

Exhibit 1: International sales contributed ~46% to overall revenues in FY16


Exhibit 2: Profitability of the international business is significantly lower than that of the standalone business


As highlighted in the exhibit below, the firm’s consolidated RoCE has materially reduced due to a combination of:

Reduction in the dividend payout ratio and fresh capital-raising by the standalone business which has been used to fund acquisitions.

The international business continues to generate sub-10% RoCE due to frequent acquisitions and lower EBITDA margin than that of the standalone business.

Exhibit 3: RoCE of GCPL’s International business (non-standalone) has been sub-10% over the last five years


15%

20%

25%

30%

35%

40%

45%

50%

0

9,000

18,000

27,000

36,000

45,000

FY08

FY09

FY10

FY11

FY12

FY13

FY14

FY15

FY16

Intl. sales (Rs mn) % of total sales (RHS)

10.0%

12.0%

14.0%

16.0%

18.0%

20.0%

22.0%

24.0%

FY08

FY09

FY10

FY11

FY12

FY13

FY14

FY15

FY16

Stndl. EBITDA margin (%) Intl. EBITDA margin (%)

14% 16%

6%

21%

6% 6% 7% 7% 8% 9%

0%

5%

10%

15%

20%

25%

0%

10%

20%

30%

40%

50%

60%

70%

80%

FY07 FY08 FY09 FY10 FY11 FY12 FY13 FY14 FY15 FY16

Div. payout ratio (%) Standalone RoCE (%)

Consol RoCE (%) non-standalone RoCE (%), RHS

Godrej Consumer


Employee incentive structure has low RoCE benchmark for pursuing inorganic growth The incentive structures for the middle and senior management team are largely driven by YoY increase in the Economic Value Added (EVA), based on which a multiplier is applied to the salary structure of every employee. Each country manager and his/her subordinates are evaluated on growth in EVA for their respective countries. The key drivers of EVA are: (a) growth in operating profits; and (b) assumption of Weighted Average Cost of Capital (WACC). However, the WACC-based approach sets a low benchmark for outperformance as compared to RoCE of at least 30-40% generated by efficient consumer firms in India. Note that, in FY11, despite acquisition of businesses in a higher-risk geography like Africa, the WACC assumed for EVA calculation was lowered to 10% as shown in the exhibit below.

Exhibit 4: WACC declined in FY11 to just 10% despite the acquisition in a high-risk geography like Africa


Acquisitions are straining management bandwidth Acquisitions in emerging markets face issues like: (a) lack of well-established systems and processes in the acquired companies; and (b) macro-related issues, including a weak infrastructure, political uncertainties, and weak consumerism in some emerging markets. Hence, efficient integration and synergies generated from such acquired businesses require high quality of integration expertise and senior management involvement, which strain the management bandwidth of the existing businesses.

Due to the reasons discussed above, GCPL’s inorganic growth ambitions pose risks to growth longevity.

8%

9%

10%

11%

12%

13%

14%

50

100

150

200

250

300

FY05 FY06 FY07 FY08 FY09 FY10 FY11

EVA (Rs mn) WACC (%, RHS)

Godrej Consumer


Valuations: GCPL deserves to trade at a discount to peers GCPL would deliver sales/EPS CAGR of 10%/9% over FY17-20, which is lower than the sector average of 12%/13%. GCPL’s poor track record of capital allocation increases risks of capital misallocation as the company pursues its target of ‘10 times’ growth in ’10 years’ assisted by acquisitions. Given poor visibility on longevity of growth, GCPL should trade at a discount to the sector average. Our DCF-based TP of `1,030 (29% downside) implies FY18E P/E of 27x vs the sector average of 33 (discount of ~18%).

Our WACC assumptions for the DCF model are summarised in the exhibit alongside. The cash flow and return profiles generated from our model are shown in the exhibits below.

Exhibit 5: Cash flow profile for GCPL


Exhibit 6: Returns profile for GCPL


Exhibit 7: One–year forward P/E for GCPLx


Exhibit 8: One-year forward EV/EBITDA for GCPL


(15,000)

(10,000)

(5,000)

-

5,000

10,000

15,000

20,000

-

5,000

10,000

15,000

20,000

25,000

FY10

FY11

FY12

FY13

FY14

FY15

FY16E

FY17E

FY18E

FY19E

FY20E

CFO (Rs mn) Free Cash Flow (Rs mn) (RHS)

0%10%20%30%40%50%60%70%80%90%

15%

20%

25%

30%

35%

40%

45%

50%

FY10

FY11

FY12

FY13

FY14

FY15

FY16E

FY17E

FY18E

FY19E

FY20E

ROE (LHS) EBITDA MarginEPS Growth YoY Growth in sales

20 25 30 35 40 45 50

Jan-

12

May

-12

Sep-

12

Jan-

13

May

-13

Sep-

13

Jan-

14

May

-14

Sep-

14

Jan-

15

May

-15

Sep-

15

Jan-

16

May

-16

Sep-

16


15

20

25

30

35

Jan-

12

May

-12

Sep-

12

Jan-

13

May

-13

Sep-

13

Jan-

14

May

-14

Sep-

14

Jan-

15

May

-15

Sep-

15

Jan-

16

May

-16

Sep-

16


+1 s.d. -1 s.d.

WACC assumptions

Item Value







Tax rate (%) 28.0

WACC (%) 13.0



Godrej Consumer


Summary of our key assumptions and estimates Exhibit 9: Key assumptions and estimates

(` mn) FY15 FY16 FY17E FY18E FY19E FY20E Comments

Profit and loss Domestic revenues 43,693 47,473 44,542 50,559 57,066 64,440 Expect hair colour and home insecticides to be

the domestic growth drivers Growth (%) 8.6% 8.7% -6.2% 13.5% 12.9% 12.9%

International revenues 38,970 42,744 49,364 53,827 60,198 67,371 Indonesia to lead growth; Africa and Latin America may drag down growth in the international business Growth (%) 8.7% 9.2% 4.1% 11.2% 12.4% 12.4%

Total revenues 82,663 90,217 93,906 104,385 117,264 131,811 Expect 10% CAGR over FY16-20

Growth (%) 8.9% 8.4% 4.6% 11.2% 12.4% 12.4%

Gross Profit 44,348 51,223 53,538 59,010 66,309 74,554 We expect gross margin contraction due to headwinds around raw material Gross margin (%) 53.6% 57.1% 57.1% 56.6% 56.6% 56.6%

Employee cost (% of sale) 9.4% 10.7% 11.0% 11.0% 10.9% 10.8%

Expect costs to marginally reduce in employee and other expenses

Advertising (% of sale) 14.6% 14.9% 13.4% 13.4% 13.6% 13.5%

Freight & forwarding (% of sale) 3.1% 2.9% 2.9% 2.9% 2.9% 2.9%

Other expenses (% of sale) 10.1% 10.5% 11.1% 11.0% 10.9% 10.8%

EBITDA 13,653 16,242 17,507 19,049 21,427 24,486 Above changes to lead to marginal EBITDA margin improvements after FY19 EBITDA Margin 16.5% 18.1% 18.7% 18.3% 18.3% 18.6%

PAT 9,936 12,069 12,702 13,380 15,338 17,342 Expect 9% PAT CAGR over FY16-20

Growth (%) 22.1% 21.5% 5.2% 5.3% 14.6% 13.1%

Balance Sheet Capex 380 3,492 900 1,400 1,900 2,400 No material capex requirement in the near

future Working Capital days (9) 21 0 0 0 0 Expect working capital days to remain stable

Cash flows (` mn) Operating cash flows 8,077 4,936 19,396 15,099 17,206 19,382 With no material capex requirements, free cash

flows to grow strongly over FY16-20 Free cash flows 7,214 3,420 18,496 13,699 15,306 16,982


Godrej Consumer


Risks Higher-than-expected fiscal stimulus: While we expect the Government to

dole out `10,000-12,000 per household for the bottom 15-20% of households, a higher stimulus could lead to a sooner-than-expected recovery in demand.

Faster rollout of DBT: While we expect a pan-India rollout of DBT for food and fertilisers by 2HFY18, a faster implementation could boost rural demand.

New acquisitions at cheap multiples: With the management’s focus on M&A to drive growth in the longer term, acquisition of an attractive asset at a low valuation poses risks to our stance.

Catalysts Increasing competitive intensity: Higher competitive intensity from incumbent

MNCs with strong balance sheets in the premium categories of hair care and soaps is likely to lead to pressure on GCPL’s EBITDA margins (higher A&P spend).

Integration of the African business: GCPL had planned to realise significant integration benefits from its African business. However, delays in the Darling acquisition have already postponed the realisation of some of these integration benefits. Further delays or change in the Darling acquisition plans could affect GCPL’s valuations over the longer term.

Poor sales growth in 4QFY17: The wholesale channel will take at least 3-4 months to recover its sales to pre-demonetisation levels. Continuation of poor sales growth even in 4QFY17 would support our thesis.

Ambit vs consensus Exhibit 10: Our FY17/18/19 estimates vs consensus


FY17E

Net Sales (` mn) 93,788 99,231 -5% We expect higher impact due to demonetisation

EBITDA (` mn) 17,507 18,827 -7% Sales impact flow through EBITDA and PAT

EPS (`/share) 35.9 38.6 -7%

FY18E

Net Sales (` mn) 104,286 112,993 -8% We factor in impact due to GST implementation

EBITDA (` mn) 19,049 21,753 -12% We expect headwinds around raw material to impact EBITDA margin

EPS (`/share) 37.6 45.3 -17% EBITDA impact flow through PAT

FY19E

Net Sales (` mn) 117,186 128,765 -9% We expect slow recovery than consensus

EBITDA (` mn) 21,427 25,045 -14% Headwinds around raw material to continue

EPS (`/share) 43.0 53.2 -19% EBITDA impact flow through PAT


Explanation of our forensic accounting scores Exhibit 11: Explanation for our forensic accounting scores


Accounting AMBER

Although Godrej Consumer has reported good cash conversion, efficient management of working capital in the domestic business, and reasonable levels of loans and advances and contingent liabilities, company’s treatment of impairing goodwill through the balance sheet instead of the P&L statement makes us assign an Amber rating.

Predictability AMBER Whilst the company has seen strong performance in its domestic business, it is still investing in its African and Latin American businesses, which cause volatility in reported numbers at the EBITDA margin level.

Earnings momentum RED We have cut our EPS estimates by more than 8%/12%/13% for FY17/18/19


Godrej Consumer






Total Networth 43,107 50,977 60,353 70,177 81,415

Minority Interest 1,620 842 1,316 1,884 2,566

Debt 21,697 26,309 32,809 29,309 25,809

Other long term liabilities 305 348 348 348 348

Deferred tax liability (312) (413) (413) (413) (413)


Gross block 22,890 26,383 27,283 28,683 30,583

Net block 15,069 17,363 17,140 17,379 18,081

CWIP 2,246 437 437 437 437

Goodwill 40,441 45,741 57,741 57,741 57,741

Investments 343 344 344 344 344


Debtors 8,046 11,180 10,278 11,429 12,842

Inventory 10,717 13,070 12,848 14,286 16,053

Loans & advances 3,758 3,975 3,854 4,286 4,816

Other current assets - - - - -



Provisions 977 648 678 754 847



Total assets 66,417 78,063 94,413 101,306 109,726





% growth 8.9% 8.4% 4.6% 11.2% 12.4%


EBITDA 13,653 16,242 17,507 19,049 21,427

% growth 18.7% 19.0% 7.8% 8.8% 12.5%

Depreciation 908 1,031 1,123 1,161 1,198

EBIT 12,745 15,210 16,384 17,889 20,228

Interest expenditure 1,002 1,002 1,234 1,296 1,150

Non-operating income 915 1,031 1,134 1,248 1,372

Adjusted PBT 12,659 15,240 16,284 17,840 20,451

Tax 2,723 3,171 3,583 4,460 5,113


% growth 23.6% 20.4% 6.9% 9.6% 14.6%

Extraordinaries (172) (268) - - -


Minority Interest (693) (395) (474) (569) (682)





Godrej Consumer




EBIT 13,660 16,242 17,518 19,136 21,601

Depreciation 908 1,031 1,123 1,161 1,198

Others (1,725) (1,838) (760) (728) (468)

Tax (2,723) (3,171) (3,583) (4,460) (5,113)

(Incr) / decr in net working capital (2,044) (7,328) 5,097 (10) (13)


Capex (5,779) (6,816) (12,900) (1,400) (1,900)

(Incr) / decr in investments (0) (1) - - -

Others - - - - -


Net borrowings 4,674 4,612 6,500 (3,500) (3,500)

Interest paid (1,002) (1,002) (1,234) (1,296) (1,150)

Dividend paid (2,240) (2,356) (2,852) (2,988) (3,418)

Others (1,342) (841) 760 728 468

Cash flow from financing 91 413 3,175 (7,056) (7,600)

Net change in cash 2,388 (1,468) 9,671 6,643 7,706


Free cash flow 2,298 (1,880) 6,496 13,699 15,306


Ratio Analysis


Gross margin (%) 53.6% 57.1% 57.1% 56.6% 56.6%

EBITDA margin (%) 16.5% 18.1% 18.7% 18.3% 18.3%

EBIT margin (%) 16.5% 18.1% 18.7% 18.3% 18.4%



Net debt: equity (x) 0.3 0.3 0.2 0.1 (0.1)

Working capital turnover (x) (38.7) 17.3 1,009.0 1,009.0 1,009.0


RoCE (%) 17.4% 17.8% 15.8% 14.7% 15.4%

RoE (%) 24.6% 25.7% 22.8% 20.5% 20.2%


Valuation Parameter


EPS (`) 27.1 34.3 35.9 37.6 43.0

Diluted EPS (`) 27.1 34.3 35.9 37.6 43.0



P/E (x) 55.8 44.2 42.2 40.2 35.2

P/BV (x) 12.0 10.1 8.5 7.3 6.3

EV/EBITDA (x) 38.6 32.8 30.3 27.3 23.7

Price/Sales (x) 6.2 5.7 5.5 4.9 4.4



Rural skew will cause pain

Dabur’s rural skew (45% of sales) makes it more vulnerable to demonetisation/GST, given: 1) demand weakness due to farmer distress and job losses in the informal sector, and 2) stalling of wholesalers servicing rural stores. Margin hit will be muted (50bps over FY16-18E) due to: 1) lower support to wholesalers and 2) lower sensitivity to crude and INR (<30% of COGS). We might turn positive when inherent business strengths (diversified portfolio, natural/herbal platform, product launches) start overcoming near-term earnings weakness. Our DCF-based TP of `240 implies FY18 P/E of 31x, which is marginally below sector average due to higher near-term impact. Key risks: Resilience in demand; stable margins due to cut in A&P spend.

Competitive position: MODERATE Changes to this position: NEGATIVE Inherent business strengths being offset by near-term pain

We like Dabur’s differentiated herbal positioning, ability to retain market share despite the rise of Patanjali, new launches in premium and high-growth categories like OTC healthcare, and focus on direct distribution. These should lead to strong sales growth and margin gains in the long term. However, demonetisation impact (higher rural exposure, lower trade support, deferment of new launches which would have contributed 30% of growth) is hurting. Margins would be resilient

Dabur would do better than peers like HUL on margins given: 1) lower support to trade as Dabur does not want to spoil the margin ladder of the chain; 2) less than 30% of COGS exposed to crude inflation and INR depreciation; 3) strong backward integration for raw materials like herbs and fruit pulps, which will reduce tax-compliance-related hike in procurement cost post GST. Positive category mix offset by weak market shares

Dabur has a healthy skew towards staples (32% of sales*) and healthcare (21%), which would be resilient. Juices (11% of sales), despite being discretionary, should do well as they are over-indexed to modern trade (25% of sales). But weak market share in key categories like oral care (10% of sales), hair care (15%) and skin care (3%) can hurt as capital-constrained wholesalers would prefer stocking brands with higher market share for faster churn. Earnings downgrades could lead to a further de-rating

Dabur has de-rated from 35x 1-year forward P/E to 34x currently. Dabur would witness steep earnings cuts (we are 8-10% below consensus) due to higher near-term impact of demonetisation/GST. Also, with HUL looking to launch its own Ayurvedic range to counter Patanjali, Dabur could face rising competition, which could increase the risk profile of the stock.

COMPANY INSIGHT DABUR IN EQUITY January 03, 2017

Dabur

SELL

Consumer Staples

Recommendation Mcap (bn): Rs490/US$7.2 6M ADV (mn): Rs479/US$7.1 CMP: Rs275 TP (12 mths): Rs240 Downside (%): 14

Flags Accounting: GREEN Predictability: GREEN Earnings Momentum: RED

Catalysts

Earnings weakness over next 3-4 quarters due to demonetisation

Market share loss in key categories like honey and toothpaste

Performance (%)


*We are taking Total Sales which includes 32% of Sales coming from International business which is also immune from demonetisation impact

70 80 90

100 110 120

Dec

15

Feb

16

Apr

16

Jun

16

Aug

16

Oct

16

Dec

16

Dabur Sensex

Research Analysts

Anuj Bansal

+91 22 3043 3122

[email protected]

Ritesh Vaidya, CFA

+91 22 3043 3246

[email protected]

Dhiraj Mistry, CFA

+91 22 3043 3264

[email protected]

Key financials


Operating income (Rs mn) 78,271 84,540 83,003 94,872 110,107

EBITDA (Rs mn) 13,163 15,198 14,800 16,632 19,688

EBITDA Margin (%) 16.8% 18.0% 17.8% 17.5% 17.9%

Adjusted PAT (Rs mn) 10,657 12,527 12,190 13,873 16,483

Adjusted EPS (Rs) 6.1 7.1 6.9 7.9 9.4

RoE (%) 35.5% 33.3% 27.4% 27.4% 28.6%

P/E (x) 45.4 38.6 39.7 34.9 29.3


Dabur


Demonetisation will hurt in the near term Dabur’s higher exposure to rural market (45% of sales) makes it more vulnerable to the near-term disruption. This is due to: 1) higher weakness in demand in the rural market from farmers’ distress and job losses in the informal sector; and 2) supply issues due to stalling of wholesale channel, which mainly caters to rural stores. Dabur’s margins will be relatively immune because: 1) it is unlikely to provide materially higher margins to support wholesalers; and 2) its sensitivity to crude and INR is low (less than 30% of COGS). The business retains its inherent strengths of: 1) wide and diversified product portfolio; 2) differentiated positioning vs global peers on the herbal and natural platform; 3) healthy launch pipeline of new products; and 4) strong focus on developing a superior distribution network than that of peers.

Sales impact can be significant We are building in a 1.8% YoY decline in sales for Dabur in FY17, including ~10% decline in 2HFY17. We expect a partial recovery in FY18 with 14.3% sales growth in FY18, the bulk of which will be back-ended towards 2HFY18. The FY16-18E sales CAGR of 5.9% is lower than that of peers (sector average at 9%) as higher rural exposure and weaker market shares in key categories (oral care, shampoos, skin care) will hurt Dabur’s sales more than it will hurt peers.

Exhibit 1: Dabur’s sales split as of FY16


Higher rural exposure will hurt demand

Rural demand will be affected more than urban demand as economic distress is likely to be higher in rural India, given: 1) our channel checks suggest (click here for note dated 12 Dec 2016) farmers are being forced to sell their perishable produce at steep discounts; and 2) expectation of job losses in the informal and construction sectors. With Dabur deriving 45% of sales from rural India (only matched by HUL in terms of rural exposure), the impact on sales is likely to be higher for Dabur.

Supply chain issues

Supply constraints will also be significantly higher in rural India as wholesalers are the key link between distributors and rural retail stores. The wholesale channel is currently disrupted due to the cash crunch and expectations of higher taxes if full turnover gets reported due to the shift to cashless transactions.

Ideally, Dabur should have been less affected than peers given its wholesale dependence is lower, at 30-35% vs 35-50% for most peers. However, its direct coverage of stores is <1mn vs 3mn for HUL, which would allow HUL to service additional rural stores better than Dabur and take away market share.

