Sunday, March 01, 2009
Investors can consider buying the stock of Godrej Consumer Products, now trading at Rs 127. The stock has not participated in any of the recent run-ups in the FMCG sector, due to a string of earnings disappointments from the company over the past three quarters.
But as lower input costs and slower consumer offtake look set to turn the tables on its competitors, Godrej Consumer, with its focus on mass-market brands and strong rural presence, may record stronger growth.
Though the stock (at 20 times trailing earnings) appears pricey on a historic basis, it appears reasonably valued on forward earnings, at about 15 times FY-10 earnings. That is at a substantial discount to rivals such as Hindustan Unilever (24 times), Colgate Palmolive India (20 times) and Dabur India (18 times).
On a consolidated basis (including overseas subsidiaries), Godrej Consumer’s net sales expanded by a whopping 26.4 per cent in the first nine months of 2008-09, beating most FMCG peers. This was backed by a 21 per cent sales growth in soaps and a 10 per cent growth in hair colour.
But net profits straggled behind edging up by just 1.4 per cent. Rising costs of raw materials such as palm oil derivatives (inputs to soaps) and petroleum derivatives (inputs to the overseas hair care business) sharply reduced operating profit margins to 14 per cent (19 per cent last year) for the nine-months ended December 2008.
A narrow product portfolio (soaps and hair colour contribute 81 per cent of sales), a focus on value-for-money brands and a decision to refrain from price increases after the September quarter, all contributed to the poor profit growth for Godrej Consumer, compared to competitors.
Margin expansion likely
But the company’s fortunes appear set to reverse now, with a steep correction in palm oil prices and signs of downtrading in staple FMCGs in the recent December quarter.
Lower demand from the biofuel segment and expectations of worldwide recession have triggered a collapse in palm oil product prices over the past six months. Even after the commodity rally in January, palm oil prices now hover at less than half the levels seen at the March 2008 peak.
Godrej Consumer’s profit margins are more sensitive to input costs than most of its peers. Given its focus on high-TFM (total fatty matter) soaps, Godrej has a much higher raw material component in its cost structure than rivals. Two, as the company makes forward purchases of inputs, Godrej Consumer continued to grapple with margin pressures until December as it consumed its internal inventories.
With these stocks fully depleted last quarter, the company is well-placed to lock into inputs at much cheaper prices now. Godrej’s operating profit margins may see a strong recovery from the current quarter.
Downtrading may help
The company’s decision to hold back price increases on its soaps portfolio in recent months may now stand it in good stead amid the slowdown. The December quarter has already brought signs that consumers may be economising on FMCG staples such as soaps by switching to value-for-money brands.
Godrej managed a strong 19 per cent volume growth in its soap brands (Godrej No.1, Fairglow, Cinthol) while companies present in the mid- and high-priced segments saw soap volumes actually decline this quarter. Going forward, as price increases become more difficult to push through for its rivals, Godrej Consumer may be able to report better volumes, market share and thus higher topline growth.
The other key business — hair colour — has seen Godrej ceding market share to premium brands over the past two years (market share down from 35 to 32.4 per cent in one year). However, the company has taken remedial action over the past two quarters to aid growth — a price hike of about 11 per cent in the September quarter, which has helped increase retailer margins and launches such as Godrej Expert Hair Colour in powder form.
These initiatives have resulted in sales growth in the hair colour brands accelerating from a negative 6 per cent (lagging the category) in the September quarter to a healthy 14 per cent (matching the category) in December.
Godrej’s initiatives to expand rural market presence and its conservative pricing strategies will also help its brands deliver, even if urban discretionary spends slow down. While the limited portfolio does remain a concern, the company has made efforts to broadbase this with the launch of variants such as Godrej No.1 Strawberry and Walnut, Cinthol Deo and Expert Hair Colour in powder form. The acquisition of an overseas subsidiary has also given Godrej an entry point into high-margin hygiene market with the brand, Snuggy.
One final area of concern surrounding Godrej’s earnings has been the weak performance of its overseas subsidiaries. Over the past three years, Godrej has added a substantial overseas presence through a string of acquisitions — Keyline Brands in the UK; Kinky, a hair products and accessories brand in South Africa, and Rapidol, a hair colour brand with a presence in the same geography.
While two of these businesses have delivered reasonable revenue growth, unexpected depreciation of the South African Rand against the rupee and interest costs on borrowings taken to acquire these brands have dented their contribution to Godrej’s consolidated numbers over the past three quarters.
While currency volatility will remain a risk, plans to retire debt taken for these acquisitions with the proceeds of its 2008 rights offer, offers room for optimism on the net profit front.
