The consumer staples sector has outperformed the broader market in FY18 yet again (7 out of last 10 years). We believe FY19 should see a gradual recovery in topline led by trade normalisation (post demon and GST) and mild rural uptick. However, underlying drivers for strong rural recovery are still missing. Margins will play a lesser role in driving earnings. Valuations are close to all-time high on an absolute and relative basis. Prefer discretionary over staples.
Can current valuations sustain amidst rising yields?
Global staples valuations are already off peak levels in last 12-18 months given fears of disruption and rising bond yields. Historical correlation for Indian staples sector to bond yields doesn’t seem to suggest a clear pattern. In fact, relative earnings growth vs broader market is the key valuation and sector performance driver. Sustainable bond yields increase driven by growth pick-up in broader economy typically leads to sector underperformance while sudden spikes in bond yields due to inflation fears doesn’t de-rate the sector. PE rerating and earnings growth have been equal drivers of stock price returns in last 5 years which would be difficult to replicate in our view given valuations are already at +2 std dev.
Demand surge in pre-election year?
History doesn’t seem to suggest so. Rural drivers (wage inflation, agri prices) are still not robust enough for a strong recovery. However, we should have a better rural and overall volume and pricing growth in FY19 for staples sector given trade normalisation post demonetisation and GST related disruptions in FY17/18 and a modest uptick in rural. Monsoons would also need to be watched post near-normal rainfall in the last couple of years (typically negative impact of monsoons is there if two consecutive failures happen).
Margins, how much more to go?
Gross and Ebitda margin expansion in staples has been a one-way secular story, especially over last 5-7 years. Pricing discipline, strong cost savings programmes, efficiency in ad spends and premiumisation have played a key role apart from benign RM prices in last few years. We believe while RM prices might see reversal, other factors seem to be sustainable and thus margins would still be well-supported, though may not contribute as much to earnings growth as in the recent past.
What to look out for in FY19?
(i) Pace of rural recovery in staples remains the key monitorable. We see mild downside risks to consensus expectations on pace of topline recovery. (ii) Broader market growth pick-up would determine sector outperformance but odds are very high for a likely PE multiple compression, on both absolute and relative basis. (iii) Superior execution by management teams within core categories and new product innovation would differentiate stock winners as overall strong growth tailwinds largely absent. (iv) Innovation intensity to pick-up given normalised trade conditions. A&P spend might still not pick-up much given efficiencies and shift to digital and ZBB. (v) Patanjali incremental impact on sector starts to moderate (vi) Shift from unorganised to organised seems overhyped.
What to buy
Within the ‘superior execution’ bucket in staples, viz. HUVR, BRIT and GCPL, we find risk-reward less compelling given very rich valuations now. Thus, we have only HUVR as Buy in this bucket and BRIT, GCPL as Hold given limited upsides. Our preference is more with the ‘potential turnaround’ set of companies on improving fundamentals going into FY19, viz. NEST, Dabur and ITC where we have a Buy. We still remain on the sidelines and less convinced with risk-reward on Marico, Emami and Colgate, albeit recent correction provides some upside in our base case now. Overall, we prefer discretionary space with JUBI as top pick and APNT as a buy on improving risk-reward while TTAN and UNSP remain Hold as valuations are still ahead of fundamentals despite correction.
Valuations and stock price drivers: Odds stacked against staples
The consumer staples sector has been investor’s delight in last many years, outperforming the index in 7 out of the last 10 years. Stock performance for the sector has largely been led by multiple re-rating against earnings growth, as consumer staple stocks have given 24% CAGR returns over FY09-18e, while earning growth over the same period has been 13%. We believe that going forward, the potential for a further re-rating in multiples is unlikely and stock performance in the sector will be driven by earnings growth and hence giving some tough time to the investors. One will need to be selective and cautious in the sector with higher focus towards earnings growth.