Health Supplements,

12% Digestives, 4%

OTC & Ethicals, 6%

Home Care, 4%

Hair Care, 15%

Skin Care, 3%

Oral Care, 10%

International business, 32%

Foods, 11%

Others, 4%

http://reports.ambitcapital.com/reports/Ambit_Consumer_Whenelephantsfightthegrassgetstrampled_12Dec2016.pdf

Dabur


Also, other than juices (11% of sales, 25% through modern trade), other categories are under-indexed to modern trade. This will impact sales as modern trade is relatively less affected than other channels in the current environment.

Exhibit 2: Wholesalers contribute 32% of Dabur’s revenues


Exhibit 3: Dabur’s key distribution data

Dabur




Direct channel reach (%) 16%

Direct channel sales (%) 68%


Indirectly serviced 349

Sales/wholesaler/year (`) 418,245


Indirect outlet sales as % of direct outlet 9%

EBITDA margin 18%

Impact on EBITDA margin 1%


Deferment of new product launches will hurt growth

One of the key growth drivers for Dabur historically has been a robust new product pipeline, which used to contribute 30% of incremental growth each year. In the current environment, where demand forecasting is difficult and the supply chain is disrupted, launching new products has become difficult. Dabur has deferred its new product launches, which will hurt sales growth.

Category mix is favourable but weak market share is a disadvantage

A key positive for Dabur is its category skew towards staples (60%) including health and wellness, which makes demand stickier. This should aid Dabur overcome some demand suppression. However, some of this advantage would be lost due to share losses to market leaders like HUL and Colgate in oral care (10% of sales), hair care (15% of sales) and skin care (3% of sales). When the wholesale channel revives, it will be capital constrained and will prefer stocking products of market-leading brands for faster churn. With Dabur indicating reluctance in supporting trade with higher margins to compensate for higher taxation, its ability to push sales will also get affected.

Exhibit 4: Dabur’s category details

Category Key brands Key Competitors Market Position % of turnover

Health supplements

Dabur Chyawanprash, Dabur Honey, Dabur Glucose-D

Emami, Heinz, Baidyanath, Patanjali

Chyawanprash #1, Honey #1,Glucose #2 12%

Digestives Hajmola, Pudin Hara SSG Pharma, Anil Foods Herbal Digestives #1 4%

OTC & ethicals Honitus, Lal Tail J&J, Pfizer Ayurvedic OTC #1 6%

Hair Care Amla Hair Oil, Vatika Shampoo

Parachute, CavinKare, HUL

Hair Oils #2, Shampoo #4 15%

Home Care Odomos, Odonil, Odopic, Sanifresh

Reckitt Benckiser, Godrej Consumer, HUL

Air fresheners #1, Mosquito repellent cream #1, Toilet cleaners #2

4%

Oral Care Babool, Red, Meswak Colgate, HUL, Patanjali

Toothpaste #3, Toothpowder #2 10%

Skin care Gulabari, Fem, Uveda HUL, L'Oreal Bleaches #1 3%

Foods Real, Hommade Pepsi, Manpasand, Hector Beverages Juices #1 11%

International business

Hobby, Organic root stimulator

Local players, L'Oreal, P&G 32%


Distributors, 60%

MT/ eCommerce

, 8%

Wholesalers, 32%

Dabur


Margins are likely to show more resilience We are building in a cumulative 50bps margin impact for Dabur over FY16-18E, with an initial hit of 20bps in FY17E and a higher hit of 30bps in FY18E. This is better than the outlook for our sector coverage, where we expect an average margin decline of 70bps over FY16-18E. The key causes of the decline in margins would be: 1) higher below-the-line spending to push sales to the trade; and 2) hit from the rise in crude oil prices and no material impact of INR depreciation. The cut in A&P spends is a near-term phenomenon and normal spending should resume from FY18. Hence, we are not building in material savings on that count.

Exhibit 5: Dabur’s EBITDA trends over FY12-20E


Exhibit 6: GM, EBITDA margin and A&P/sales trends over FY12-20E


Strategy to protect trade margins could lower margin hit

Dabur is reluctant to provide higher trade margins to compensate for higher tax compliance by the channel (especially wholesalers) as the company believes this might set a bad and irreversible precedent. Given our expectations of share losses for Dabur due to lower support from wholesalers, sustenance of this stance looks difficult. Either the management will have to change this stance or provide higher volume-based incentives or below-the-line support to the trade to stem loss of market share. An area where Dabur is likely to benefit is providing higher margins to suppliers to compensate for higher taxes. Dabur has a well-integrated supply chain (including sourcing of fruit pulp, herbs etc.) which is already formalised and has a high level of tax compliance.

Impact of crude oil price inflation and INR depreciation will be low

Packaging is the predominant crude-linked cost for Dabur. This accounts for ~19% of COGS for Dabur. Its sensitivity to INR depreciation is very low as imports account for only 1% of COGS. We expect pricing power will be weak in the current demand scenario and, hence, margins will be hit by the rise in crude prices.

-5%

0%

5%

10%

15%

20%

5,000

10,000

15,000

20,000

25,000

FY12

FY13

FY14

FY15

FY16

FY17E

FY18E

FY19E

FY20E

EBITDA (Rs mn) EBITDA growth (RHS)

12%

14%

16%

18%

20%

48%

50%

52%

54%

56%

FY12

FY13

FY14

FY15

FY16

FY17E

FY18E

FY19E

FY20E

Gross margin EBITDA margin (RHS)

A&P as % of sales (RHS)

Dabur


Exhibit 7: Only 1% of COGS is sensitive to INR fluctuation


Exhibit 8: Crude oil accounts for 29% of Dabur’s COGS


Return to business as usual will be the trigger for turning positive Dabur has inherent strengths which will remain intact during the near-term impact of demonetisation and GST. These are: 1) a wide product portfolio spread across several high-growth categories like skin care, shampoos, cooking aids, health supplements and fruit juices; 2) focus on herbal and natural products which help the company differentiate from global peers; 3) superior supply chain, which is well-integrated for sourcing raw materials and has higher direct reach than local peers; and 4) a healthy new product pipeline, including OTC healthcare products. We would look to turn positive on Dabur as and when the following triggers transpire:

Sales growth should recover from both demand and supply shock: We expect the demand and wholesale disruption to be largely over by 2HFY18. Hence, we will look out for any signs of sales growth recovery then.

New product launches need to resume: Dabur has an exciting new product pipeline of OTC healthcare, skin care and health supplements. Rollout of this pipeline is critical for Dabur to maintain double-digit growth in the medium term.

Margins should bottom: We would closely monitor Dabur’s investment in trade and also pricing action to mitigate the impact of crude price increase. Dabur’s new product launches are premium and hence Dabur should have a natural bias towards margin improvement as the portfolio premiumises. We will await the margin trajectory to resume.

Valuation should reflect the near-term earnings pain: In the absence of any of the above fundamental turnarounds playing out, we would wait for valuation to correct from current levels. There will be risk to earnings estimates if the recovery does not kick in by 2HFY18 and a series of earnings downgrades could be accompanied by a de-rating as well.

Imported, 1%

Indigenous, 99%

Crude linked, 29%


Dabur




Profit and loss Total revenues 78,064 84,360 82,804 94,653 109,866 127,645 Expect revenue growth to be impacted in FY17 due to

impact of demonetisation Growth (%) 10.4% 8.1% -1.8% 14.3% 16.1% 16.2%

Gross Profit 41,070 46,570 45,413 51,717 60,352 70,111 Expect no change in gross margins due to slow growth of premiumisation of portfolio Gross margin (%) 52.5% 55.1% 54.7% 54.5% 54.8% 54.8%

Employee cost (% of sale) 8.8% 9.4% 10.0% 9.4% 9.4% 9.4% Expect operational efficiencies to lead to minor benefits in employee costs

Advertising (% of sale) 14.4% 14.7% 13.5% 14.5% 14.5% 14.5% Increasing competitive intensity to lead to higher advertisement spends

Freight & forwarding (% of sale) 2.0% 2.1% 2.1% 2.1% 2.1% 2.1% Expect freight expenses to remain stable


EBITDA 13,163 15,198 14,800 16,632 19,688 23,127 Above changes to lead to margin contraction. EBITDA contraction in FY17 and FY18 EBITDA Margin 16.8% 18.0% 17.8% 17.5% 17.9% 18.1%

Tax rate 19.0% 19.4% 21.0% 22.0% 23.0% 23.0% Tax rates to increase marginally

Net Profit margin 13.6% 14.8% 14.7% 14.6% 15.0% 15.3% Expect PAT growth to be lower than sales growth in FY18-20 due to increasing competition from Patanjali and impact of demonetisation and GST

Balance Sheet

Capex 1,281 2,393 2,000 2,000 2,000 2,000 No material capex requirements for FY17-19

Capital Work in Progress 503 448 448 448 448 448

Working Capital days 7 13 11 11 11 11 Expect stable working capital days

Debtor days 33 35 35 35 35 35 Expect Debtors’ days to remain stable

Current Liabilities days 76 73 71 71 71 71 Expect current liabilities’ days to remain stable

Inventory days 45 47 47 47 47 47 Expect inventory days to remain stable

Net debt/(cash) to equity (0.4) (0.5) (0.5) (0.6) (0.6) (0.6)

Cash flows (` mn)

Operating cash flows 10,895 12,450 14,036 14,875 17,429 20,516 Expect free cash flows to grow strongly from FY19

Free cash flows 8,357 10,439 12,036 12,875 15,429 18,516


Dabur


Dabur deserves a slight discount to the sector average While Dabur is inherently a strong business model, we expect the impact of demonetisation and GST to be higher on Dabur than peers. This is due to: 1) higher rural exposure; 2) weaker market share, which would lead to capital constrained wholesale channel to prefer higher market-share brands of competitors; and 3) stalling of new product launches, which were a bigger driver of growth for Dabur than peers. Hence, Dabur deserves to trade at a slight discount to the sector average and expect correction in the stock price.

After taking into account the potential hit to sales and margins from demonetisation and GST, we expect sales/EPS CAGR of 11%/12% over FY16-20E. We see limited upside from CMP. We reiterate SELL with a TP of `240 (14% downside; implied FY18E P/E of 31x). This multiple is at a 7% discount to the FMCG sector’s average multiple justified by higher impact on near-term earnings vs peers.

Our WACC assumptions for the DCF-model are summarised in the exhibit alongside. The cash flow and return profiles generated by our model are shown in the exhibits below.

Exhibit 10: Dabur’s cash flow profile (` mn)


Exhibit 11: Dabur’s return profile


Exhibit 12: Dabur’s one-year forward P/E bands


Exhibit 13: Dabur’s one-year forward EV/EBITDA bands


(10,000)

(5,000)

-

5,000

10,000

15,000

20,000

-

5,000

10,000

15,000

20,000

25,000

FY11

FY12

FY13

FY14

FY15

FY16

FY17E

FY18E

FY19E

FY20E

CFO Free Cash Flow (RHS)

-10%

0%

10%

20%

30%

0%

10%

20%

30%

40%

50%

60%

FY11

FY12

FY13

FY14

FY15

FY16

FY17E

FY18E

FY19E

FY20E

ROE (LHS) EBITDA MarginEPS Growth YoY Growth in sales

20 25 30 35 40 45 50

Jan-

12

May

-12

Sep-

12

Jan-

13

May

-13

Sep-

13

Jan-

14

May

-14

Sep-

14

Jan-

15

May

-15

Sep-

15

Jan-

16

May

-16

Sep-

16


15

20

25

30

35

40

Jan-

12

May

-12

Sep-

12

Jan-

13

May

-13

Sep-

13

Jan-

14

May

-14

Sep-

14

Jan-

15

May

-15

Sep-

15

Jan-

16

May

-16

Sep-

16


+1 s.d. -1 s.d.

WACC assumptions

Item Value







Tax rate (%) 28.0

WACC (%) 13.0



Dabur


Risks Lower-than-expected impact on demand: Given the favourable category mix

(16% staples, 6% healthcare), Dabur might show resilience to the disruption and offset the impact of weak consumer sentiment and supply chain constraints (from stalling of wholesale channel). This could pose upside risks to our sales decline estimates.

Margin decline might be lower than estimated: Cut in A&P spends could prove to be large enough to be able to offset the impact on margins caused by higher support to the trade channels and crude price inflation.

Catalysts Earnings weakness over the next 3-4 quarters: Dabur should disappoint on

earnings as recovery is likely to emerge only by 2HFY18. This should lead to a series of earnings downgrades as well as a potential de-rating.

Loss of market share: We expect Dabur to suffer loss of market share in some of its key categories due to its higher rural exposure and because wholesalers prefer loyalty to larger brands when they face capital constraints.

Ambit vs consensus Exhibit 14: Our FY17/18/19 estimates vs consensus (` mn)


FY17E

Net Sales (` mn) 83,003 86,294 -4% We factor in higher impact of demonetisation than consensus

EBITDA (` mn) 14,800 16,113 -8% We build in higher impact on margin due to rise in crude prices

EPS (`/share) 6.9 7.7 -10% EBITDA flow through PAT

FY18E Net Sales (` mn) 94,872 96,800 -2% We are marginally behind consensus due to GST implementation

and high competitive intensity in Ayurveda/natural segment EBITDA (` mn) 16,632 18,253 -9% Margin to remain under pressure due to high competition


FY19E Net Sales (` mn) 110,107 107,935 2% We are marginally ahead of consensus

EBITDA (` mn) 19,688 20,899 -6% Margin pressure to continue due to high competition





Accounting GREEN In the past, Dabur has reported strong cash conversion and working capital management, and low levels of loans and advances and contingent liabilities. Consequently, we give a high rating to its accounting quality.

Predictability GREEN The predictability of Dabur’s profit margin has been stable in the last 6 quarters due to stable input cost.

Earnings momentum RED Dabur’s estimates have been trimmed by Consensus for FY17 and FY18 due to the impact of demonetisation.


Dabur


Balance Sheet




Total networth 33,541 41,601 47,439 53,903 61,494

Minority Interest 182 217 217 217 217


Debt 7,336 7,912 5,912 5,658 5,658



Gross block 19,194 21,588 23,588 25,588 27,588

Net block 12,557 13,285 13,965 14,595 15,176

CWIP 503 448 448 448 448

Investments 18,134 25,239 25,239 25,239 25,239


Debtors 7,108 8,097 7,959 9,097 10,558

Inventory 9,733 10,965 10,766 12,305 14,281

Loans & advances 2,996 3,560 1,819 2,079 2,413




Provisions 3,022 3,841 4,093 4,679 5,430




Total assets 35,431 44,281 48,119 54,328 61,919


Income statement



Growth (%) 10.3% 8.0% -1.8% 14.3% 16.1%


EBITDA 13,163 15,198 14,800 16,632 19,688

Growth (%) 13.8% 15.5% -2.6% 12.4% 18.4%

Depreciation 1,150 1,338 1,319 1,370 1,419

EBIT 12,013 13,860 13,481 15,262 18,269

Interest expenditure 401 480 146 6 (32)


Adjusted PBT 13,193 15,572 15,431 17,786 21,407

Tax 2,509 3,018 3,240 3,913 4,924


Growth (%) 16.5% 17.5% -2.9% 13.8% 18.8%



Minority Interest (26) (27) - - -





Dabur


Cash Flow Statement


EBIT 13,594 16,053 15,576 17,792 21,375

Depreciation 1,150 1,338 1,319 1,370 1,419

Others (266) (294) (146) (6) 32

Tax (2,509) (3,018) (3,240) (3,913) (4,924)

(Incr)/decr in net working capital (1,074) (1,628) 526 (369) (473)


Capex (2,538) (2,011) (2,000) (2,000) (2,000)

(Incr)/decr in investments (7,369) (7,105) - - -

Others - - - - -


Net borrowings 254 576 (2,000) (254) -


Interest paid (401) (480) (146) (6) 32

Dividend paid (4,154) (4,764) (6,352) (7,410) (8,892)

Others 479 296 - - -


Net change in cash (2,835) (1,037) 3,539 5,205 6,569


Free cash flow 8,357 10,439 12,036 12,875 15,429


Ratio Analysis


Gross margin (%) 52.5% 55.1% 54.7% 54.5% 54.8%

EBITDA margin (%) 16.8% 18.0% 17.8% 17.5% 17.9%

EBIT margin (%) 17.4% 19.0% 18.8% 18.8% 19.4%



Net debt: equity (x) 0.2 0.2 0.1 0.1 0.1

Working capital turnover (x) 53.0 27.2 32.2 32.2 32.2


RoCE (%) 28.9% 28.0% 23.5% 24.2% 25.6%

RoE (%) 35.5% 33.3% 27.4% 27.4% 28.6%


Valuation Parameter


EPS (`) 6.1 7.1 6.9 7.9 9.4

Diluted EPS (`) 6.1 7.1 6.9 7.9 9.4



P/E (x) 45.4 38.6 39.7 34.9 29.3

P/BV (x) 14.3 11.5 10.1 8.9 7.8

EV/EBITDA (x) 37.0 32.2 32.7 28.8 24.0

Price/Sales (x) 6.2 5.7 5.8 5.1 4.4



Key financials



EBITDA (` mn) 8,701 10,625 11,124 12,585 14,591

EBITDA Margin (%) 15.2% 17.3% 19.0% 18.6% 18.7%

Adjusted PAT (` mn) 5,735 7,248 7,888 9,050 10,480

Adjusted EPS (`) 4.4 5.6 6.1 7.0 8.1

RoCE (%) 28.7% 33.3% 34.3% 35.3% 35.8%

P/E (x) 58.5 46.3 42.5 37.1 32.0


Even I am mortal!

A loyal distributor base built with IT investments to improve ease of business and category leading brands would help Marico recover faster than peers from the demonetisation and GST disruptions (5-8% domestic sales decline vs 8-12% for peers in 2HFY17). While Marico should deliver a consistent performance (13%/14% CAGR in sales/PAT) over the next decade as its franchise is built on quality of talent, strong Board and loyalty of distributors, the current macro headwinds leave little room for upside in the next 12 months. We expect a sales/PAT CAGR of 10%14% over FY16-20 with RoCE improving from 33% to 36% by FY20. Key risk: Higher-than-expected Government stimulus.

Competitive position: STRONG Changes to this position: NO CHANGE Near-term headwinds for sales and margins

Over the next 12 months, demonetisation and GST would impact Marico’s sales due to disruption in the wholesale channel. Margins will be hit by formalisation of vendor base under GST and higher margin payment to wholesalers to help them revive. However, given Marico derives only ~35% of sales from wholesale and leadership in its categories, it would recover faster than peers. Franchise built on quality of talent, Board and loyalty of distributors

Marico’s work culture built on empowerment, meritocracy, openness, innovation and integrity, high quality Board that is truly independent, and distributor connect have helped it deliver at least 10% YoY sales growth and 15% ROCE in the past decade. Transformational changes like (a) change in top management incentive structure to reward from sustainable growth, (b) IT investments in distribution and (c) focus on capital allocation should help it deliver a similar consistent performance over the next decade as well. VAHO, Saffola and Bangladesh to drive growth hereon

The domestic business would deliver 16% revenue CAGR over FY17-20E, driven by: (a) 16% sales CAGR in VAHO led by 10-11% volume growth; and (b) increased urban penetration of Saffola (~16% CAGR). Focus on non-coconut oil growth in Bangladesh (11% CAGR) and organic growth in RoW should drive ~15% revenue CAGR over FY16-20E in the overseas business. Long-term prospects are secure, but limited upside in the near term

Given Marico’s sales/PAT growth would be 2-3% higher than peers with improvement in RoCE from 34% now to over 40% in the next decade, Marico deserves to trade at ~10% premium to most FMCG peers except HUL and Nestle. However, given macro headwinds over the next 12 months, there would be limited upside in the next 12 months. Our DCF-based TP of `240 (9% downside) implies 34x FY18E EPS (2% premium to sector average of 33x).