Investors can consider holding on to the stock of Indian Overseas Bank (IOB). Though the stock may carry limited downside risk, given the valuations, the stock may continue to underperform peers over the near term.
Business positives such as strong advances growth, good return ratios and a good distribution reach may be offset by concerns about a low provision cover, even as asset quality deteriorates across the banking sector. IOB is a Chennai-based mid-sized public sector bank with more than 1,900 branches.
At current market price of Rs 46, the stock is trading at a modest trailing one-year price earnings multiple (PEM) of 2.1; a huge discount to other PSU banking peers.
The stock is valued at just 0.4 times its December 2008 book value. It carries a dividend yield of 8 per cent, considering the dividend payout for this year.
IOB has delivered strong business growth (21 per cent), enjoys superior return ratios (ROE of 28 per cent and ROA of 1.3 per cent for FY08) and a diversified advances book which is adequately capitalised. It has a high credit-deposit ratio.
The bank has had higher exposure to export credit and the construction sector (based on March quarter numbers) and there is a risk of this leading to higher provisioning in the coming quarters.
IOB’s advances growth, at 30 per cent, is higher than the industry average of 21 per cent. Higher advances growth was contributed to mainly by growth in corporate advances, even as the retail segment was flat.
On the deposit front, the proportion of bulk deposits has come down from 20 per cent in March 2008 to 16 per cent in December 2008. Nevertheless, the proportion is high and puts pressure on the margins in terms of higher cost of deposits. The low-cost deposit proportion has come down from 30.93 per cent to 29.23 per cent in a year and this has further increased the cost of deposits.
IOB’s advances grew at 31 per cent compounded annually in the last five years. Higher advances growth helped the bank’s profit grow by 23 per cent annually. For the nine months ended December 2008, the net interest income of the bank grew by 25.4 per cent, aided by above-industry average growth in advances and improved margins. The net interest margin for the bank improved from 3.11 per cent to 3.15 per cent in a year; but this is a more muted rise compared to its public sector bank peers, due to the bank’s high cost of funds. ‘Other income’ boosted by treasury gains helped the bank attain operating profit growth of 25 per cent.
The growth would have been higher but for higher operating expenses (grew by 29 per cent). The net profit growth of 12 per cent year-on-year saw slight moderation on the back of higher provisions for NPAs and wages.
Although the bank has made higher provisioning for NPAs, higher slippages left the provision coverage at 46 per cent. Though this is above RBI stipulated limits, it is among the lowest within PSU banks. The net NPA/Advances at 1.3 per cent are higher relative to several public sector banking peers.
The capital adequacy of the bank according to Basel-2 norms is 14.09 per cent which improved significantly from 11.85 per cent sequentially, as the bank raised Rs 955 crore of tier-2 capital and re-valued its fixed assets in the past quarter.
Going forward, IOB may be vulnerable to the macro risks to the banking sector. Net profit growth could moderate if the bank sets aside higher provisions for NPAs and wages.
The ‘other income’ growth may slow down as bond yields harden. Falling credit growth may also put pressure on Net Interest Income growth. Higher competition for deposits at lower rates may force cost of funds upwards. However, weighed against this, further rate cuts, which appear quite likely at this juncture, may help offset some of these pressures.
IOB is in a better position than most of its peers in terms of the credit-deposit ratio which is as high as 79 per cent. Unlike other banks, the bank has opted for an in-house CBS solution which saved it considerable costs.
The proposed merger with troubled Shree Suvarna Sahakari Bank, where it takes assets and liabilities of the bank and not its branches, also creates uncertainty.
It owns 19 per cent equity in non-life insurance company Universal Sompo General Insurance and acquired 11.83 per cent in Asset Reconstruction Company owned by JM Financial, which may contribute to the bank’s fee income stream in future.
Retail major Pantaloon Retail India, operating in both value and lifestyle retail, is among the preferred exposures in the Indian retailing sector.
However, investors in the stock have to brace for the stock underperforming markets over the next few quarters, given the challenges relating to curtailed consumer spending, low ability to add debt and poor performance from subsidiaries. At Rs 126, the stock trades at 15 times its trailing 12-month standalone earnings per share.
Though this is at a substantial premium to the overall market, it is at a discount to the historic valuations enjoyed by the stock. Enterprise value stands at 0.50 times its estimated standalone FY10 revenues.
Growth in question
Pantaloon has a retail portfolio addressing almost every consumer need, placing it at an advantage over most peers. It operates apparel chain, Pantaloon Fresh Fashion, hypermarket major Big Bazaar, lifestyle chain Central, discounter Brand Factory, home product provider Home Solutions and lesser-known food chains such as Blue Sky. Private brands include names such as John Millers, Bare Casuals, Umm, Agile, and others.
