THE past year has been difficult for the consumer sector in India, but with a slow improvement in the economy we forecast an increase in volumes from the current trough. The recovery could come sooner than expected as the incremental consumer is young and more willing to spend compared with earlier cycles. We believe an improvement in sentiment is a key to trigger volume momentum.

The consumer sector is trading close to its five-year mean PE. There was some de-rating last year, which correlated with a deceleration in EPS (earnings per share) growth for the sector. We forecast higher sector profit growth in FY15 (from a low base) and believe sector PE should at least remain at the current level, with stock performance reflecting earnings growth.

We expect the fastest growth in segments where there is scope for consumers to upgrade from unbranded to branded products and from regional to national brands. Consumers upgrading to value-added brands will remain critical for margin expansion, in our view. Some companies are launching mid-range products between their mass and premium offerings as a means of upgrading consumers in stages. Value packs and mid-price brands are appearing in the short-term to cater to middle-income consumers.

Our economist expects India?s real GDP growth to pick up in FY15, but we do not expect the recovery to be particularly robust. We forecast GDP growth of 5.7% in FY15. Below-par growth in FY15-FY16 will likely be the price to pay for a reduction in inflation and the fiscal deficit. In the longer term, these adjustments should clear the way for a more meaningful growth recovery.

The past year has been difficult for consumer companies, but visibility on the sector is improving. The recovery could come sooner as the incremental consumer is younger, and a sentiment improvement should be sufficient to trigger volume momentum.

We believe volume growth will rebound from the current level of 0.5% to 5-6% over the next one to two years, given the volume growth of 6-7% year-on-year recorded in the 2004-08 period. The golden years for rural growth of 2009-12, when volumes grew 7-9%, are unlikely to return soon. Consumer companies are reacting to this new demand outlook by: (i) filling segment niches; (ii) aggressively widening their product portfolios and geographic footprints; (iii) expanding the use of IT for demand forecasting in sourcing and distribution; and (iv) driving volume throughput to ensure the profitability of intermediaries (distributors and wholesalers).

Since mid-2013, the Indian consumer sector has underperformed the benchmark Sensex by 8.4% (on a market cap weighted basis). The period of underperformance has been most marked since the broader market started to build in the return to positive economic growth momentum. Consumer stocks also fell on earnings estimate reductions and when company results did not meet market expectations. We believe consensus estimates do not reflect an improvement in operating fundamentals from an upswing in economic growth for this sector.

Key picks in the sector

ITC (Buy, PT R425): ITC is our top sector pick as it has maintained positive earnings momentum aided by volume growth in its cigarettes business and a turnaround in the consumer staples segment, which both provide sustainable earnings potential. ITC remains market leader in the cigarette category where it has brands at all price points that reach consumers through a wide distribution network.

Titan Industries (Buy, PT R325): Titan Industries? strength in management, governance, branding and retail presence is a significant positive, in our view. Regulatory issues in the jewellery segment have affected competition and aided a share improvement for Tanishq due to its ownership, (part of the Tata group), market position and willingness to pay a premium for gold. We believe the economic challenges have peaked; the one-year forward visibility on discretionary consumption seems positive.

Hindustan Unilever (Buy, PT R680): Hindustan Unilever owns India?s largest staple brands, with the widest and deepest distribution platform in the sector. HUL has had problems with Wheel (its volume-driver brand) and Fair & Lovely (its value-driver brand) in the past couple of years. We believe the relaunch of both brands with quality upgrades but no change in price points indicates the importance of correct market positioning. HUL is the best exposure to the delta on growth at the low end of the market given its deepest presence and point-of-purchase strength in retail.

Key Sell in the sector

United Spirits (Sell, PT R2,250): United Spirits has market leadership (38% value share) in the IMFL (Indian made foreign liquor) market in India. We believe improving corporate governance at United Spirits will be time consuming and potentially cause some short-term disruption. Therefore, we are lowering our volume growth estimates. The key risk to our rating remains a higher-than-expected sale price for Whyte & Mackay. Management expects the sale by June 2014.

?UBS