COMPANY INSIGHT MRCO IN EQUITY January 03, 2017

Marico

SELL

Consumer Staples


Flags Accounting: AMBER Predictability: AMBER Earnings Momentum: RED

Catalyst

Weaker-than-expected sales growth in

2HFY17

Performance (%)


70

90

110

130

150

Dec

15

Feb

16

Apr

16

Jun

16

Aug

16

Oct

16

Dec

16

Marico Sensex

Research Analysts

Ritesh Vaidya, CFA

+91 22 3043 3246

[email protected]

Anuj Bansal

+91 22 3043 3122

[email protected]

Dhiraj Mistry, CFA

+91 22 3043 3264

[email protected]

Marico

03 January, 2017 Ambit Capital Pvt. Ltd.

Demonetisation/GST will impact sales and margins in the near term The wholesale channel accounts for ~35% of Marico’s India sales. This makes Marico one of the least dependent players on the wholesale channel amongst peers. Market leadership in hair oil, edible oil and youth portfolio and one of the best distribution networks should help Marico recover from the demonetisation impact faster than peers. However, the implementation of GST could add to its woes in 1HFY18. Market-share gains from the unorganised sector due to implementation of GST will be limited and back-ended for Marico. It is expected to face margin headwinds of: (i) formalisation of the wholesale channel and its vendor base; and (ii) an increase in copra prices. Given the sales and margin pressures, we expect Marico to deliver 10%/14% sales/PAT CAGR over FY16-20.

Marico less impacted than peers due to lower wholesale channel contribution India contributes ~78% to Marico’s total sales. About 50% of the India sales come from stores serviced directly by sales executives and ~35% come from the wholesale channel. Marico’s dependence on wholesale is one of the lowest amongst FMCG peers due to its efforts to increase its direct reach through initiatives like Project One. Marico’s hair oil portfolio is over-indexed to the wholesale channel and could face sales disruption over the next 3-4 months. Its portfolio of Saffola premium refined edible oils is more dependent on the modern trade channel and, hence, should face lesser channel disruption.

Market leadership should limit the impact of demonetisation

Parachute coconut oil (~30% of sales), Saffola (~15% of sales) and Youth portfolio ex-deodorants (~4% of sales) are market leaders in their individual categories. Hence, when liquidity is restored in the channel, we expect Marico’s brands to post a faster recovery in sales than competitors in these categories. Given Saffola’s positioning as a preventive heart-care oil, we see limited impact on demand despite its price premium. The lower-priced variants of Saffola could help retain customers in this brand even if customers resort to downtrading. The liquidity crunch could impact impulse purchases of youth products like hair gels and serums over the next 2-3 months. We expect Marico’s sales to decline by 10% YoY for 2HFY18.

Exhibit 1: Marico’s brands are amongst the top-3 in their respective categories

Brand Category Brand Size (` bn)

Market position

% of Marico sales

Parachute Coconut hair care `10bn+ #1 30% of sales

Hair and care VAHO `5bn+ #1 20% of sales

Saffola Premium edible oil `10bn+ #1 17% of sales


Limited GST-driven gains from the unorganised market

The eventual rollout of GST is expected to curb the unorganised sector as all transactions will be logged into the GST Network in order to claim input tax credit. However, in the case of unorganised hair oil manufacturers, their entire supply chain (from procurement of raw material to sale of end-product to the retailer) is in cash and tracking them would be difficult even under GST. As a result, we see limited GST-led gains for Marico from market-share gains from the unorganised sector.

Marico


Margin headwinds from formalisation of the channel and higher input costs

As mentioned in the thematic section, for the wholesale channel to revive to its sales to pre-crisis levels, FMCG companies will have to offer higher profit margin to channel partners to offset compliance costs of doing business in a formal environment. Marico will also face the impact as it derives ~35% of its sales from the wholesale channel. Marico could also face headwinds from an increase in copra prices as black money holders have been hoarding copra to convert demonetised currency to new notes (Click here for detailed note 12 Dec2016). Additionally, increasing crude prices and INR depreciation will increase packaging costs for Marico. We expect Marico’s EBITDA margin to contract by 40bps YoY in FY18.

http://reports.ambitcapital.com/reports/Ambit_Consumer_Whenelephantsfightthegrassgetstrampled_12Dec2016.pdf

Marico


Domestic FMCG with MNC attributes Whilst understanding the sales or earnings growth potential of a company’s product categories, it is essential to analyse key attributes, such as management quality, ability to hire and retain high quality talent, focus on capital allocation and use of technology in the business. These factors decide the ability of a firm to grow over long periods of time whilst sustaining (or increasing) its RoCE. Marico scores the highest amongst its domestic FMCG peers on all these attributes. This is reflected in Marico’s delivery of least 10% YoY sales growth and 15% RoCE for 18 out of last 20 years, higher than most of its FMCG peers.

Attracts the best talent in the sector Marico has fostered a competitive, professional culture amongst employees that is focused on empowerment, meritocracy, innovation, openness and integrity. These practices place Marico at par with its MNC FMCG competitors like HUL and Nestle, making it an employer of choice amongst its domestic FMCG peers.

We spoke to a recruitment consultant about how job-seekers perceived Marico as a place to work for and the response was:

“Amongst the domestic FMCG companies, Marico and Asian Paints are considered in the top tier, whilst Dabur and GCPL are a notch below.”

“Marico has been able to create substantial brand equity, making it the employer of choice among the domestic FMCG peers.”

“Employees of MNC FMCG companies like Mondelez and HUL seek opportunities with domestic companies like Marico, as the company is in a higher growth trajectory which allows its staff to grow at a faster rate as well. This has allowed Marico to attract some of the best talent in the market.”

This is one of the biggest intangible assets that helps Marico create and maintain a high-quality middle management team, which is the key ingredient needed across various business functions for the successful evolution of a firm through different phases of its business cycle.

Incentive structure aligned to long-term goals Since 2014, Marico has changed the incentive structure of its top-100 managers. The incentive structure focuses on the longer-term goals of creating capability ahead of growth:

Only 50% of the variable pay is linked to goals like annual sales and profit targets.

About 50% of the incentive is linked to long-term value-added objectives. For e.g., preparing the product pipeline for the next 2-3 years for a manager in the R&D department or increasing the number of junior managers groomed to take up leadership roles for the HR department.

Capital allocation to increasingly focus on RoCE “Acquisitions had become an escape button for not growing the domestic portfolio. We are changing that. We need to grow organically.” - Mr. Saugata Gupta, MD and CEO, Marico

After a series of large acquisitions, including Paras in India and others overseas, Marico’s RoCE halved to 17% in FY13 from 41% in FY08. Over the last 12 months, the management has been reiterating its focus on increasing RoCE through the following steps:

50% of the incentive is linked to long-term value-added objectives

Marico


Large-scale M&A transactions unlikely over the next couple of years: The management team has indicated that Marico does not intend to pursue more big-ticket acquisitions over the next 2-3 years as it would focus on improving profitability and realising more synergy benefits from its recent acquisitions. It plans to leverage the existing overseas businesses to enter the neighbouring geographies in an organic manner. Entering into new product categories through the inorganic route would not be a focus area.

Higher dividend payout ratio: As the company does not plan to make any big-ticket acquisitions, it expects to increase its dividend payout ratio from current levels of ~30%. Marico’s Chairman, Mr. Harsh Mariwala, acknowledged this in an interview to Forbes India: “There are some other issues like dividend payout which, in our case, was lower than some other FMCG companies as a percentage of profit. We have taken one jump and, maybe, over a period of time, we will take one more.” (Source: http://tinyurl.com/o78t6r5)

As a result of these strategic initiatives, we forecast an increase in RoCE for Marico from 18% in FY15 to 39% in FY20.

Leveraging IT to drive higher sales and improve ease of business for distributors Marico continues to be at the forefront for using technology to improve ease of business for its distributors. It was one of the first companies to give hand-held terminals to sales representatives in the early 2000s. The company started tracking secondary sales almost a decade ago, which is another industry first. Recently, the company implemented the completely automated distributor ordering system, which has increased the ease of business for its distributors and improved their RoI through reduced inventory and higher turns. It has also increased the bandwidth of its sales force to pursue secondary sales instead of primary sales.

http://tinyurl.com/o78t6r5

Marico


Value-added products to drive growth We expect hair oil to be among the key categories to benefit from DBT-induced increase in rural spending as rural consumers are expected to shift from loose to branded hair oil. Marico is expected to benefit from an uptick in sales of coconut oil, as: (a) 35-40% of the coconut oil market is still dominated by loose unbranded oil purchases; and (b) Marico is the market leader in coconut oil with ~57% volume share through its brands, Parachute and Nihar.

Overall, we expect Marico to deliver 10% consolidated sales CAGR over FY17-20, led by a 16% CAGR in its domestic portfolio and 14% CAGR in its international business. Growth in the domestic portfolio will be led by value-added hair oils (VAHO) and Saffola edible oil, which are likely to record 16% sales CAGR over FY16-20E. Coconut oil is expected to grow at ~15% CAGR over FY17-20, optically helped by a low base of more than a 10% decline in FY16 and fundamentally led by the shift from loose coconut oil to branded oil.

Growth of the international business is likely to be largely organic and will be led by 13%/16%/17% CAGR in the Bangladesh/MENA/Vietnam businesses over FY16-20E. Entry into new geographies like Nepal, Pakistan, Cambodia, Myanmar, Sri Lanka and North Africa will be through the organic route; these are likely to contribute over `1bn in sales by FY18E (1.5% of the firm’s overall revenues as of FY16).

Exhibit 2: Marico’s sales growth across categories over FY17-20

Category FY17-20 sales CAGR

Market share growth Growth drivers

Coconut oil (30% of FY17E consolidated sales)

~15% value growth comprising 7-8% volume growth

~130bps market share increase over FY17-20

Conversion of users from loose coconut oil to branded coconut oil, which happens only as long as branded oil is priced lower than the 150% premium to loose oil. As a result, Marico has to take price corrections when prices of copra correct.

Increasing rural penetration;

Strong brand equity of Parachute should help it grow ahead of the market

Value Added Hair Oil (VAHO, 21% of FY17E consolidated sales)


~250bps market share increase over FY17-20

Drive value share ahead of volume share by launching new premium hair oils (using modern ingredients like Moroccan and Argan oil) Focus on 'consumer need based' positioning instead of an 'ingredient-based positioning Capture attrition of coconut oil users to VAHO by using Parachute Jasmine as the main brand in South India

Saffola edible oils (~17% of FY17E consolidated sales)


~200bps market share gain over FY17-20

Increasing penetration in SEC A/B households Unique positioning as a healthy lifestyle brand focused on preventive heart care has enabled it to gain market share despite stiff competition

Youth portfolio (~4% of FY14E consolidated sales)

~18% value growth

~100bps market share gain in Hair Gels/Creams and Serums; Flat market share in Deos over FY17-20

Focus on increasing leadership in the Hair Gels/Creams and Serums categories Looking to only sustain market share in deodorants

Increasing penetration and focus on the chemist/cosmetics channel is likely to drive sales in this category

Bangladesh (~10% of consolidated sales) ~13% value growth

Focus on deriving ~80% of growth through the non-coconut oil portfolio by introducing new products from the Indian portfolio Increase consumption of coconut oil users to drive modest growth in this category Use Bangladesh as a hub to expand into adjacent countries, such as Nepal, Pakistan, Myanmar and Sri Lanka

Middle East and Egypt (~4% of consolidated sales)

~16% value growth

Grow the hair creams/gels market and establish the VAHO portfolio

Gain lost market share in the Middle East

Use MENA as a base to enter adjacent countries in the North Africa region

Vietnam (~6% of consolidated sales) ~17% value growth

Grow market in male shampoos/shower gels by increasing penetration

Gain share in male deos

Extend into other South East Asian countries New geographies (Nepal, Pakistan, Cambodia, Myanmar, Sri Lanka, North Africa) These countries are likely to contribute >`1bn sales by FY17


Marico


Marico is not a commodity play Marico has been taking steps to increase growth of its value-added products with brand creation and addition of new categories using the following measures:

Marico has created four `2.0bn+ brands in the VAHO segment over the last 15 years, Nihar Shanti Amla, Parachute Advansed Jasmine, Nihar Naturals and Hair & Care, through the organic and inorganic routes.

After having attained the highest volume share in VAHO, Marico now plans to increase value-share gains ahead of volume share by: (i) upgrading its portfolio through premium launches, such as the recently launched prototypes, Parachute Aromatherapy, Parachute Advansed Aloe Vera Enriched Coconut Hair Oil; and (ii) new region-specific launches, such as the recently launched Nihar Naturals Sarson Kesh Tel.

Marico plans to achieve more than 80% growth at Marico Bangladesh through the non-coconut oil portfolio.

Marico plans to expand the youth portfolio by focusing on high-margin categories like hair gels and serums.

As a result of these measures, we expect the firm’s product mix to shift towards value-added segments (see exhibit below).

Exhibit 3: Proportion of non-coconut oil products should increase over the longer term


36.1% 35.1% 29.8% 30.7% 30.5% 30.2%

17.9% 19.1% 20.5% 20.3% 20.6% 20.9%

15.0% 15.3% 16.7% 16.5% 16.6% 16.8%

31.0% 30.5% 32.9% 32.5% 32.3% 32.1%

0%

25%

50%

75%

100%

FY15 FY16 FY17E FY18E FY19E FY20E

Others

Premiumedible oil

VAHO

Coconut oil

Marico is driving innovation to reduce dependence on the coconut oil portfolio

Marico


Summary of our key assumptions and estimates Exhibit 4: Key assumptions and estimates (` mn) FY15 FY16 FY17E FY18E FY19E FY20E Comments

Profit and loss Total revenues 57,330 61,320 58,622 67,753 77,920 89,773 Expect sales growth to be affected due to demonetisation

in FY17 and slow recovery from FY18 Growth (%) 22.3% 7.0% -4.4% 15.6% 15.0% 15.2%

Gross Profit 26,139 30,706 30,586 35,011 40,382 46,660 Expect gross margin contraction due to headwinds around raw material Gross margin (%) 45.6% 50.1% 52.2% 51.7% 51.8% 52.0%

Employee cost (% of sale) 5.7% 5.9% 6.6% 6.5% 6.5% 6.5% Expect employee expenses to remain stable

Advertising (% of sale) 11.3% 12.8% 12.1% 12.5% 12.5% 12.5% Do not expect material savings in A&P spends as the company would focus on new product launches

Carriage & freight (% of sale) 3.8% 4.1% 4.3% 4.2% 4.2% 4.2% Expect carriage and freight expenses to remain stable


EBITDA 8,701 10,625 11,124 12,585 14,591 16,945 Expect EBITDA margin contraction due to contraction of gross margin EBITDA Margin 15.2% 17.3% 19.0% 18.6% 18.7% 18.9%

PAT 5,735 7,248 7,888 9,050 10,480 12,157 Expect PAT CAGR of 14% over FY16-20

Growth (%) 18.1% 26.4% 8.8% 14.7% 15.8% 16.0%

Balance Sheet Capex 364 946 1,100 1,200 1,300 1,300 No material capex requirements over FY16-20

Working Capital days 39 27 26 26 26 26 Expect working capital days to remain stable

Cash flows (` mn) Operating cash flows 3,441 9,744 9,103 9,278 10,678 12,281 Strong growth in free cash flows as capex requirements

are low Free cash flows 3,077 8,798 8,003 8,078 9,378 10,981


Limited upside over the next 12 months Following the good monsoon in 2016, the upcoming harvest season was expected to boost the flagging rural consumer demand over the next few quarters. However, the disruption caused by demonetisation has postponed expectations of a recovery by another 12 months. Supply chain disruptions during the eventual implementation of GST could further complicate matters. With the government machinery occupied with handling the demonetisation, implementation of initiatives like DBT for food and fertiliser subsidy which were expected to support demand from 2HFY17 would be delayed by 6-12 months. Given Marico’s superior distribution network and category-leading brands, we expect it to recover faster from these disruptions. However, even this high quality consumer franchise is not immune to the macro headwinds over the next 12 months.

Good franchise to own over the next decade but limited upside potential in the next 12 months

Focus on capital allocation, quality talent, categories where it has right-to-win and a work culture based on empowerment, meritocracy, integrity, openness and innovation provide visibility on sustenance of return ratios and profit growth over the next decade by Marico (as opposed to peers like GSK Consumer, Colgate, Dabur and GCPL) (click here for our Coffee Can note on Marico 09 Feb 2016).

While Marico is a quality franchise to own over a 7- to 10-year period, we see limited upside over the next 12 months due to the macro headwinds highlighted earlier. We expect Marico to deliver 15%/16% sales/PAT CAGR over FY17-20, with RoCE improving from 34% in FY17 to 36% in FY20. Our DCF-based valuation suggests a target price of `240/share (8% downside), valuing the company at 34x FY18E EPS (2% premium to sector average multiple).

http://reports.ambitcapital.com/reports/Ambit_Marico_CompanyInsight_Theartofpeoplemanagement_09Feb2016.pdf

Marico


A higher-than-expected fiscal stimulus could result in an upgrade to our estimates. Similarly, a prolonged channel disruption due to a continued liquidity crunch could lead to cuts to our estimates.

Exhibit 5: Marico’s cash flow profile

Source: Ambit Capital research; Note: FCF and CFO for FY14 are distorted due to the demerger of Kaya Ltd.

Exhibit 6: Marico’s returns profile

Source: Ambit Capital research; Note: Sales and EPS growth for FY14 is distorted due to the demerger of Kaya Ltd.

Exhibit 7: Marico’s one-year forward P/E


Exhibit 8: Marico’s one-year forward EV/EBITDA


Risks Higher-than-expected fiscal stimulus: While we expect the Government to dole out `10,000-12,000 per household for the bottom 15-20% of households, a higher stimulus could lead to a sooner-than-expected recovery in demand.

Faster rollout of DBT: While we expect a pan-India rollout of DBT for food and fertilisers by 2HFY18, a faster implementation could increase rural demand.

Catalysts Poor sales growth in 4QFY17: The wholesale channel will take at least 3-4 months to recover its sales to pre-crisis levels. Continued poor sales growth even in 4QFY17 would be a key catalyst.

(6,000)

(1,000)

4,000

9,000

14,000

FY09

FY10

FY11

FY12

FY13

FY14

FY15

FY16

FY17E

FY18E

FY19E

FY20E


-15%

-5%

5%

15%

25%

35%

20%

25%

30%

35%

40%

45%

FY10

FY11

FY12

FY13

FY14

FY15

FY16

FY17E

FY18E

FY19E

FY20E

ROE (LHS) EBITDA Margin (RHS)

EPS Growth (RHS) YoY Growth in sales (RHS)

20 25 30 35 40 45 50

Jan-

12

May

-12

Sep-

12

Jan-

13

May

-13

Sep-

13

Jan-

14

May

-14

Sep-

14

Jan-

15

May

-15

Sep-

15

Jan-

16

May

-16

Sep-

16


10

15

20

25

30

35Ja

n-12

May

-12

Sep-

12

Jan-

13

May

-13

Sep-

13

Jan-

14

May

-14

Sep-

14

Jan-

15

May

-15

Sep-

15

Jan-

16

May

-16

Sep-

16


+1 s.d. -1 s.d.

Marico


Ambit vs consensus Exhibit 9: Our estimates for FY17/18/19 vs consensus


FY17E

Net Sales (` mn) 58,622 63,036 -7% We expect higher impact of demonetisation than consensus

EBITDA (` mn) 11,124 11,959 -7% Higher impact of demonetisation flow through EBITDA

EPS (`/share) 6.1 6.5 -6% Lower EBITDA flow through PAT

FY18E

Net Sales (` mn) 67,753 71,942 -6% We expect impact of demonetisation to continue and also factor in sales impact due to GST implementation

EBITDA (` mn) 12,585 13,805 -9% Expect lower EBITDA due to headwinds around raw material


FY19E

Net Sales (` mn) 77,920 82,009 -5% We expect slow recovery of sales which is impacted due to demonetization

EBITDA (` mn) 14,591 15,795 -8% Expect lower margin due to longer impact of GST





Accounting AMBER In the past, Marico has reported strong cash conversion, effective management of working capital and low levels of loans and advances. However, it still ranks lower than the overall FMCG average and runs the risk of contingent liabilities not working in its favour.