Over a three-year period, Pantaloon’s sales registered a 70 per cent annual growth, before slowing in the current fiscal. Sales grew 24 per cent in the December 2008 quarter over last year, moderating from the 39 and 35 per cent in the preceding quarters.
Flat sequential December quarter sales were disappointing – given that this was a key period for festival and New Year sales. After hovering above 10 per cent for most of 2008, same-store sales growth was negative in the last two months of 2008, before moving back to positive territory in January at 5 per cent. The latter may have been aided by continual discounts.
With macro indicators showing discretionary purchases on the wane, caution may rule spending for some time yet, which may curb Pantaloon’s growth in the next few quarters.
Pantaloon has built an army of subsidiaries, such as Whole Wealth to source international products, Future Logistics to provide end-to-end logistics and others. Future Capital Holdings, a 55 per cent subsidiary, is a financier and investment advisor and now the highest contributor to subsidiary profits. The home products subsidiary, Home Solutions Retail, incurs the most losses, though it may break even this financial year. Of the ten operational subsidiaries, only two are profitable, thus pulling Pantaloon to a loss on a consolidated level for 2007-08.
With many of these businesses in a nascent stage (Pantaloon disbursed Rs 1,500 crore to associates and subsidiaries last year), and credit markets drying up, Pantaloon may have to put off expansion plans, which could have enabled them to unlock their potential; subsidiaries may, therefore, continue to weigh on the parent’s profits.
Trials in expansion
Unlike many retailers, Pantaloon’s expansion plans are still on, with the company proposing to reach 15 million square feet across formats from the current 11 million. Funding these plans may be difficult , since the company has accumulated an estimated Rs 2,800 crore debt. Though the debt-equity ratio of 1.6 times is not particularly high in the retail space, the steadily depleting interest cover, (from 3.4 times in 2006 to its current 1.7 times), is a concern. Pantaloon may have the upper hand in negotiating rental properties and is looking at rent control through a revenue-sharing models with developers.
Gross margins have been maintained above 10 per cent in the last three quarters, an improvement over the 8.5 per cent averaged in the preceding four quarters. Margin improvement was mainly on account of a control on employee expenditure and other expenses.
But interest — which jumped 52 per cent in the June 08 quarter — and depreciation hammered net margins to less than 2.5 per cent consistently over the past four quarters. Net margins were lower in the December and September 2008 quarters compared to the same period in 2007.
Given the quantum of debt, interest costs may remain quite substantial. Increasing share of value retail, at the expense of lifestyle retail, in overall sales may pinch margins further. Discounts to attract customers may pressure margins as well.
Hindustan Dorr Oliver (HDO) is one of the few small-cap engineering companies that managed to weather the current slowdown by focussing on diversification of services and offering specialised technologies through overseas tie-ups. The company’s recent order-win from Uranium Corporation of India for a greenfield ore mining and processing facility demonstrates its ability to quickly capitalise on new business opportunities. At Rs 31.8, this listed subsidiary of IVRCL Infrastructures & Projects holds strong earnings potential from a medium-term perspective. Investors can consider investing in this stock, which trades at a modest 2.8 times its expected per share earnings for FY10.
HDO’s expertise lies in providing turnkey solutions and Engineering Procurement and Construction (EPC) services in liquid solid separation applications in industries such as mineral processing, fertiliser and chemical and environmental management. The diversified operation has aided in steady order flows even in a downturn such as the present one. The company has managed a 63 per cent growth in net profits for the nine months ended FY09 compared to year-ago numbers. The profit growth would have been higher but for the steep hike in interest costs primarily on account of working capital requirements.
Investors in the stock of Akruti City (Rs 880) can consider booking profits by reducing their holdings in the stock. The steep surge in Akruti’s stock price (over 40 per cent between January 2009 and now) does not appear to be supported by any near-term fillip to its fundamentals. Further, at 12 times its trailing earnings, the stock is at a steep premium to similar-sized and even bigger players in the realty space, which are mostly trading at a price earnings multiple range of 4-8 times.
Most of the real estate stocks have been beaten down to rock-bottom valuations as a result of the current slowdown. Severe selling pressure faced by the realty companies was also reflected in their financials especially in the December 2008 quarter. Akruti City, a key player in the Mumbai slum rehab projects, also proposes to generate much of its future revenues from the same segments as its peers, suggesting that the premium it currently enjoys may not be justified. It’s sales for the quarter-ended December 2008, declined by 64 per cent while profits declined by 79 per cent. Of the total saleable area, Akruti has significant proportion of projects in the commercial and IT park space — segments which have witnessed a significant decline in offtake. The company has shifted focus to budget residential space. This, along with primary presence in the relatively robust Mumbai market, may aid earnings prospects over the long-term.