Predictability AMBER Marico is strongly influenced by commodity price volatility. Whilst the company has historically reported strong volume growth, certain segments like Saffola and its international portfolio have seen erratic growth trends in recent quarters.

Earnings momentum RED We have downgraded our EPS estimates by 10%/15%/21% for FY17/18/19 due to the demonetisation and possible implementation of GST in FY18.


Marico


Balance Sheet


Shareholders' equity 645 1,290 1,290 1,290 1,290


Total networth 18,248 20,968 23,862 27,166 31,147


Debt 3,342 1,532 - - -

Deferred tax liability 79 (1) (1) (1) (1)


Gross block 9,841 10,326 11,426 12,626 13,926

Net block 5,868 5,458 5,713 6,026 6,394

CWIP 30 367 367 367 367

Goodwill 4,892 4,980 4,980 4,980 4,980

Investments 2,838 4,164 4,164 4,164 4,164


Debtors 1,768 2,524 2,413 2,789 3,208

Inventory 9,947 9,258 8,851 10,229 11,764

Loans & advances 2,298 3,494 2,409 2,784 3,202

Other current assets 1,564 888 1,606 1,856 2,135



Provisions 1,040 1,147 1,097 1,268 1,458



Total assets 21,805 22,642 23,999 27,298 31,274


Income statement



% growth 22.3% 7.0% -4.4% 15.6% 15.0%


EBITDA 8,701 10,625 11,124 12,585 14,591

% growth 16.3% 22.1% 4.7% 13.1% 15.9%

Depreciation 843 1,018 845 887 932

EBIT 7,857 9,606 10,279 11,698 13,659

Interest expenditure 230 203 169 - -

Non-operating income 589 934 992 1,042 1,094

Adjusted PBT 8,217 10,338 11,102 12,740 14,753

Tax 2,368 2,971 3,220 3,695 4,278


% growth 16.0% 25.9% 7.0% 14.7% 15.8%



Minority Interest 114 118 (5) (5) (5)

Share of associates - - - - 1




Marico


Cash Flow statement


EBIT 8,446 10,540 11,271 12,740 14,753

Depreciation 843 1,018 845 887 932

Others (583) (394) (169) - -

Tax (2,368) (2,971) (3,220) (3,695) (4,278)

(Incr) / decr in net working capital (2,898) 1,551 376 (654) (729)


Capex (364) (946) (1,100) (1,200) (1,300)

(Incr) / decr in investments (2,082) (1,414) - - -

Others - - - - 1


Net borrowings (1,917) (1,810) (1,532) - -

Interest paid (230) (203) (169) - -

Dividend paid (1,750) (5,025) (4,512) (5,264) (6,016)

Others 886 700 (313) (482) (482)


Net change in cash (2,015) 1,048 1,477 2,332 2,879


Free cash flow 3,077 8,798 8,003 8,078 9,378


Ratio Analysis


Gross margin (%) 45.6% 50.1% 52.2% 51.7% 51.8%

EBITDA margin (%) 15.2% 17.3% 19.0% 18.6% 18.7%

EBIT margin (%) 14.7% 17.2% 19.2% 18.8% 18.9%



Net debt: equity (x) 0.1 (0.1) (0.2) (0.3) (0.3)



RoCE (%) 28.7% 33.3% 34.3% 35.3% 35.8%

RoE (%) 36.0% 37.0% 35.2% 35.5% 35.9%


Valuation Parameter


EPS (`) 4.4 5.6 6.1 7.0 8.1

Diluted EPS (`) 4.4 5.6 6.1 7.0 8.1



P/E (x) 58.5 46.3 42.5 37.1 32.0

P/BV (x) 17.5 15.2 13.4 11.8 10.3

EV/EBITDA (x) 38.7 31.4 29.7 26.1 22.3

Price/Sales (x) 5.9 5.5 5.7 5.0 4.3



Not such a sweet story anymore

Britannia’s stock price has run up 5.4x in five years on sharp margin growth of 9% and 43% EPS CAGR since 2011. Demonetisation/GST will halt this run, given: 1) cash crunch will hit demand for a discretionary/impulse category like biscuits (80% of sales); 2) need to provide higher margins to contract manufacturers (50% of sales) and wholesalers (30% of sales) to compensate for tax compliance costs post GST. Valuation of 39x FY18E P/E is rich given sales/EPS CAGR of 8%/5% over FY16-18E and 40bps margin drop. Risks: Lower-than-expected hit on demand and margin support from fall in agri-commodity prices.

Competitive position: STRONG Changes to this position: POSITIVE Britannia’s margin run set to take a breather Britannia’s EBITDA margins grew by 900bps since 2011 given: 1) pricing power (price/mix CAGR of ~6%); 2) benign raw material costs (GM up 9%); 3) increasing share of in-house manufacturing (50% vs 33% in 2011); and 4) moderating logistics costs (down 150bps as % of sales). Margins are nearing their peak because: 1) further reduction in logistics cost is difficult; 2) weak demand will curtail price hikes/premiumisation; and 3) further efficiency gains by optimising manufacturing footprint and supply chain are difficult. Britannia is a relative gainer, but an absolute loser in the near term Britannia would gain share from Parle given a more premium sales mix (glucose is 5% of sales for Britannia vs 35% for Parle) and resultant higher exposure to urban/modern-trade channel that reduces wholesale-related disruptions. ITC with no presence in Glucose and over-indexation to South (less impacted geography) might also gain share. However, absolute hit to Britannia’s sales is likely to be high (we build in 10% sales decline in 2HFY17 with recovery by 2HFY18) as biscuits are a discretionary/impulse category. Stable demand and revival of margin gains will make us turn positive

We appreciate Britannia’s brand strength, new product launch track record, premium product portfolio, and renewed management focus on efficiencies in manufacturing/distribution. However, to turn positive we await: 1) sustained recovery in sales; 2) improved visibility of margin gains through more premium launches, fall in input costs, more internal efficiency programmes and operating leverage; and 3) better valuations led by a correction in stock price. Valuations are at a 38% premium to 5-year average and global peers Muted earnings growth of 8% over FY16-18E could reverse Britannia’s re-rating (18x to 36x since 2011). Our TP of `2,600 implies FY18E P/E of 34x, in line with historical 5-year average but at 100% premium to global peers given superior growth (8% vs 0% for global peers) and returns (55% RoE vs 14% for peers). Also, there is a risk if Varun Berry (CEO) exits as continuity of efficiency programmes initiated by him are key to further margin gains.

COMPANY INSIGHT BRIT IN EQUITY January 03, 2017

Britannia

SELL

Consumer Staples


Flags Accounting: GREEN Predictability: AMBER Earnings Momentum: RED

Catalysts

Increased competitive pressure from incumbents and MNCs

Margin decline on a high base and limited scope for more efficiencies to offset demonetisation impact

Unsuccessful new product launches by Britannia without supporting A&P spend

Performance (%)


70

90

110

130

Dec

15

Feb

16

Apr

16

Jun

16

Aug

16

Oct

16

Dec

16

BRIT Sensex

Research Analysts

Anuj Bansal

+91 22 3043 3122

[email protected]

Ritesh Vaidya, CFA

+91 22 3043 3246

[email protected]

Dhiraj Mistry, CFA

+91 22 3043 3264

[email protected]

Key financials Year to March FY15 FY16 FY17E FY18E FY19E


EBITDA (` mn) 8,639 12,265 12,244 13,940 16,646

Adjusted PAT (` mn) 3,965 8,268 8,081 8,991 11,047

Adjusted EPS (`) 45.2 68.0 67.3 74.9 92.1

RoE (%) 53.1% 54.2% 41.1% 37.7% 38.3%

P/E (x) 63.8 42.4 42.9 38.5 31.4

P/B (x) 27.7 19.5 15.9 13.2 10.9


Britannia


Double whammy of near-term and long-term headwinds to growth Britannia has delivered a healthy 43% EPS CAGR over FY11-16 predominantly due to EBITDA margin expansion of 9% (up from 5.1% to 14.1%). Further, expansion of margins from this base is difficult and Britannia’s earnings are likely to lag sales growth. In addition to this long-run reset of growth at a lower level, the near-term impact of demonetisation and GST will also weigh down sales and margins. Britannia should deliver 8% sales CAGR, 40bps margin decline and 5% EPS CAGR over FY16-18E.

Demonetisation to hit biscuit sales hard Near-term impact will be high given impulse-driven, discretionary nature of the category

Biscuits form 80% of sales for Britannia. This is a fairly discretionary category except for the bottom-end Glucose variant which is often used by poor consumers as a meal replacement. For the last few years, sales of small packs with entry-level pricing have been successfully increased by companies to boost penetration and premiumisation; these packs account for 20-30% of sales for Britannia. This effort has increased the ‘impulse purchase’ nature of the category and makes it more vulnerable to demand suppression in the current environment.

We expect Britannia to record a 10% sales decline in 2HFY17, bringing down FY17 sales growth to 0%. There should be a recovery in FY18 from this low base, but this is likely to happen only in 2HFY18. We expect sales to grow by 17% in FY18 before normalising to mid-teen levels.

Exhibit 1: Britannia’s sales growth trends and estimates


Exhibit 2: Britannia’s quarterly sales growth trends


Britannia would fare better than peers given premium/urban focus and distribution skew towards modern trade

Britannia and ITC should gain market share in the current environment with Parle being the key loser. Both Britannia (5% of sales) and ITC (0% of sales) have low exposure to the bottom-end Glucose biscuit segment. This makes them relatively immune from the slowdown in the rural markets and bottom-end consumption due to farmer distress and job losses in the informal and construction sectors.

The premium portfolio also means salience of wholesale is less (less than 40% for Britannia vs over 50% for Parle) and that of modern trade is higher (15% of sales for Britannia, in our estimate). Given that modern trade has shown resilience (being largely cashless and urban-centric), higher share in this channel will help Britannia gain over Parle. ITC has the added advantage of managing ‘pan’ shops and maintaining better growth through that channel as well.

0%

5%

10%

15%

20%

25%

40,000

60,000

80,000

100,000

120,000

140,000

160,000

FY11

FY12

FY13

FY14

FY15

FY16

FY17E

FY18E

FY19E

FY20E

Revenue (Rs mn) Revenue growth (RHS)

6%

8%

10%

12%

14%

16%

17,000

19,000

21,000

23,000

25,000

3Q

FY14

4Q

FY14

1Q

FY15

2Q

FY15

3Q

FY15

4Q

FY15

1Q

FY16

2Q

FY16

3Q

FY16

4Q

FY16

1Q

FY17

2Q

FY17


Britannia


Exhibit 3: Top 3 players’ segment-wise break-up of sales


Exhibit 4: Split of sales by channel for Top 3 players


Shift of market share from unorganised to organised is likely to be muted

One key aspect of demonetisation and GST that will not play out in favour of Britannia is market-share gain for organised players from unorganised players. This is because of the following factors:

End-to-end supply chain runs on cash: Biscuits by unorganised players are made in small family-owned bakeries using locally procured agri-based products like wheat flour, oil/butter and sugar. These are generally procured on cash basis and can continue even under GST. Given none of the ingredients are industrial in nature, the informal cash-based supply chain can easily thrive even under GST.

Localised distribution can be run even amid cash crunch: Local unbranded players rely on localised distribution within the radius of a few districts or towns in the neighborhood. Relationships with the retailers/wholesalers tend to be strong due to personal familiarity. Hence, sales can continue to run informally on cash or credit depending on availability of cash.

The non-biscuit portfolio is likely to be more resilient

For Britannia, ~20% of sales come from the non-biscuits category. Most of this is from dairy (15% of sales) where cheese is the main product category. Rest of the sales comes from breads, cakes and rusks. These non-biscuit categories are more resilient to demand suppression arising out of demonetisation as: 1) cheese is a largely urban and modern-trade-based category; and 2) breads are a daily necessity and are distributed in urban areas by Britannia. Cakes and rusks might get affected on similar lines as biscuits as they are largely impulse purchase items.

5%

35%

100% 95% 65%

0%

20%

40%

60%

80%

100%

ITC Britannia Parle

Glucose Non-Glucose

70% 70%

45%

30% 30% 55%

0%

20%

40%

60%

80%

100%

ITC Britannia Parle

Distributor Wholesaler

Britannia


Exhibit 5: Britannia’s split of sales by segment over FY12-20

Source: Ambit Capital research; Other revenue includes bread, rusks, cakes, dairy and international business

Exhibit 6: Britannia’s growth rates for various segments over FY12-20

Source: Ambit Capital research; Others includes bread, rusks, cakes, dairy and international business

Margin gains were petering out, now they will fall Sustenance of margin gains under a cloud even without the impact of demonetisation/GST

After strong growth of 9% over FY11-16, Britannia’s margins had started to flatten (1HFY17 margins are down ~45bps). Given the high base and the fact that most strategies (premiumisation and price hikes, optimisation of manufacturing and logistics, operating leverage on A&P spend) for margin gain deployed by Britannia are nearing peak, we would have been skeptical of further margin gains even in the normal course of business. We are now building in a 40bps decline in margins over FY16-18E, including drop of 10bps in FY17 and 30bps in FY18E.

Exhibit 7: Gross margin and EBITDA are at peak levels with low A&P spend


Providing support to distributors and contract manufacturers will affect margins

After demonetisation and GST, the cost of doing business for wholesalers and contract manufacturers will rise as they become more tax compliant. Britannia will have to support both with higher margins to compensate for the higher costs. Being the market leader with strong brands and scale, Britannia is likely to be able to negotiate better and become the preferred partner of capital constrained wholesalers. This should help it to limit the hit from giving increased margins to wholesalers.

- 20 40 60 80

100 120 140 160

FY12

FY13

FY14

FY15

FY16

FY17E

FY18E

FY19E

FY20E

Biscuits revenue (Rs bn) Other revenue (Rs bn)

-5%

0%

5%

10%

15%

20%

25%

30%

FY12

FY13

FY14

FY15

FY16

FY17E

FY18E

FY19E

FY20E

Biscuits Others

7%

9%

11%

13%

15%

17%

37%

38%

39%

40%

41%

42%

43%

FY13 FY14 FY15 FY16 FY17E FY18E FY19E FY20E

Gross margin % EBITDA margin % (RHS)A&P spends as % of sales (RHS)

Britannia


However, we believe the hit on contract manufacturing could be higher because Britannia is dependent on contractors for 50% of its sales. These are non-exclusive contractors that generally also manufacture for smaller brands or for private/white labels. While Britannia deals with the contractors in fully tax compliant manner, the other businesses tend to be under-reported and are likely to get affected by demonetisation and GST. Britannia may face increased cost of procurement if the contractors look to offset losses from other businesses through Britannia. Note that the smaller businesses were indirectly subsidising Britannia by providing scale to support the operations of the contractor.

Fall in agri-commodity prices and low proportion of crude-related inputs could help margins

The key positive surprise that could play out for Britannia (especially in 2HFY17) is potential gain in gross margins due to a fall in agri-commodity prices. Flour, sugar and oil are the key inputs for Britannia (~46% of COGS). Our channel checks suggest that farmers are selling their perishable produce at 30-40% cheaper prices to raise cash for their next sowing cycles or there has been hoarding of non-perishables by traders looking to get rid of old currency notes. These hoarded products are likely to be sold potentially at lower prices to churn capital quickly once cash restrictions are eased (by 4QFY17). Any such fall in agri-commodity prices will benefit Britannia.

Exhibit 8: Britannia’s COGS split of agri inputs


Exhibit 9: Prices of flour, sugar and palm oil have increased by ~40% since May’15 (rebased to 100)

Source: Bloomberg, Ambit Capital research; Prices are rebased to 100

Also, Britannia is not affected by the depreciation of INR as it imports less than 1% of its raw materials. The hit to margins from crude oil inflation is also limited as crude-linked inputs account for less than 10% of COGS for Britannia.

Exhibit 10: Only ~9% of Britannia’s COGS is sensitive to crude fluctuation


Flour, 24%

Fats and oils, 12%

Sugar, 10%

Others, 54% 80

100

120

140

160

180M

ay-1

5

Jul-

15

Sep-

15

Nov

-15

Jan-

16

Mar

-16

May

-16

Jul-

16

Sep-

16

Nov

-16

Flour Sugar Palm oil

Crude linked, 9%


Britannia


We will turn positive when long-term positives start playing out again Business model retains all its strengths

We remain positive on the strength of Britannia’s business model. Some of the key competitive advantages that Britannia has been able to develop are:

Strong market leading brands: Britannia has a ‘5 brand’ strategy with each brand having its own positioning. Britannia has consistently been rated among the top brands in India over last 10 years by Brand Equity. The market-share trends have also been largely stable over the past decade despite entry of a formidable competitor like ITC. We expect Britannia to be able to maintain its dominant positioning in the Indian biscuits segment (especially non-Glucose).

Exhibit 11: Britannia’s 5 key brands

Biscuit Segment Key Brand Revenue Share

Sweet Cookies Good Day/Cookies ~25%

Marie Marie Gold ~14%

Cream Bourbon/Treat/ Pure Magic ~13%

Non-salted Cracker 50-50 ~9%

Glucose Tiger ~5%


Exhibit 12: Britannia’s market-share trends


Robust new product pipeline: Britannia has a long track record of successful new launches. Being an impulse purchase category, new product innovation to activate demand is crucial for growth. New launches are also an important driver of premiumisation, which supports both topline growth and margin expansion.

Efficient business operations: Britannia has successfully delivered on its guidance of improving margins through efficiency in business operations. As part of this exercise, manufacturing has been moving in-house (now 50% manufacturing is in-house vs 33% in 2011). Also, distribution and logistics have been streamlined; exports have been consolidated in one factory (vs 16 earlier), number of factories have been cut down from 54 to 37 but newer factories closer to market have been setup to cut down travel time and distance, which is crucial as it saves cost, helps put products on shelves while fresh and reduces breakage.

Visibility of revival of structural growth is crucial

Packaged foods (including biscuits) will have a stronger and longer growth trajectory in India than the Home & Personal Care (HPC) category due to: 1) lower penetration of 30-40% vs 80-90% for HPC; 2) as the proportion of working women grows, convenience provided by packaged foods will become a key driver of growth; 3) being more discretionary and impulse-driven, this category grows faster with rising income levels; and 4) rising share of modern trade is a key enabler of demand for packaged foods as it provides opportunity to create impulse purchase decisions points of sale. As a dominant player in this space, Britannia is a preferred pick to play these trends.

However, given uncertainties around demand and margin pressure, we maintain SELL on Britannia. We would look to turn positive when: 1) sales growth shows sustained recovery; 2) margins appear to be bottom out with drivers like successful premium product launches, benign raw material prices, optimisation in A&P spend reemerging; and 3) stock price correction offers a more reasonable valuation.

5%

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25%

30%

35%

40%

FY11

FY12

FY13

FY14

FY15

FY16

Britannia Parle ITC

Britannia


Summary of our key assumptions and estimates Exhibit 13: Key assumptions and estimates (` mn) Consolidated FY15 FY16 FY17E FY18E FY19E Comments

Profit and loss Net Sales 78,584 86,789 87,166 101,584 119,053 Revenue growth to be affected due to demonetisation in

FY17 Growth (%) 13.7% 10.4% 0.4% 16.5% 17.2%

Gross Profit 31,666 36,799 36,883 42,654 50,417 Gross margin is expected to contract in FY18 due to slowdown in premiumisation and higher input cost Gross margin (%) 40.3% 42.4% 42.3% 42.0% 42.3%

Employee cost (% of sale) 3.6% 3.9% 4.3% 4.0% 4.0% Employee cost is expected to remain stable

Advertising (% of sale) 8.3% 8.5% 7.6% 8.3% 8.4% Normalisation of business and new product launches would lead to higher spends from FY18 onwards

Freight (% of sale) 5.4% 5.0% 5.0% 5.0% 5.0%

Costs are expected to remain stable over FY15-20 Conversion charges (% of sale) 6.2% 5.5% 5.5% 5.4% 5.4%

Other expenses (% of sale) 5.8% 5.5% 5.9% 5.6% 5.6%

EBITDA 8,639 12,265 12,244 13,940 16,646 Gross margin to flow through EBIDTA margin

EBITDA Margin 11.0% 14.1% 14.0% 13.7% 14.0%

PAT 5,426 8,164 8,081 8,991 11,047 Expect PAT growth to be lower than sales growth in FY17-18 due to the impact of demonetisation and GST implementation PAT growth YoY (%) 37.2% 50.5% -1.0% 11.3% 22.9%

Balance Sheet Capex 786 2,561 3,000 3,000 1,500 Expect capex to moderate over FY17-19 as the new

factories are commissioned Capital Work in Progress 484 901 901 901 901

Working Capital days -13 0 0 0 0

Expect working capital to remain stable Debtor days 6 7 7 7 7

Current Liabilities days 65 66 66 66 66

Inventory days 19 19 19 19 19

Net debt/(cash) to equity 0 0 0 0 -1

Cash flows (` mn) Operating cash flows 6,231 6,630 9,547 10,697 12,924

We expect strong free cash flow due to moderate capex Free cash flows 5,446 4,069 6,547 7,697 11,424


Britannia


Slowing earnings growth is increasing the risk of de-rating A strong 43% EPS CAGR over FY11-16 and change in strategy by the new management under Varun Berry resulted in a re-rating for the stock from 20-25% discount to peers to ~10% premium now. We believe the premium valuations are not warranted given earnings growth over FY16-18E is likely to sharply lower, at 5%, due to: 1) near-term hit to demand for the discretionary and impulse purchase category of biscuits; and 2) reversal of margin trajectory; margins would decline by 40bps over FY16-18E vs 900bps gain over FY11-16. Also, Britannia’s ambitions of reaching `200bn top line in 5 years through entry into highly competitive product categories, such as chocolates, snacks and breakfast items add to the risk given that the company’s track record in this aspect has been weak.

Our DCF-based valuation suggests a TP of `2,600. This implies 35x FY17E P/E, which is at a ~4% premium to average implied multiple for our coverage of FY18E P/E of 33x. This slight premium is justified given we believe packaged foods can grow faster than FMCG peers due to: 1) lower penetration; 2) rising number of working women who will seek the convenience of packaged foods; 3) discretionary and impulse categories grow faster with rising income levels; and 4) rising share of modern trade will aid impulse purchase decisions at points of sale.

Our WACC assumptions for the DCF-model are summarised in the exhibit alongside. The cash flow and return profiles generated by our model are shown in the exhibits below.

Exhibit 14: Britannia’s cash flow profile


Exhibit 15: Britannia’s return profile


Exhibit 16: Britannia’s one-year forward P/E bands


Exhibit 17: Britannia’s one-year forward EV/EBITDA bands


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FCFF Rs mn (LHS) Revenue Growth (RHS)

PBIT Margin (RHS)

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Revenue growth (%) EPS growth (%)EBITDA margin (%) (RHS) PAT margin (%) (RHS)

10

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50

60

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12

May

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12

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13

May

-13

Sep-

13

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14

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14

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15

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Sep-

15

Jan-

16

May

-16

Sep-

16


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35

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12

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12

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13

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14

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15

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-15

Sep-

15

Jan-

16

May

-16

Sep-

16


+1 s.d. -1 s.d.

DCF assumptions

Item Value

Risk-free rate (%) 8.5






WACC (%) 13.0



Britannia


Risks Promoters exiting Britannia at a premium valuation: In the event Britannia is acquired, the acquisition could happen at a sharp premium to the current market price. An acquisition multiple of 2.5x EV/sales would imply an upside of more than 80% from current levels.

Efficiencies leading to EBITDA margin expansion: Varun Berry has initiated several cost-optimisation projects, which have led to significant EBITDA margin expansion. Although we believe most of the optimisation benefits have already been realised, substantial optimisation gains from current levels could lead to significant EBITDA margin expansion.

Higher-than-expected share gains due to product launches and re-launches: Whilst we build in ~400bps market-share gains over FY15-20, higher-than-expected success of new products could result in higher share gains for Britannia.

Catalysts Increased competitive pressure from incumbents and MNCs: The ratio of Britannia’s A&P spends to sales has been rising as Parle and ITC, and MNC peers, such as Unibic and Mondelez are increasing competitive pressure.

Minimal margin expansion as benefit of lower input costs enters the base: Over the past 9 months, Britannia has benefited from lower input costs. However, over the next 6 months, with most of these lower input costs in the base, there will be limited scope for margin expansion.

Unsuccessful new product launches by Britannia without supporting A&P spend: A series of new launches, particularly in the premium segment, is planned. This will lead to higher A&P spends. An unsuccessful product launch could lead to further pressure on EBITDA margin.



FY17E

Net Sales (` mn) 87,166 96,699 -10% We expect higher impact on Britannia sales than consensus

EBITDA (` mn) 12,244 13,691 -11% We expect marginal EBITDA margin contraction


FY18E

Net Sales (` mn) 101,584 110,822 -8% We expect higher competition from ITC and Parle

EBITDA (` mn) 13,940 16,363 -15% Margin to remain under pressure due to high competition


FY19E

Net Sales (` mn) 119,053 128,423 -7% We expect higher competition from ITC and Parle

EBITDA (` mn) 16,646 19,284 -14% Margin to remain under pressure due to high competition



Britannia




Accounting GREEN Britannia has, in the past, reported high cash conversion and efficient management of working capital. It ranks in the top quartile of our forensic accounting checks for FMCG. Consequently, we give a high rating to the quality of its accounting.

Predictability AMBER Due to a combination of its presence across products, categories and SKUs, and predominant exposure to consumer-activity-led sector of the economy, revenues show stability. However, the weak macro-economic environment, volatility in raw material prices and company’s margin expansion initiatives led to some volatility in earnings.

Earnings Momentum RED Due to demonetisation consensus has cut EPS estimates for both FY17 and FY18.


Britannia


Balance Sheet




Total networth 12,451 17,693 21,638 26,083 31,659


Debt 1,402 1,270 408 408 408

Deferred tax liability (234) (277) (277) (277) (277)


Gross block 15,989 18,067 21,067 24,067 25,567

Net block 7,334 8,343 9,876 11,183 10,822

CWIP 484 901 901 901 901

Goodwill 1,107 1,159 1,159 1,159 1,159

Investments 771 3,564 3,564 3,564 3,564


Debtors 1,358 1,706 1,714 1,997 2,340

Inventory 4,040 4,407 4,426 5,158 6,045

Loans & advances 5,563 8,995 9,034 10,529 12,339




Provisions 4,228 5,092 5,114 5,960 6,985



Total assets 13,644 18,711 21,792 26,234 31,806


Income statement



% growth 13.7% 10.4% 0.4% 16.5% 17.2%


EBITDA 8,639 12,265 12,244 13,940 16,646

% growth 37.7% 42.0% -0.2% 13.8% 19.4%

Depreciation 1,445 1,134 1,468 1,693 1,861

EBIT 7,194 11,131 10,777 12,247 14,784


Non-operating income 880 1,000 1,233 1,082 1,574

Adjusted PBT 8,035 12,082 11,959 13,304 16,346

Tax 2,611 3,920 3,880 4,316 5,303


% growth 37.2% 50.5% -1.0% 11.3% 22.9%

Extraordinaries 1,461 (103) - - -


Minority Interest (2) (2) (2) (3) (4)





Britannia


Cash Flow statement


EBIT 8,074 12,131 12,009 13,329 16,358

Depreciation 1,445 1,134 1,468 1,693 1,861

Others (320) (42) 0 0 0

Tax (2,611) (3,920) (3,880) (4,316) (5,303)

(Incr) / decr in net working capital (318) (2,626) 0 16 20


Capex (786) (2,561) (3,000) (3,000) (1,500)

(Incr) / decr in investments (457) (2,846) - - -

Others - - - - -


Net borrowings (80) (133) (861) - -


Interest paid (39) (49) (50) (24) (12)

Dividend paid (2,238) (2,888) (3,637) (4,046) (4,971)

Others 1,282 (34) (500) (500) (500)




Free cash flow 5,446 4,069 6,547 7,697 11,424


Ratio Analysis


Gross margin (%) 40.3% 42.4% 42.3% 42.0% 42.3%

EBITDA margin (%) 11.0% 14.1% 14.0% 13.7% 14.0%

EBIT margin (%) 10.3% 14.0% 13.8% 13.1% 13.7%



Net debt: equity (x) (0.4) (0.2) (0.3) (0.4) (0.5)

Working capital days (13) (0) (0) (0) (0)


RoCE (%) 47.0% 50.7% 40.1% 37.5% 38.1%

RoE (%) 53.1% 54.2% 41.1% 37.7% 38.3%


Valuation Parameter


EPS (`) 45.2 68.0 67.3 74.9 92.1

Diluted EPS (`) 45.2 68.0 67.3 74.9 92.1



P/E (x) 63.8 42.4 42.9 38.5 31.4

P/BV (x) 27.7 19.5 15.9 13.2 10.9

EV/EBITDA (x) 39.5 27.9 27.8 24.2 19.9

Price/Sales (x) 4.4 4.0 4.0 3.4 2.9



All negatives priced in

Channel checks indicate cigarettes will be the segment least affected by demonetisation amongst all FMCG categories as it constitutes habit consumption. Sales should normalise from 4QFY17. Our analysis suggests that even in the worst-case scenario of GST at 40% for cigarettes, there would be no downside from the CMP of `242. We reiterate that the only way to curb tobacco consumption in India is to 'gradually' make it unaffordable over a long period. In the longer term, we expect excise duty hike of 9-10% driving volume growth of ~2% YoY and cigarette EBIT growth of 12-13% YoY. Reiterate BUY with a TP of `275 (14% upside).

Competitive position: STRONG Changes to this position: NONE Cigarette would be least affected by the demonetisation

After an initial 30-40% dip in cigarette sales following the demonetisation, our channel checks suggest that sales volumes recovered to pre-crisis levels by early December. ITC’s 80% cigarette market share ensures it is least affected amongst cigarette companies. ITC is leveraging its cigarette scale with distributors to minimise supply chain related impact on its FMCG business too. Tax collection is the larger aim for the Government

Instances of sharp excise duty hikes have been driven by the Government’s intent to garner higher tax collections from cigarettes than to control consumption (click here for our detailed note on 09 Jun 2016). Moreover, tobacco’s contribution to total excise collection has been in a tight band of 10-13% for the last five decades. Over this period, 75-80% of tobacco excise duty was contributed by cigarettes maintaining its relevance as a tool for revenue

ll i ‘Right to win’ in packaged foods; 1% cigarette volume CAGR likely

Given backward integration for raw materials and wide distribution, ITC has a ‘right to win’ in packaged foods and, hence, would grow ahead of Britannia and Nestle over the next 10 years (19% CAGR). Due to prudent capital allocation, ITC would clock RoCE of ~35% over FY16-26. CMP factors in worst case of GST at 40% and demonetisation impact

Even the worst-case scenario of 40% GST on cigarettes with no change in excise duty results in upside of ~3% from the CMP of `242. Hence, the CMP already factors in the worst-case GST scenario. We reiterate that the only way to curb tobacco consumption in India is to 'gradually' make it unaffordable over a long period. In the longer term, we expect excise duty hike of 9-10% to drive volume growth of ~2% YoY and cigarette EBIT growth of 12-13% YoY. Reiterate BUY with a TP of `275 (14% upside).

COMPANY INSIGHT ITC IN EQUITY January 03, 2017

ITC

BUY

Consumer Staples

Recommendation Mcap (bn): `2,814/US$41.7 6M ADV (mn): `2,622/US$38.8 CMP: `242 TP (12 mths): `275 Upside (%): 14


Catalysts

Volume growth of 2-3% in 4QFY17

GST rate of 28% for cigarettes

Performance (%)


70 80 90

100 110 120

Dec

15

Feb

16

Apr

16

Jun

16

Aug

16

Oct

16

Dec

16

ITC Sensex

Research Analysts

Ritesh Vaidya, CFA

+91 22 3043 3246

[email protected]

Anuj Bansal

+91 22 3043 3122

[email protected]

Dhiraj Mistry, CFA

+91 22 3043 3264

[email protected]

Key financials



EBITDA (` mn) 134,736 142,382 150,521 172,638 199,093

EBITDA Margin (%) 36.9% 38.7% 38.8% 38.3% 38.0%

Adjusted PAT (` mn) 96,077 98,447 105,394 119,821 137,172

Adjusted EPS (`) 8.8 9.0 9.7 11.0 12.5

RoE (%) 33.7% 30.9% 30.6% 31.9% 33.3%

P/E (x) 30.2 29.5 27.5 24.2 21.2


http://reports.ambitcapital.com/reports/Ambit_ITC_Goodlongtermvisibilityneartermcatalysts_09Jun2016.pdf

ITC


Least affected by demonetisation; GST concerns priced in After a dip in cigarette sales in the initial 2-3 weeks following the announcement of demonetisation, our channel checks suggest that cigarette volumes almost recovered to pre-crisis levels by early Dec’16. Due to a weak November, we build in cigarette volume decline of only 4% YoY, the lowest in the FMCG space. According to our calculations, even if GST is implemented at 40% we see limited downside from CMP. Volume growth is expected to recover from 4QFY17 with 2-3% CAGR over FY17-20. Cigarette EBIT should record a 12-13% CAGR over the same period.

Habit consumption and market-leading brands to minimise the impact After the demonetisation announcement on Nov 8, 2016, in the initial 2-3 weeks, cigarette sales dipped by 30-40%. However, given that cigarette is a habit-consumption category, consumers used various ways to tide over the liquidity crunch. As several retailers accepted old notes till the end of November, smokers opened an informal account with these retailers by handing them their old currency notes. These consumers were then able to buy cigarettes until they exhausted their balance with the retailer. Our channel checks suggest that cigarette volumes almost recovered to pre-crisis levels by early Dec’16. Given that every smoker has loyalty towards a particular brand, we did not come across instances of downtrading. On the positive side, during our channel checks we found that several illegally imported cigarettes weren’t available as imports have stalled due to unavailability of cash.

ITC’s dominant market share in cigarettes being leveraged for FMCG sales with distributors

As ITC has ~80% market share in the cigarette category, its distributors do not have any option but to stock ITC’s cigarettes even if they are facing capital constraints. ITC uses its cigarette distributors to distribute its FMCG products as well. Leveraging its cigarette category dominance, ITC can ensure that distributors stock its FMCG products as well. Hence, we see limited possibility of supply disruption even for its non-cigarette FMCG business. We expect ITC’s cigarette volumes to decline by 4% YoY and FMCG sales to decline by 5% YoY in 3QFY17.

Exhibit 1: Cigarette volume to decline by 4% YoY in 3QFY17 and recover in 4QFY17


-5%

0%

5%

10%

15%

20%

25%

-20%

-15%

-10%

-5%

0%

5%

10%

Q1FY

13

Q2FY

13

Q3FY

13

Q4FY

13

Q1FY

14

Q2FY

14

Q3FY

14

Q4FY

14

Q1FY

15

Q2FY

15

Q3FY

15

Q4FY

15

Q1FY

16

Q2FY

16

Q3FY

16

Q4FY

16

Q1FY

17

Q2FY

17

Q3FY

17

E

Q4FY

17

E

Cigarette Volume growth YoY % Cigarettes EBIT YoY %, RHS

ITC


No reduction in illegally manufactured cigarettes even under GST

Given that the supply chain from procurement of tobacco from farmers to sale of the cigarette to the retailers is in cash, we believe this supply chain can continue even under GST. Hence, when it comes to market-share gains, we see limited upside for ITC from the illegal cigarette market, even under GST.

Direct farmer sourcing should ensure minimal margin impact post GST

Formalisation of vendors after the implementation of GST is expected to affect the gross margin of several FMCG manufacturers. However, as ITC sources most of its raw material directly from farmers with most of the manufacturing done in-house, ITC’s vendor base is already formalised. As a result, we expect ITC to have negligible margin impact due to formalisation of the vendor base once GST is implemented.

GST: Worst-case scenario of 40% GST and existing excise duty priced in

We analysed various GST rate scenarios. Even the worst-case scenario of 40% GST for cigarettes with no change in excise duty results in upside of ~3% from CMP. Hence, CMP of `242 already factors in the worst-case GST scenario.

Exhibit 2: Even in the worst-case scenario of GST we expect ~10% cut to our EPS estimates, leaving upside of ~3%

(`) GST @ 40% + reduction in excise duty to have tax neutral impact GST @ 40% + current excise structure

Target Price 275 250

Upside/(Downside) 22% ~3%

Comments - FY18 EBIT growth will be 13-14% YoY - FY18 EBIT will be flat YoY

- Factor in a normal 9-10% YoY price hike FY18 onwards - Will have to take a price hike of 11-12% in FY18 to offset GST impact; expect 9-10% price hike FY19 onwards

- Expect volume growth of ~2% YoY - Despite the 11% price hike, we factor in 0-1% volume growth for FY18


Relative outperformer in the near term; reiterate BUY

As per our calculations, even in the worst case there would be no downside from CMP. If GST is set at 28% for cigarettes with no cess, it would also signal the Government’s longer-term intent on cigarette taxation. We reiterate that the only way to curb tobacco consumption in India is to 'gradually' make it unaffordable over a long period. In the longer term, we expect excise duty hike of 9-10% driving volume growth of ~2% YoY and cigarette EBIT growth of 12-13% YoY. Reiterate BUY with a TP of `275 (14% upside).

ITC


Risks to our BUY stance Sharper-than-expected volume decline over 2HFY17: While we expect cigarette sales to be almost flat for 2HFY17, a sharper-than-expected volume decline due to demonetisation can negatively surprise us.

Overall GST for cigarettes at >40%: Even in the worst case, we expect cigarette GST to come in at 40%. However, a tax rate of >40% or with a larger ad valorem component than the existing proportion will be negative to our estimates.

Catalysts Volume growth in 4QFY17: ITC should deliver 2-3% YoY volume growth for 4QFY17. We believe volume growth will be a positive catalyst for the stock.

Cigarette GST rate at 28%: If the final cigarette GST rate is set at 28%, it will be a significant positive catalyst for the stock.

Ambit vs consensus Exhibit 3: Our estimates vs consensus for FY17/18/19


FY17E


EBITDA (` mn) 150,521 151,428 -1% We expect higher margin due to recent price hike


FY18E

Net Sales (` mn) 450,259 458,328 -2% We are marginally behind of consensus

EBITDA (` mn) 172,638 172,234 0% In line with consensus


FY19E

Net Sales (` mn) 523,534 513,598 2% We are marginally ahead of consensus

EBITDA (` mn) 199,093 196,086 2% We are marginally ahead of consensus

EPS (`/share) 11.4 11.5 -1% We are marginally behind of consensus




Accounting GREEN The company in the past has shown high levels of cash conversion and efficient working capital management. It is also professionally managed.

Predictability GREEN The company has high pricing power in its cigarettes business and has consistently seen margin expansion in the segment. Further, FMCG losses are declining and hence, visibility of earnings is very high.

Earnings Momentum RED We have cut our EPS estimate by 5% due to the impact of demonetisation.


ITC


Balance Sheet




Total networth 307,357 329,290 359,046 392,875 431,603


Debt 387 294 294 294 294



Gross block 217,270 226,478 243,174 262,621 285,416

Net block 141,785 142,045 147,459 154,453 163,407

CWIP 21,141 25,008 25,008 25,008 25,008

Goodwill - - - - -

Investments 84,055 128,542 128,542 128,542 128,542


Debtors 17,224 16,864 17,760 20,612 23,966

Inventory 78,368 85,198 89,727 104,137 121,084

Loans & advances 20,563 27,873 29,354 34,069 39,613




Provisions 62,068 84,308 88,789 103,049 119,818



Total assets 324,060 348,069 377,824 411,654 450,381


Income statement



% growth 9.8% 0.9% 5.3% 16.1% 16.3%


EBITDA 134,736 142,382 150,521 172,638 199,093

% growth 9.6% 5.7% 5.7% 14.7% 15.3%

Depreciation 9,617 10,345 11,282 12,453 13,842

EBIT 125,118 132,038 139,239 160,185 185,251



Adjusted PBT 139,975 149,584 159,688 181,547 207,836

Tax 43,898 51,137 54,294 61,726 70,664


% growth 11.8% 2.5% 7.1% 13.7% 14.5%





ITC


Cash Flow statement


EBIT 140,549 150,075 160,188 182,047 208,336

Depreciation 9,617 10,345 11,282 12,453 13,842

Others 2,772 1,677 (500) (500) (500)

Tax (43,898) (51,137) (54,294) (61,726) (70,664)

(Incr) / decr in net working capital 10,696 14,360 700 2,227 2,619


Capex (29,459) (14,472) (16,696) (19,447) (22,795)

(Incr) / decr in investments 4,180 (44,488) - - -

Others - - - - -


Net borrowings (124) (93) - - -


Interest paid (574) (491) (500) (500) (500)

Dividend paid (59,990) (81,816) (75,638) (85,992) (98,444)

Others 9,223 5,793 500 500 500




Free cash flow 90,278 110,848 100,680 115,054 130,838


Ratio Analysis


Gross margin (%) 59.8% 62.8% 61.3% 61.3% 61.0%

EBITDA margin (%) 36.9% 38.7% 38.8% 38.3% 38.0%

EBIT margin (%) 34.3% 35.8% 35.9% 35.6% 35.4%



Net debt: equity (x) (0.5) (0.6) (0.6) (0.6) (0.6)

Working capital days 1.2 (13.0) (13.0) (13.0) (13.0)


RoCE (%) 32.1% 29.4% 29.1% 30.4% 31.9%

RoE (%) 33.7% 30.9% 30.6% 31.9% 33.3%


Valuation Parameter


EPS (`) 8.8 9.0 9.7 11.0 12.5



P/E (x) 30.2 29.5 27.5 24.2 21.2

P/BV (x) 10.3 9.2 8.5 7.8 7.1

EV/EBITDA (x) 20.5 19.2 18.0 15.5 13.3

Price/Sales (x) 8.0 7.9 7.5 6.5 5.6



Color of the season is red

We like Asian Paints given: 1) leading brand and market share (55%); 2) efficient supply chain (<20 days working capital and 1-2 day order-to-delivery cycle); and 3) strong dealer and painter reach/connect (2.5x that of Berger). However, deferrable nature and high ticket size expose paints to demonetisation disruption in the medium term. Rising raw material prices amid the weak demand pose risks to peak margins. The perfect storm of falling sales (10% decline for 2HFY17E-1HFY18E), declining gross margin (-260bps over FY16-19E) and peak valuations (45x FY18E; 15% premium to 5-year average) make us SELLers. Key risks: Strong market share gain and reversal in crude price trends.

Competitive position: STRONG Changes to this position: POSITIVE Adverse category dynamics will overshadow internal strengths

Paints would be severely impacted given high ticket size, deferrable nature of projects, negative wealth effect, and slowdown in real estate development/transactions. Asian Paints should gain share by riding on its inherent strengths (branding, distribution and premium product mix) but not enough to offset demand decline. We expect a double-digit sales decline over 2HFY17-1HFY18. Lengthy run of margin gain set to reverse

Asian Paints had a prolonged margin gain trajectory, with GM up 720bps and EBITDA margin up 240bps since FY12, given: 1) weak input cost as prices of crude and rutile (a key raw material) declined; 2) premiumisation; 3) operating efficiencies. With crude up 70% since Jan’16 and limited ability to exert pricing power or drive premiumisation amid weak demand, margins would decline over FY16-19E (GM down 260bps and EBITDA margin down 80bps). Long-term positives are intact; we look for bottom to turn positive

Asian Paints’ superior business model built on 1) consumer connect by branding and innovative products, and 2) dealer/painter connect by lowering capital requirement (timely fulfillment and color-tinting machines reducing stocks) remains intact. However, we await sustained sales recovery, bottoming of margins and/or lower valuations before turning positive. Expensive in the current environment

At 45x FY18E P/E, the stock trades at a 23% premium to FMCG sector and 180% premium to global peers. Strong sales/EPS CAGR of 15%/16% over last 5 years and robust business model have driven the re-rating. However, given weaker sales/EPS growth and lower return ratios vs FMCG, the premium is not justified. Compared to global peers, Asian Paints has structurally higher growth but with weaker return ratios. We believe a de-rating for Asian Paints is warranted. Our DCF-based TP of `800 implies FY18E P/E of 40x.

COMPANY INSIGHT APNT IN EQUITY January 03, 2017

Asian Paints

SELL

Consumer Discretionary

Recommendation Mcap (bn): `855/US$12.6 6M ADV (mn): `1,319/US$19.4 CMP: `891 TP (12 mths): `800 Downside (%): 10


Catalyst

• Sales decline of ~10% in 2HFY17E

• Margin pressure from rising raw material costs

Performance (%)


70

90

110

130

150

Dec

15

Feb

16

Apr

16

Jun

16

Aug

16

Oct

16

Dec

16

APNT Sensex

Research Analysts

Anuj Bansal

+91 22 3043 3122

[email protected]

Ritesh Vaidya, CFA

+91 22 3043 3246

[email protected]

Dhiraj Mistry, CFA

+91 22 3043 3264

[email protected]

Key financials


Net Sales 141,828 155,341 153,648 173,399 199,721

EBITDA 22,354 28,086 28,081 29,490 34,512

EBITDA (%) 16% 18% 18% 17% 17%

EPS (`) 14.8 18.5 18.7 19.8 23.8

RoCE (%) 31% 33% 29% 28% 31%

RoE (%) 32% 34% 30% 29% 32%

P/E (x) 60.1 48.0 47.8 45.0 37.4


Asian Paints


Demand uncertainty could last longer than expected We like Asian Paints as a business for its leading brands, innovative products and superior supply chain. However, we believe there are near-term threats like demand suppression due to the demonetisation and rising input costs with limited pricing power over the next 12 months which are not fully priced in (valuations remain 12% above the last five-year average). Hence, a double whammy of earnings downgrades and multiple de-rating is a possibility which has prompted us to rate the stock as SELL.

Near-term growth visibility remains clouded Paints is the most discretionary, deferrable consumption and the highest-ticket category in our coverage. We believe the near-term lack of liquidity will force consumers to defer their painting plans. In the medium term, negative wealth effect for a certain section of consumers and slowdown in new house construction will hurt demand recovery. We are building in a 1% sales decline in FY17 (implying 12% decline in 2HFY17) and a recovery in FY18 with 12.9% sales growth. The recovery will be largely back-ended due to a gradual pick-up in demand and low base effect.

Severe near-term impact due to discretionary nature of the category

Our channel checks suggest a sharp drop in demand for paints post demonetisation. While there have been pockets of high demand as consumers rushed to place large orders to utilise their old notes, but overall there has been a sharp slowdown in demand. Cash-based purchases by painters form a large proportion of sales in the industry and the lack of currency has been severely hit with home owners deferring their painting plans.

Negative wealth effect could delay the recovery

There is a certain section of consumers which would have suffered loss of wealth (at least to some extent) due to the demonetisation. These would generally be affluent consumers, who are among the key drivers of painting demand at the higher end. Loss of wealth could force some of these consumers to defer their home renovation and painting projects until their economic situation and the sentiment improve.

Weakness in real estate and new home development will also hit demand

Real estate has been one of the most affected sectors of the Indian economy post-demonetisation. There is a high cash component in the sale and purchase of real estate in India. Lack of cash has stalled transactions and until the economy is remonetised this will remain a problem. For Asian Paints, painting of new homes by builders forms only a small proportion of sale (less than 15%) due to its premium positioning. However, most new home buyers (who prefer Asian Paints given its branding) tend to renovate and paint their homes after purchase. This demand will be severely affected as a result of stalled real estate transactions.

Asian Paints


Exhibit 1: Asian Paints’ quarterly sales growth

Source: Ambit Capital research; revenue from Mar’15 is as per Ind AS

Exhibit 2: Asian Paints’ sales growth trends


Rising crude and falling INR will sharply hit margins We expect a sharp hit on gross margins (260bps over FY16-19E) due to rising input costs as Asian Paints will not be able to pass on the increase to consumers due to the weak demand situation. Margins benefited by 490bps during the sharp fall in oil prices over FY14-16. A large part of this margin gain should reverse as crude prices start rising. The other key raw material, TiO2 (Rutile or titanium dioxide), has also been witnessing a sharp price correction due to rapid capacity addition in China. However, certain industry reports (https://goo.gl/ig9FrS) suggest that further capacity addition looks difficult with demand likely to grow at 4% per annum. This could lead to a reversal in price trends for TiO2 as well.

Exhibit 3: Asian Paints’ 20% COGS is sensitive to currency fluctuation


Exhibit 4: Asian Paints’ 43% COGS is sensitive to crude


Pricing power will be limited due to the current demand weakness

Asian Paints has managed to keep profit margins in a reasonably tight band by passing on input cost inflation to consumers. Also, as wage inflation has significantly outpaced paint price inflation over the years (over 10% wage inflation vs 4-5% paint price inflation), the proportion of paint cost in the overall painting job declined to 35-40% from over 50%. This has reduced the sensitivity of consumers to price inflation for Asian Paints. However, given weak demand is likely to persist in the medium term, we believe Asian Paints may not be able to pass on input cost inflation to customers.

-20%-15%-10%-5%0%5%10%15%20%

30,000

32,000

34,000

36,000

38,000

40,000

42,000

44,000Se

p'1

4

Dec

'14

Mar

'15

Jun'

15

Sep'

15

Dec

'15

Mar

'16

Jun'

16

Sep'

16

Dec

'16E

Mar

'17E

Revenue (Rs. Mn) Revenue growth (RHS)

-5%

0%

5%

10%

15%

20%

25%

30%

60000

90000

120000

150000

180000

210000

240000

FY10

FY11

FY12

FY13

FY14

FY15

FY16

FY17E

FY18E

FY19E

FY20E


Imported, 20%

Indigenous, 80%

Crude linked, 43% Non-crude

linked, 57%

https://goo.gl/ig9FrS

Asian Paints


Exhibit 5: Gross margin of Asian Paints over FY07-16


Exhibit 6: WTI crude prices over FY06-16 (USD per barrel)


Rise in procurement or distribution costs seems unlikely

On a positive note, Asian Paints deals directly with its entire supply chain (suppliers and dealers) in a transparent manner. Hence, a rise in procurement or distribution costs to support the channel due to increased cost of doing business seems unlikely.

30%

35%

40%

45%

50%

FY07

FY08

FY09

FY10

FY11

FY12

FY13

FY14

FY15

FY16

Gross margin

020406080

100120140160

Dec

-06

Dec

-07

Dec

-08

Dec

-09

Dec

-10

Dec

-11

Dec

-12

Dec

-13

Dec

-14

Dec

-15

Dec

-16

Crude

Asian Paints


We will turn positive when long-term growth starts playing out again Asian Paints has created a superior business model through: 1) consumer connect by branding and innovative products; and 2) dealer/painter connect by lowering capital requirement (timely fulfillment and colour tinting machines reducing stocks) remains intact. This will not only support Asian Paints’ long-term structural growth, but also, even in the near term, it should gain share from peers who will be affected more by demonetisation and GST. We will wait for demand to stabilise, margins to bottom out and/or valuation to price in near-term earnings weakness before turning positive.

Positives from demonetisation + GST Supply constraints are not an issue and can actually help gain share

Paint companies with sales skewed towards mid-to-lower end brands have a higher wholesale component (15-20% of sales) and are being affected by the channel disruption. Supply constraints due to disruption of the wholesale channel faced by other paints and FMCG companies will not affect Asian Paints as it distributes its products directly to dealers and dependence on intermediary/indirect channels is minimal.

Another factor helping Asian Paints is the tendency of dealers in times of demand distress to push sales of one company to collate demand under one umbrella, achieve volume targets and get incentives. Given that Asian Paints has a dominant market share, a strong brand and a better trade incentive structure, it tends to become the company of choice for most dealers in this scenario. This helps Asian Paints gain share and offset some of the industry-wide weakness in demand.

Shift from informal to formal branded sector is the strongest in paints

Paints is best placed to benefit from the shift in market share from unorganised to organised. Some of the key enablers are:

Supply chain will have to become formal post GST: Several raw materials (Rutile, mineral oil, chemicals) for a paints company have to be either imported or are industrial products. After the implementation of GST, these will be captured on the GST network and, hence, under-reporting of procurement by unorganised players will become difficult.

Price gap between organised and unorganised: Our channel checks suggest that the price gap between local players and entry-level products of branded players is less than 25%. Hence, any price hikes by unorganised players to compensate for higher cost of doing business can sufficiently narrow the price gap for consumers to upgrade and, thereby, hasten the shift to branded players.

Brand becoming increasingly important for customers: Painting is a high-ticket project and is reasonably cumbersome. These factors make consumers highly conscious of the product they use, making choice of brand an important factor. Hence, if the price gap between higher-end and lower-end products is not favourable, the possibility of upgrading is high.

Inorganic growth opportunities could arise

One opportunity that is not yet factored in is the possibility of Asian Paints expanding into home interiors and home building. Given the high likelihood of stress in these categories, there is a possibility that Asian Paints might get an opportunity to acquire a high quality branded business at a reasonable valuation. While we prefer Asian Paints to remain focused on its core business of paints that still has a long, strong growth ramp, an upside to our estimates from such inorganic growth is a possibility.

Asian Paints


Business model remains strong We continue to like the business model and strong competitive advantages that Asian Paints has built, including: 1) an unrivaled supply chain; 2) customer connect and brand; 3) dealer relationships enhanced by lower capital requirements through tinting machines and best-in-class fulfillment rates; and 4) being the preferred brand for painters. Hence, we look forward to improved visibility on earnings growth and moderation in valuation before turning positive on the stock.

Competitive advantages of branding and supply chain remain strong

Brand: Asian Paints has cut A&P spends sharply in the near term to cushion near-term margin impact while peers like Kansai Nerolac are maintaining aggressive spending. Despite this divergence, we believe Asian Paints would retain its preferred brand status with home owners, painters and dealers given the strength of the brand built over several decades.

Supply chain: Unlike other consumer companies, Asian Paints has a robust supply chain entirely controlled by the company. Formal sourcing of raw material, fully owned and operated manufacturing and logistics, and direct distribution to end-consumer-facing dealers place Asian Paints in a unique position in terms of control over the supply chain. This implies minimal impact of the GST and demonetisation on the company.

Exhibit 7: Comparing Asian Paints on IBAS framework

Asian Paints

Berger Paints

Kansai Nerolac

Akzo Nobel Comments

Innovation

Asian Paints has regularly innovated around products by staying close to its customers

Empowerment of professionals to take control of middle and senior management as early as 1969

Attempting a transition from a products company to a services company (home décor company)

Brand

Asian Paints has consistently maintained its focus on advertising from as early as the 1950s

Asian Paints’ advertising expense is 1.3x of summation of other 3 competitors

Architecture

Nurtured professional talent in a unique work culture by rapid career progression for those who perform, allowing creativity

Proactive investments in technology Independent board of directors are high quality professionals with relevant

experience

Strategic asset

Asian Paints has created a network of factories and depots across the country with 8 factories, 6 regional distribution centres and 125 depots

Deep rooted relationships with >35,000 dealers

Overall


Market share: Gap with competition should widen

Asian Paints remains the number one paints brand in India with 53% value share in decorative paints. We expect this gap with peers to widen as:

Dealers rally behind the market leader: During distressed demand multi-brand dealers tend to consolidate behind the market leader to meet volume-based incentive targets. Since they believe meeting targets of multiple brands will be difficult, they try to push demand towards the brand they believe has the best chance to aggregate demand and help them achieve the target for at least that particular brand. Asian Paints gains disproportionate share in such a scenario.

Higher share of premium products: For Asian Paints, premium paints account for 40% of sales. This segment is least price sensitive and would be resilient in the weak demand environment. Peers (e.g. Berger) that have a higher share of the lower-end market are likely to be hit harder and, hence, could lose market share.

Asian Paints


Exhibit 8: Asian Paints gained market share from Kansai Nerolac and Akzo Nobel during 1997-2015

Source: Industry, Ambit Capital research.

When would we turn positive on the stock?

We would look to turn positive on Asian Paints if: 1) recovery in sales growth appears sustainable; 2) margins bottom out and impact from raw material cost inflation is factored in; and/or 3) valuation starts pricing in the near-term headwinds. We would also monitor the M&A activity carried out by the company as we expect Asian Paints to actively scout for inorganic growth opportunity with the aim of buying out good quality assets at lower valuations given near-term distress. However, in our view, the historical acquisitions of Sleek and Ess Ess have been suboptimal utilisation of capital by Asian Paints. Issues that we see in these businesses are: 1) difficulty in achieving scalability and dominant market share; 2) lack of synergies with the core Paints business; and 3) difficulty in replication of competitive advantages that Asian Paints has built in its core category of paints.

38% 38% 37% 39% 41% 43% 44% 44% 43% 43% 44% 47% 51% 52% 52% 51% 51% 52% 53% 53% 13% 13% 14% 14% 15% 16% 16% 17% 18% 18% 18% 18% 18% 17% 17% 17% 17% 17% 17% 17% 18% 18% 17% 17% 18% 18% 18% 19% 19% 19% 19% 18% 16% 17% 18% 17% 16% 16% 16% 16% 27% 27% 28% 26% 23% 19% 17% 17% 16% 16% 14% 13% 11% 10% 9% 13% 13% 12% 12% 12%

5% 4% 4% 4% 4% 4% 4% 3% 4% 4% 4% 4% 4% 4% 3% 3% 3% 2% 2% 2%

0%

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19

97

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98

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99

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11

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13

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14

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15

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16

Shalimar Paints

Akzo Nobel

Kansai Nerolac

Berger Paints

Asian Paints

Asian Paints


Summary of our key assumptions and estimates Exhibit 9: Key assumptions and estimates (` mn) FY15 FY16 FY17E FY18E FY19E Comments

Profit and Loss

Consolidated revenue 141,828 155,341 153,648 173,399 199,721 Factors in lower growth for FY17/18 due to higher impact on volume growth on the back of demonetisation and implementation of GST in FY18

Consolidated revenue growth 11.5% 9.5% -1.1% 12.9% 15.2% Gross Profit 62,114 73,286 71,870 78,172 89,036 Gross margins 43.8% 47.2% 46.8% 45.1% 44.6% Factors in lower gross margins over FY17-19 given the

sharp depreciation in the rupee and crude impact Salaries and wages as a % of sales 6.4% 6.6% 6.7% 6.5% 6.5% We expect employee expenses to remain stable

Freight & Handling (% of sales) 5.0% 5.2% 5.1% 5.0% 4.8% We expect lower freight expenses due to supply chain efficiency and GST implementation

Advert & Publicity (% of sales) 5.2% 5.8% 5.2% 5.2% 5.2% We expect A&P expense to remain stable

Cash discount (% of sale) 4.0% 4.0% 4.0% 4.0% 3.9%

Others as a % of sales 7.4% 7.5% 7.5% 7.4% 6.9% We expect higher operating efficiency due to scale benefits

EBITDA 22,354 28,086 28,081 29,490 34,512 EBITDA Margins 15.8% 18.1% 18.3% 17.0% 17.3% Lower gross margin to flow through EBITDA margin

Tax rate 30.9% 31.7% 31.0% 31.0% 31.0% We expect stable tax rates

Net Profit Margins 9.8% 11.1% 11.6% 11.0% 11.4% Balance Sheet

Capex (` mn) 2,043 10,464 6,000 2,000 2,000 We expect phase-wise capex of `40bn for Karnataka and Andhra Pradesh plants over the next 12 years Capital work in progress (` mn) 1,960 1,108 1,000 1,000 1,000

Working Capital Days 18 16 15 19 19 We expect working capital days to worsen marginally

Debtor days 29 29 30 28 28 We expect debtor days to stabilise at 30 days

Creditor days 67 63 67 63 62 We expect creditor days to worsen marginally

Inventory days 56 51 54 55 54 We expect inventory days to worsen marginally.

Net debt to equity 0.0 (0.0) (0.0) (0.1) (0.2) Expect higher cash accumulation over FY17-19

Cash Flows (` mn)

Operating cash flows 11,877 23,333 17,537 22,592 26,280 Expect healthy free cash flow generation over FY17-19

Free cash flows 7,501 15,274 11,645 20,592 24,280


Perfect valuations pricing in an imperfect environment Asian Paints is the most affected stock in our coverage universe by the near-term disruption caused by the demonetisation given paints companies would be most affected by the demand suppression. Additionally, the sensitivity to increase in crude oil prices and INR depreciation is also highest. Asian Paints does deserve a rich multiple for its dominant market share in a fast growing segment and its competitive moats. However, at 44x FY18E P/E (10% premium to the historical five-year average), the stock is expensive even if we factor in the strong business model. Our DCF-based TP of `800/share (10% downside) implies FY18E P/E of 40x. We believe, there will be a series of earnings downgrades over the next few quarters. This could lead to a double whammy of lower earnings and potential de-rating and could provide good entry points.

Our WACC assumptions for the DCF are summarised in the exhibit alongside. Our cash flow and return estimates are shown in the exhibits below.

WACC Computation

Item %

Risk-free rate of return 8.2


Risk Premium 7

Cost of Equity 13

Cost of Debt 12

Debt/Equity 0

Corporate Tax Rate 30

WACC 13.0


Asian Paints


Exhibit 10: Asian Paints’ cash flow profile


Exhibit 11: Asian Paints’ return profile


Exhibit 12: Asian Paints’ one-year forward P/E


Exhibit 13: Asian Paints’ one-year forward EV/EBITDA


-

10,000

20,000

30,000

40,000

50,000

FY12

FY13

FY14

FY15

FY16

FY17E

FY18E

FY19E

FY20E


25%

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40%

0%

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30%

FY11

FY12

FY13

FY14

FY15

FY16

FY17

E

FY18

E

FY19

E

FY20

E

Revenue growth EPS growth

EBITDA margin RoCE (RHS)

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30

40

50

60

70

Jan-

12

May

-12

Sep-

12

Jan-

13

May

-13

Sep-

13

Jan-

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May

-14

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Jan-

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May

-15

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15

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-16

Sep-

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15

25

35

45

Jan-

12

May

-12

Sep-

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Jan-

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May

-13

Sep-

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14

May

-14

Sep-

14

Jan-

15

May

-15

Sep-

15

Jan-

16

May

-16

Sep-

16


+1 s.d. -1 s.d.

Asian Paints


Risks Lower-than-expected demand suppression: Buoyancy in the external

environment, better internal activation or higher market-share gain could lower the impact of demand weakness on sales. This would not only pose upside risks to our estimates but also sustain valuation multiples due to renewed confidence in Asian Paints’ business model.

Reversal in crude oil prices: If crude prices fall, margin pressure on Asian Paints might not materialise to the extent that’s currently built into our estimates.

Catalysts Sales decline in the near term: We are building in an 11% sales decline in

2HFY17 and a 10% decline in 1HFY18. This could lead to a series of earnings downgrades and a de-rating as the aura of invincibility which has kept the stock at such elevated valuations could be hurt.

Margin pressure from rising raw material costs: We believe Asian Paints’ margins will remain under pressure if crude prices keep rising. The margin trajectory of the company has been strong over the last few years; we believe peak margins are not sustainable in the current environment of depressed demand and rising input costs.



FY17E


EBITDA (` mn) 28,081 31,968 -12% We expect higher margin impact due to crude impact and INR depreciation

EPS (`/share) 18.7 21.4 -13% EBITDA growth flow through EPS

FY18E

Net Sales (` mn) 173,399 193,529 -10% We expect higher impact of GST than consensus



FY19E

Net Sales (` mn) 199,721 225,985 -12% We expect slower recovery in volume growth than consensus






Accounting GREEN Asian Paints scores well on cash conversion, related-party advances and return on surplus cash; its working capital cycle, RoE and provisions for debtors outstanding for more than six months are better than those of peers.

Predictability GREEN Predictability of earnings remains high for Asian Paints given: (a) high correlation of industry volume growth rate with GDP; (b) strong correlation of raw material costs with crude and foreign exchange rates; and (c) market-share changes across players in the industry.

Earnings Momentum RED Consensus has cut EPS estimates for Asian Paints since last earnings release due to the likely impact of the demonetisation.


Asian Paints


Balance Sheet




Total networth 47,424 56,053 63,284 68,819 75,931

Minority Interest 2,637 2,942 3,552 4,254 5,061


Debt 4,099 3,060 3,060 3,060 3,060



Gross block 41,123 51,105 57,105 59,105 61,105

Net block 26,600 34,031 36,642 34,994 33,216

CWIP 1,960 1,108 1,000 1,000 1,000

Investments 15,878 20,982 20,982 20,982 20,982


Debtors 11,799 12,483 12,629 14,252 16,415

Inventory 22,585 20,640 24,415 27,554 31,736

Loans & advances 5,404 4,683 5,051 5,701 6,566




Provisions 7,591 8,877 7,156 8,076 9,302




Total assets 55,959 64,231 72,072 78,309 86,227


Income statement



Growth (%) 11.5 9.5 -1.1 12.9 15.2


Operating profit 22,354 28,086 28,081 29,490 34,512

Growth (%) 11.9 25.6 0.0 5.0 17.0

Depreciation 2,659 2,880 3,388 3,648 3,778

EBIT 19,695 25,207 24,692 25,842 30,734



Adjusted PBT 21,045 26,809 26,815 28,557 34,245

Tax 6,495 8,491 8,313 8,853 10,616


Growth (%) 14 26 1 6 20

Prior Period Items - - - - -







Asian Paints


Cash Flow statement


EBIT 21,392 27,214 27,161 28,903 34,591

Depreciation 2,683 2,880 3,388 3,648 3,778

Others (1,367) (1,124) - 0 0

Tax (6,329) (8,154) (8,313) (8,853) (10,616)

(Incr)/decr in net working capital (4,502) 2,517 (4,700) (1,106) (1,474)


Capex (4,377) (8,059) (5,892) (2,000) (2,000)

(Incr)/decr in investments 306 (832) - - -

Other income (expenditure) 816 847 - - -

Others (1,523) (648) - - -


Net borrowings 1,531 (1,139) - - -


Interest paid (345) (401) (346) (346) (346)

Dividend paid (6,947) (7,642) (10,661) (13,467) (15,711)

Others - - - - -


Net change in cash 1,339 5,460 638 6,780 8,222


Free cash flow 7,501 15,274 11,645 20,592 24,280


Ratio Analysis

Year to March (%) FY15 FY16 FY17E FY18E FY19E

EBITDA margin (%) 15.8% 18.1% 18.3% 17.0% 17.3%

EBIT margin (%) 15.1% 17.5% 17.7% 16.7% 17.3%



Net debt: equity (x) 0.0 (0.0) (0.0) (0.1) (0.2)



RoCE (%) 31.4% 32.7% 28.9% 27.8% 30.6%

RoIC (%) 34.7% 34.9% 30.9% 31.2% 37.6%

RoE (%) 32.4% 34.4% 30.0% 28.8% 31.5%


Valuation Parameter


EPS (`) 14.8 18.5 18.7 19.8 23.8

Diluted EPS (`) 14.8 18.5 18.7 19.8 23.8



P/E (x) 60.1 48.0 47.8 45.0 37.4

P/BV (x) 18.0 15.2 13.5 12.4 11.3

EV/EBITDA (x) 35.7 28.5 28.1 26.3 22.4

EV/EBIT (x) 40.1 31.5 31.6 29.7 24.8



Can postpone this paint job

The decorative paints growth story over the next two decades remains intact. However, in the near term, paints would be the most impacted segment of the consumer sector given large ticket size and ease of postponement of demand. Berger’s sales/PAT should decline by 5%/10% over the next 12 months vs 9%/44% growth in the past 12 months. The recent 12% increase in crude prices and INR depreciation pose further headwinds to margins in the next 12 months. Consensus is yet to factor in this slowdown, so we expect 5-10% earnings downgrades. Beyond the near-term risks, Berger would gain market share from unorganised players under GST. We expect 15%/23% CAGR in sales/PAT with RoE rising from 24% to 29% over FY17-20.

Competitive position: STRONG Changes to this position: NO CHANGE Paints to be the worst affected consumer category in the near term

The demonetisation would affect paint demand over the next 12 months given: a) high ticket size of projects; b) ease of postponement of demand; and c) negative wealth effect. So, Berger would record ~15% YoY sales decline in 2HFY17 and almost flat sales in 1HFY18. Note that the deceleration is a category phenomenon and not specific to Berger. Berger has competitive advantages in supply chain, work culture and prudent capital allocation. Initiatives to improve HR processes and work culture… Since 2011, Berger has made changes like streamlining sales hiring and performance measurement across the country, removing sales sluggishness by hiring younger, more agile personnel and altering incentive structures. These, combined with a long list of operational initiatives pioneered by Berger, have helped significantly improve the work culture. …would help improve market share and margins

With those initiatives, Berger would gain ~150bps market share from Kansai and Akzo Nobel over FY17-20. The firm’s gross margin differential against Asian Paints has already narrowed from >500bps until FY10 to <270bps in FY16. EBITDA margins would expand by ~100bps over FY17-20 as investments in employees, marketing initiatives and operational efficiencies start delivering. Category slowdown to limit upside potential over the next 12 months

Headwinds such as the demonetisation and rising input costs could result in sales/PAT decline of 5%/10% over next 12 months. Nevertheless, given the longevity of growth of decorative paints, category revenue would post CAGR of 13.5%/11% over FY15-25/FY25-35, with Berger recording 12.5%/15% CAGR due to its focus on improving its supply chain and better marketing to drive premiumisation.

COMPANY INSIGHT BRGR IN EQUITY January 03, 2017

Berger Paints

SELL

Consumer Discretionary



Catalysts

Sales decline in the near term

Margin pressure from rising raw material costs

Performance (%)


70

120

170

220

Dec

15

Feb

16

Apr

16

Jun

16

Aug

16

Oct

16

Dec

16

BRGR Sensex

Research Analysts

Ritesh Vaidya, CFA

+91 22 3043 3246

[email protected]

Anuj Bansal

+91 22 3043 3122

[email protected]

Dhiraj Mistry, CFA

+91 22 3043 3264

[email protected]

Key financials Year to March FY15 FY16 FY17E FY18E FY19E

Net Revenues (` mn) 43,221 46,341 45,527 51,786 60,000

Operating Profits (` mn) 5,107 6,554 6,722 7,405 9,000

Net Profits (` mn) 2,647 3,698 3,953 4,474 5,619

Diluted EPS (`) 2.7 3.8 4.1 4.6 5.8

RoE (%) 22.2% 27.0% 24.4% 24.0% 26.6%

P/E (x) 77.4 55.4 51.8 45.8 36.5

P/B (x) 11.6 9.9 11.7 10.4 9.1


Berger Paints

January 03, 2017 Ambit Capital Pvt. Ltd. Page 145

Weak macro to impact sales/PAT growth over next 12 months Demand in the paints category would be affected by demonetisation due to: a) high ticket size of paint projects; b) ease of postponement of demand; and c) negative wealth effect. We do not expect supply chain issues in the paints category as paint companies directly service all their dealers with payments through the electronic/cheque mode. The 10% rise in crude oil prices over the last month should limit EBITDA margin expansion to only 60bps YoY for FY17 despite ~200bps margin expansion in 1HFY17. While demonetisation is a near-term disruptor, organised paint companies can potentially gain market share from unorganised players due to the implementation of the GST. Over the next 12 months, demand headwinds will impact sales/PAT growth of Berger, resulting in 5%/10% YoY decline in sales/PAT.

Near-term pain but long-term gain from GST Paints is the most discretionary, deferrable consumption and the highest ticket-size category within our coverage. In the near term, lack of liquidity will force consumers to defer their painting activity. In the medium term, negative wealth effect for a certain section of consumers and slowdown in new house construction will hurt demand recovery. Our channel checks suggest a sharp drop in demand for paints post-demonetisation. While there have been pockets of high demand where consumers rushed to place large orders to utilise their old notes, the over-arching trend has been that of a sharp slowdown in demand.

When in doubt prefer the leaders

During our paint dealer checks post demonetisation, we were told that when demand is weak (down 25-30% YoY) as has been the case over the last 6 weeks, they usually prefer pushing sales of market-leading companies like Asian Paints or Berger Paints. This helps them achieve annual sales incentives for at least these companies. Pushing sales of smaller brands or unorganised players isn’t feasible despite the higher margins offered by these companies. As a result, demonetisation could result in market-share gains for leaders like Asian Paints and Berger Paints.

Margins to be hit the hardest by rising crude and falling INR

Due to the 10% rise in crude oil prices over the last month, gross margin expansion of ~380bps YoY in 1HFY17 would not continue into 2HFY17. The EBITDA margin would expand by only 60bps YoY for FY17 despite ~200bps margin expansion in 1HFY17. Historically, paint companies have passed on input cost inflation to consumers through commensurate price hikes. However, the current weak consumer demand scenario will limit their ability to take price hikes. Hence, we should see EBITDA margin compression over the next 12 months.

Shift of informal to formal branded sector due to GST strongest for paints

The shift in share from unorganised to organised will be felt the most in the paints category, given:

Supply chain will have to formalise post GST: Several raw materials (Rutile, mineral oil, chemicals) have to be either imported or are industrial products. Post GST implementation, these will be captured on the GST Network and hence under-reporting of procurement by the unorganised segment will be difficult.

Low price gap between organised and unorganised: Our channel checks suggest that the price gap between local products and entry-level products of branded players is less than 25%. Hence, any price hikes by unorganised players to compensate for higher cost of doing business can narrow the price gap enough for consumers to upgrade, thereby hastening the shift from unbranded to branded players.

Berger Paints


High involvement and aspirational nature make brand important: Painting is a big-ticket project and is reasonably cumbersome, which make consumers cautious of the product they use. Brand is, therefore, important and if the price gap between a higher-end and a lower-end product is not favourable, the possibility of upgrading is high.

Long-term growth potential intact; Berger is well-placed to grow ahead of the market Despite the near-term concerns around the impact of GST and demonetisation, the long-term growth prospects of the decorative paints category remain in place. Due to the longevity of growth of decorative paints, we expect category growth of 13.5%/11% CAGR over FY15-25/FY25-35.

We have identified six drivers of competitive advantages and compare the four leading players on these drivers, as shown in the exhibit below.

Exhibit 1: Comparison of top-4 paint players across drivers of competitive advantages

Asian Paints Berger Paints Kansai Nerolac ICI/Akzo Nobel

Supply chain management Product range

Products with special characteristics

Marketing initiatives

Benefits to dealers/painters

Quality of management professionals

Overall

Source: Industry, Ambit Capital research; Note: is the strongest and is the weakest.

Berger is the second-best on our competitive advantage framework. Berger would deliver 12.5%/15% sales/PAT CAGR over FY15-35 as the company’s genesis is built around: a) hiring and retaining high-quality talent; b) improving employee work culture by promoting freedom to innovate and make mistakes; and c) driving impactful marketing (increase in A&P spends as % of sales by 140bps over FY13-16 and use of Bollywood actress, Katrina Kaif, for endorsing Berger Silk). This is supported by the promoter’s sole focus on the paints industry (good capital allocation) and a hands-off approach which gives professionals complete control of ground-level execution.

Berger Paints


Transforming from a follower to a challenger to Asian Paints As highlighted in our ‘Coffee Can’ note on Berger (Click here), until 2010, Berger spent its efforts in catching up with Asian Paints which is better than its peers, Akzo Nobel and Kansai Nerolac. As a result, Berger successfully rose up the ranks in market share to become the second-largest player in the decorative paints industry in India from being the eighth-largest player until the late 1970s. Despite this, in 2010, the firm still lacked basic operational infrastructure; i.e. a) its ERP systems were sub-optimal; b) timely product replenishment in the channel was difficult; and c) whilst it was gaining share in the economy segment, it was incredibly difficult to do the same in the premium segment against Asian Paints and Dulux (by Akzo Nobel).

However, since 2010, Mr. Abhijit Roy (MD and CEO of Berger Paints) has implemented initiatives which substantially improved operational capabilities to the extent that in many aspects Berger has been the pioneer in introducing new initiatives in the industry. Based on our recent channel checks, we have given some examples of these initiatives below.

Sales-oriented initiatives implemented over FY10-16 Focusing on the painter rather than the dealer – winning formula in the economy segment

The extent of end-customer involvement in the paint process is exceptionally low in rural areas and the economy paint segment with the customer relying almost entirely on the painter for selection of the product. Under Mr. Abhijit Roy, Berger has been focusing on the painter (the key influencer in the paint project) over the past six years. This was achieved through a combination of the following initiatives:

Shorter-period painter schemes: While all companies have had annual incentive schemes for painters, Berger appears to have been the first to start shorter-period (monthly or quarterly) schemes, albeit this approach has been replicated by its peers now.

Interacting directly with the painter rather than the dealer: In order to allocate incentives to various painters across the country, paint companies had relied on dealers for collecting data on the quantum of paint purchased by each painter. Moreover, these incentives used to be distributed to the painters through the dealers. This process clearly led to a lot of inefficiencies in distribution of painter incentives. Some of these inefficiencies arose because the data reported by dealers was inaccurate, resulting in several eligible painters either not being aware of or not in receipt of the incentives they were entitled to.

However, over the last 3-4 years, Berger has pioneered the implementation of a Centralised Helpline (toll free number for a call centre) which helps the painters to directly call the paint company and log a product purchase from the distribution network. In order to complete the information loop, this Centralised Helpline verifies the product purchase with the respective dealer. To further improve data collection accuracy for distribution of incentives, Berger has started offering a coupon code inside the paint container, which is accessible only to the painter, who then calls the Centralised Helpline to log his product purchase. This process further empowers the painter in the whole process.

Express Painting – breaking into the premium segment

Over the past 24 months, Berger has significantly scaled up the distribution and marketing of its Express Painting service. This concept involves enabling the painter to execute a paint project in a substantially quicker and cleaner manner. The firm is leveraging on the fast rising popularity of this concept amongst premium households to achieve the following outcomes:

http://reports.ambitcapital.com/reports/Ambit_BergerPaints_ChangeinStance_TheCoffeeCanStory_07Dec2015.pdf

Berger Paints


Convincing a new dealer to stock its products for the first time as it helps such a dealer to remain relevant in an emerging trend.

Building painter/contractor loyalty by offering training programmes to painters for Express Painting. The firm has set up a training academy called ‘iTrain’, which helps the painters get trained on upgraded technology like Express Painting tools.

Express Painting is being used as a good tool for both ATL and BTL marketing alongside the ‘Silk’ campaign featuring Bollywood actress Katrina Kaif, which has been running for the last 4 years.

Berger’s sales team is increasingly focusing on ‘lead-conversion’ rather than on ‘lead-generation’ because the awareness built with dealers, painters and customers works towards generating leads about a new project.

Mobile App for dealers and the sales team

Berger launched an Android mobile application which aims to help the dealers and firm’s sales team in the following manner:

Real-time update on dealer-level account settlement, which helps improve transparency for dealers.

Improved platform for performance measurement and incentivisation of the sales team.

Although Asian Paints already has a website to enable these functionalities for dealers, it does not yet have a mobile application in place.

Improved supply chain efficiencies

The speed of the supply chain in Berger’s distribution channel has improved substantially over the past 3-4 years. This has been achieved through a combination of: a) CRM implementation in 2012 (albeit Berger was one of the last amongst the top four paint companies to make such an IT investment) and nurturing this platform for improved data analytics; b) investing in servicing demand from hitherto remote locations, much before the scale of demand from such locations was big enough; and c) bringing more agility in the sales team by hiring young talent, thereby reducing the average age of employees in the team.

As a result of these initiatives, in larger cities, Berger now fulfills demand in 4-5 hours (vs 3-4 hours for Asian Paints) compared to previous timelines which were at least twice that of Asian Paints in such cities till 5-6 years ago.

“Now there are set timings for Berger’s lorry to leave the depot and we (dealers) know about these timings because we deal with the company regularly. So we place our orders accordingly.” – a large dealer of Berger in North India during our conversation with him in Aug’16.

Improvements in HR process and work culture Over the past five years, Berger has streamlined its HR processes including the implementation of a system called ‘Human Resource Management System (HRMS)’. We understand that the following aspects of HR management have improved:

Previously, the recruitment of a sales officer used to be carried out by various branch managers. This led to a lack of consistency in the quality of people being hired across geographies and hence inter-branch transfers used to create problems. The firm has standardised these processes across the country.

Sluggishness in the sales team has been shaken out by the hiring of younger and more agile workforce.

The management trainees are being recruited from IIMs and, hence, recruiting quality talent has been improved along with increased focus on training these recruits.

Berger Paints


Incentive structures of the sales team have been changed with infrastructure implemented to track performance granularly.

As a result of these changes, the work culture of the organisation has improved in the following manner:

Whilst several of the operational changes implemented were initially not very well accepted, having seen the successful outcome of these changes, employees are encouraged about the firm moving forward in the industry.

Virtuous cycle of positivity: Employees in the sales-team do not feel that they are the ‘Number 2’ player in every aspect of the business (Number 1 being Asian Paints). As a result, when they tell the dealers, they feel proud to call themselves as leaders in a few aspects of the business. As these dealers increase their association with Berger over time, it further improves the confidence and morale of the workforce.

Employees across the hierarchy, including those in junior managerial roles, have a clear vision about where their career and operational role are headed.

There is freedom to innovate and to make mistakes. Employees are not berated or scolded for having made mistakes whilst trying to innovate. This culture has helped cultivate an entrepreneurial feeling amongst employees.

Mr. Abhijit Roy, in a conversation with us last year, mentioned “We have a very open culture. Like anybody from field level to sales manager can walk into my room without appointment and talk to me to either give information or ask for my views. I sometimes call branch managers into a conference room and ask them to present their success story which we put up on SharePoint (a team collaboration software tool) for everyone else to understand and share. This encourages people to think differently and innovate.”

Berger Paints




Profit and Loss

Consolidated revenue 43,221 46,341 45,527 51,786 60,000 69,374 Demonetisation will impact Berger Paints’ revenue for FY17-18

Consolidated revenue growth 11.7% 7.2% -1.8% 13.7% 15.9% 15.6%

Gross margins 41.4% 44.5% 45.5% 44.5% 44.8% 44.8% Factor in decrease in gross margins due to rise in crude prices

Salaries and wages (% of sales) 5.9% 6.1% 6.3% 6.3% 6.2% 6.2% Employee costs to remain stable

Freight & Handling (% of sales) 6.2% 6.4% 6.3% 6.2% 6.2% 6.2% Freight expenses to remain stable.

Advert & Publicity (% of sales) 6.6% 6.9% 6.5% 6.4% 6.2% 6.0% The company to reduce its advertisement spends. Expect cash discounts to remain fairly stable Cash discount (% of sales) 3.5% 3.6% 4.1% 3.9% 3.8% 3.8%

Others (% of sales) 7.5% 7.4% 7.6% 7.4% 7.4% 7.4% Other expenses to remain stable.

EBITDA Margins 11.8% 14.1% 14.8% 14.3% 15.0% 15.2%

Tax rate 34.5% 34.1% 32.0% 32.0% 32.0% 32.0% Stable tax rates

Net Profit Margins 6.1% 8.0% 8.7% 8.6% 9.4% 9.6% Net profit margins to improve due to lower A&P spends

Balance Sheet

Capex (` mn) 1,393 1,324 1,500 1,500 1,500 1,500 No material capex plans expected after the current capex over FY16-20 Capital work in progress (` mn) 1,004 623 623 623 623 623

Working Capital days 50 33 31 29 27 25 Working capital days to remain stable

Debtor days 45 46 45 44 43 42 Debtor days to stabilise

Creditor days 60 74 74 74 74 74 Creditor days to remain constant.

Inventory days 61 60 59 58 57 56 Build in an improving inventory cycle given its investments in supply chain

Net debt to equity 0.3 0.1 (0.0) (0.1) (0.2) (0.2) Berger to turn debt free in FY17

Cash Flows (` mn)

Operating cash flows 3,454 5,982 5,573 5,469 6,489 7,583 Healthy cash flows over FY16-20

Free cash flows 1,839 4,739 4,073 3,969 4,989 6,083


Berger Paints


Priced to perfection, no room for upside Despite paints companies being classified as chemicals companies globally and despite paints being linked to the home building sector, the business models and growth prospects of paints companies in India are akin to the consumer staples and entry-level consumer discretionary companies. This is because paint companies are highly cash-generative B2C businesses in India with drivers of competitive advantages, such as supply chain efficiencies, quality of distribution and strength of their brand recall.

We use a DCF-based valuation for Berger Paints due to the highly cash-generative nature of the business. Our DCF-based valuation suggests TP of `180/share (15% downside), implying 39x FY18E EPS. Berger Paints is currently trading at a 38% premium to peers like Kansai Nerolac, and in line with the market leader, Asian Paints. Berger’s valuation premium over Kansai and Akzo is justified due to its superior competitive advantages (see Exhibit 1). The firm deserves to trade at a slight discount of 5-10% against Asian Paints since the market leader continues to have superior efficiencies in the supply chain, working capital cycles and capital allocation, which are supported by a high-quality talent pool at the middle and senior management level.

Weak demand over the next 12 months (demonetisation and GST) and margin headwinds leave little room for upside from the current market price. A potentially good entry point could emerge in the next 12 months when consensus estimates factor in these headwinds.

Our WACC assumptions for the DCF model are summarised in the exhibit alongside. The cash flow and return profiles generated by our model are shown in the exhibits below.

Exhibit 3: Berger Paints’ cash flow profile


Exhibit 4: Berger Paints’ returns profile


Exhibit 5: Berger Paints’ one-year forward P/E


Exhibit 6: Berger Paints’ one-year forward EV/EBITDA


(2,000)

-

2,000

4,000

6,000

8,000

- 1,000 2,000 3,000 4,000 5,000 6,000 7,000 8,000

FY12

FY13

FY14

FY15

FY16

FY17

E

FY18

E

FY19

E

FY20

E

CFO (Rs mn) Free cash flow (Rs mn)

10%

15%

20%

25%

30%

35%

-10%

0%

10%

20%

30%

40%

50%

FY11

FY12

FY13

FY14

FY15

FY16

FY17

E

FY18

E

FY19

E

FY20

E

FY21

ERevenue growth (LHS) EPS growth (LHS)

RoCE (RHS) EBITDA Margin (RHS)

10

20

30

40

50

60

70

Jan-

12

May

-12

Sep-

12

Jan-

13

May

-13

Sep-

13

Jan-

14

May

-14

Sep-

14

Jan-

15

May

-15

Sep-

15

Jan-

16

May

-16

Sep-

16


10

20

30

40

Jan-

12

May

-12

Sep-

12

Jan-

13

May

-13

Sep-

13

Jan-

14

May

-14

Sep-

14

Jan-

15

May

-15

Sep-

15

Jan-

16

May

-16

Sep-

16


+1 s.d. -1 s.d.

WACC computation

Item %

Risk free rate of return 8.2


Risk Premium 7

Cost of Equity 14.2

Cost of Debt 12

Debt/Equity 20

Corporate Tax Rate 30

WACC 13.0


Berger Paints


Key risks Lower-than-expected demand suppression: More buoyancy in the external

environment or better internal activation and higher share gain by Berger Paints can lead to lower-than-expected sales impact. Berger Paints has been taking initiatives to reduce the monthly targets for dealers and paints to more manageable weekly targets. Initiatives like these, if they help drive market-share gains for Berger Paints, can be a risk to our assumption of 5-10% sales decline.

Reversal in crude oil prices: In case crude oil prices resume downward trajectory, the margin pressure on Berger Paints might not materialise to the extent anticipated by us.

Catalysts Sales decline in the near term: We are building in a 5% sales decline over the

next 12 months leading to a series of earnings downgrades of ~10%.

Margin pressure from rising raw material costs: Berger Paints would witness a continued pressure on margins as crude prices keep rising up. Margin trajectory for Berger Paints has been strongly positive over the last few years and these peak margins in the current environment of depressed demand and rising input costs is not sustainable.


Ambit Consensus Divergence from Consensus Comments

FY17E Net Sales (` mn) 45,527 49,802 -9% Higher impact of demonetisation than consensus

EBITDA (` mn) 6,888 7,767 -11% Higher margin impact due to crude impact and INR depreciation


FY18E

Net Sales (` mn) 51,786 58,686 -12% Higher impact of GST than consensus



FY19E

Net Sales (` mn) 59,139 69,343 -15% Slower recovery in volume growth than consensus






Accounting GREEN Berger scores well on cash conversion, related party advances and return on surplus cash; however, its working capital cycle is average; RoEs and provisions for debtors outstanding for more than six months are better than peers.

Predictability GREEN Predictability of earnings remains high for Berger given: (a) high correlation of industry volume growth rates with GDP; (b) strong correlation of raw material costs with crude and foreign exchange rates; and (c) market-share changes across various players in the industry.

Earnings momentum RED Due to demonetisation we have cut our estimate by more than 10%.


Berger Paints


Balance Sheet




Total networth 12,606 14,792 17,546 19,747 22,527


Preference share capital 0 0 0 0 0

Debt 6,089 3,243 2,243 1,243 243



Gross block 14,613 15,938 17,438 18,938 20,438

Net block 9,307 9,764 10,197 10,590 10,948

CWIP 1,004 623 623 623 623

Investments 1,345 2,992 2,992 2,992 2,992


Debtors 5,352 5,806 5,579 6,204 7,024

Inventory 7,195 7,582 7,324 8,189 9,323

Loans & advances 1,070 1,202 1,181 1,343 1,556




Provisions 765 1,095 1,075 1,223 1,417



Miscellaneous 0 0 0 0 0

Total assets 19,273 18,722 20,475 21,677 23,456


Income Statement



Growth (%) 11.7% 7.2% -1.8% 13.7% 15.9%


Operating profit 5,107 6,554 6,722 7,405 9,000

Growth (%) 18.4% 28.3% 2.6% 10.2% 21.5%

Depreciation 925 1,000 1,067 1,106 1,142

EBIT 4,182 5,554 5,655 6,299 7,858


Non-operating income 360 345 386 425 467

Adjusted PBT 4,041 5,609 5,813 6,579 8,263

Tax 1,394 1,911 1,860 2,105 2,644

Adjusted PAT/Net profit 2,647 3,698 3,953 4,474 5,619

Growth (%) 6% 40% 7% 13% 26%

Prior Period Items - - - - -



Share of associates 0 0 0 0 0




Berger Paints


Cash Flow Statement


EBIT 4,542 5,899 6,041 6,723 8,325

Depreciation 925 1,000 1,067 1,106 1,142

Others (142) (315) - (0) (0)

Tax (1,437) (1,812) (1,860) (2,105) (2,644)

(Incr)/decr in net working capital (434) 1,211 326 (256) (334)


Capex (1,615) (1,243) (1,500) (1,500) (1,500)

(Incr)/decr in investments (361) (1,451) - - -

Other income (expenditure) 148 122 - - -

Others - - - - -


Net borrowings (149) (2,387) (1,000) (1,000) (1,000)

Issuance of equity - 0 277 - -

Interest paid (451) (257) (228) (145) (62)

Dividend paid (1,169) (1,080) (1,477) (2,272) (2,840)

Others - - - - -


Net change in cash (144) (314) 1,646 553 1,087

Closing cash balance 1,697 480 2,741 3,293 4,381

Free cash flow 1,839 4,739 4,073 3,969 4,989


Ratio Analysis

Year to March (%) FY15 FY16 FY17E FY18E FY19E

EBITDA margin (%) 11.8% 14.1% 14.8% 14.3% 15.0%

EBIT margin (%) 10.5% 12.7% 13.3% 13.0% 13.9%



Net debt: equity (x) 0.3 0.1 (0.0) (0.1) (0.2)



RoCE (%) 16.5% 21.2% 21.7% 22.4% 25.9%

RoIC (%) 19.0% 23.2% 24.1% 26.2% 31.3%

RoE (%) 22.2% 27.0% 24.4% 24.0% 26.6%


Valuation Parameter


EPS (`) 2.7 3.8 4.1 4.6 5.8

Diluted EPS (`) 2.7 3.8 4.1 4.6 5.8



P/E (x) 77.4 55.4 51.8 45.8 36.5

P/BV (x) 11.6 9.9 11.7 10.4 9.1

EV/EBITDA (x) 38.6 30.2 29.1 26.3 21.7

EV/EBIT (x) 46.4 35.3 34.3 30.7 24.6


Berger Paints


Institutional Equities Team Saurabh Mukherjea, CFA CEO, Institutional Equities (022) 30433174 [email protected] Pramod Gubbi, CFA Head of Equities (022) 30433124 [email protected]

Research Analysts

Name Industry Sectors Desk-Phone E-mail

Nitin Bhasin - Head of Research E&C / Infra / Cement / Industrials (022) 30433241 [email protected] Aadesh Mehta, CFA Banking / Financial Services (022) 30433239 [email protected] Abhishek Ranganathan, CFA Retail (022) 30433085 [email protected] Anuj Bansal Mid-caps (022) 30433122 [email protected] Aditi Singh Economy / Strategy (022) 30433284 [email protected] Ashvin Shetty, CFA Automobile (022) 30433285 [email protected] Bhargav Buddhadev Power Utilities / Capital Goods (022) 30433252 [email protected] Deepesh Agarwal, CFA Power Utilities / Capital Goods (022) 30433275 [email protected] Dhiraj Mistry, CFA Consumer (022) 30433264 [email protected] Gaurav Khandelwal, CFA Automobile (022) 30433132 [email protected] Girisha Saraf Mid-caps / Small-caps (022) 30433211 [email protected] Karan Khanna, CFA Strategy (022) 30433251 [email protected] Mayank Porwal Retail (022) 30433214 [email protected] Pankaj Agarwal, CFA Banking / Financial Services (022) 30433206 [email protected] Paresh Dave, CFA Healthcare (022) 30433212 [email protected] Parita Ashar, CFA Metals & Mining / Aviation (022) 30433223 [email protected] Prashant Mittal, CFA Strategy / Derivatives (022) 30433218 [email protected] Rahil Shah Banking / Financial Services (022) 30433217 [email protected] Ravi Singh Banking / Financial Services (022) 30433181 [email protected] Ritesh Gupta, CFA Oil & Gas / Chemicals / Agri Inputs (022) 30433242 [email protected] Ritesh Vaidya, CFA Consumer (022) 30433246 [email protected] Ritika Mankar Mukherjee, CFA Economy / Strategy (022) 30433175 [email protected] Ritu Modi Automobile (022) 30433292 [email protected] Sagar Rastogi Technology (022) 30433291 [email protected] Sudheer Guntupalli Technology (022) 30433203 [email protected] Sumit Shekhar Economy / Strategy (022) 30433229 [email protected] Utsav Mehta, CFA E&C / Industrials (022) 30433209 [email protected] Vivekanand Subbaraman, CFA Media (022) 30433261 [email protected]

Sales

Name Regions Desk-Phone E-mail

Sarojini Ramachandran - Head of Sales UK +44 (0) 20 7886 2740 [email protected] Dharmen Shah India / Asia (022) 30433289 [email protected] Dipti Mehta India (022) 30433053 [email protected] Krishnan V India / Asia (022) 30433295 [email protected] Nityam Shah, CFA Europe (022) 30433259 [email protected] Punitraj Mehra, CFA India / Asia (022) 30433198 [email protected] Shaleen Silori India (022) 30433256 [email protected]

Singapore

Praveena Pattabiraman Singapore +65 6536 0481 [email protected] Shashank Abhisheik Singapore +65 6536 1935 [email protected]

USA / Canada

Ravilochan Pola – CEO Americas +1(646) 793 6001 [email protected] Hitakshi Mehra Americas +1(646) 793 6002 [email protected] Achint Bhagat, CFA Americas +1(646) 793 6752 [email protected]

Production

Sajid Merchant Production (022) 30433247 [email protected] Sharoz G Hussain Production (022) 30433183 [email protected] Jestin George Editor (022) 30433272 [email protected] Richard Mugutmal Editor (022) 30433273 [email protected] Nikhil Pillai Database (022) 30433265 [email protected]

Berger Paints


Hindustan Unilever Ltd (HUVR IN, BUY)


Asian Paints Ltd (APNT IN, SELL)


Nestle India Ltd (NEST IN, SELL)


Dabur India Ltd (DABUR IN, SELL)


Godrej Consumer Products Ltd (GCPL IN, SELL)


Colgate Palmolive (India) (CLGT IN, SELL)


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Hindustan Unilever Ltd

0200400600800

1,0001,2001,400

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-15

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Asian Paints Ltd

01,0002,0003,0004,0005,0006,0007,0008,000

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Nestle India Ltd

050

100150200250300350

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14

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-15

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15

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Dabur India Ltd

0200400600800

1,0001,2001,4001,6001,800

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Godrej Consumer Products Ltd

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Colgate-Palmolive India Ltd

Berger Paints


Glaxosmithkline Consumer (SKB IN, SELL)


Berger Paints India Ltd (BRGR IN, SELL)


Marico Ltd (MRCO IN, SELL)


Britannia Industries Ltd (BRIT IN, SELL)


ITC Ltd (ITC IN, BUY)


01,0002,0003,0004,0005,0006,0007,0008,000

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GlaxoSmithKline Consumer Healthcare Ltd

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Berger Paints India Ltd

050

100150200250300350

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Marico Ltd

0500

1,0001,5002,0002,5003,0003,5004,000

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-14

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Britannia Industries Ltd

140160180200220240260280

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ITC Ltd

Berger Paints


Explanation of Investment Rating

Investment Rating Expected return (over 12-month)

BUY >10%

SELL <10%

NO STANCE We have forward looking estimates for the stock but we refrain from assigning valuation and recommendation

UNDER REVIEW We will revisit our recommendation, valuation and estimates on the stock following recent events

NOT RATED We do not have any forward looking estimates, valuation or recommendation for the stock POSITIVE We have a positive view on the sector and most of stocks under our coverage in the sector are BUYs

NEGATIVE We have a negative view on the sector and most of stocks under our coverage in the sector are SELLs

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Berger Paints


26. Ambit and its affiliates and their respective officers directors and employees may hold positions in any securities mentioned in this Report (or in any related investment) and may from time to time add to or dispose of any such securities (or investment). Ambit and ACUK may from time to time render advisory and other services to companies referred to in this Report and may receive compensation for the same.

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Disclosures

29. The analyst (s) has/have not served as an officer, director or employee of the subject company. 30. There is no material disciplinary action that has been taken by any regulatory authority impacting equity research analysis activities. 31. All market data included in this report are dated as at the previous stock market closing day from the date of this report..

Analyst Certification

Each of the analysts identified in this report certifies, with respect to the companies or securities that the individual analyses, that (1) the views expressed in this report reflect his or her personal views about all of the subject companies and securities and (2) no part of his or her compensation was, is or will be directly or indirectly dependent on the specific recommendations or views expressed in this report. © Copyright 2016 AMBIT Capital Private Limited. All rights reserved.

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