A perspective on FMCG valuation (November 16, 2018)

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Dear partners,

In our periodic reviews, we have been asked by many of you why we don’t own any FMCG names in our portfolio.   We had shared some perspective on this in our Q1FY 19 letter.  However, we have been getting this question so often that it merits a more detailed response.

The best businesses are those that can grow predictably while generating cash and can grow without any or very little reinvestment of this cash.    Most FMCG companies fall into this bucket –  they have the choice to outsource manufacturing and they have very low (or even negative) working capital requirements.  Their brands and distribution provide them a differentiation and hence predictability of earnings. 

However, growth is only one leg of the value creation stool.  Share-holder returns are also a function of change in valuation multiple.   Hence, great companies may not be great Investments when measured over 3-5 year time horizons, if too high a price is paid.

The challenge with buying FMCG companies for some time has been their valuations.     Current sectoral valuations (see chart below for 1 yr Forward PE) are ~1.5 standard deviations above mean (last 15 years). Hence, stock price returns over 3-5 years from current valuation levels could be very poor if multiples revert to historical mean as earnings growth would be negated by multiple decline

What is the probability that valuations could revert to mean? Valuation multiples are primarily a function of growth, Cost of Capital and Return on Capital (durability of competitive advantage).  

There is no significant change in growth rates or ROCE to justify higher valuations.    Interest rates which impact (Cost of Capital) are on the rise.    

However, the traditional moats that allowed FMCG companies high ROCE are gradually getting challenged. 

1.      FMCG brands need significant investments in brand building to reach critical scale.  Hence, it has not been easy for entrants to compete.   However, VCs are now willing to fund cash burn required by challengers to achieve scale (e.g. Prataap Snacks is majority owned by Sequoia)

2.      Organized retail is becoming a larger share of the sales mix.  Margins earned from organized retail and terms of trade will certainly be lower than the traditional channel due to better bargaining power. 

3.      Incumbents distribution clout with Kirana stores allows them to place new products whilst blocking challengers entry and their size allows them to leverage national media most effectively.   However, for many new growth categories, these advantages are important but not as relevant 

·         Premiumisation of offerings, a key lever to boost profitability of incumbent FMCG players, is witnessing emergence of brands targeting niches.

·         Millennials with purchasing power are displaying consumer choices and brand loyalty which is very different from their parents’ generation 

·         Organized retail, which continues to gain share, especially in premium categories, is allowing challenger brands access to premium customers and shelf space

·         Digital enables brands to reach consumers cost effectively

A few months ago Zydus bought out Heinz’s portfolio in India in a control transaction.  Valuations paid were ~ 40-45% of what listed FMCG companies are trading at.  Partners must note that “control” transactions typically happen at a premium.  Even though every company is unique, this is another data point that we are in slippery terrain on valuations. 

Hence, even as we believe that incumbent FMCG players will enjoy stable growth for many years, valuation multiples “should” trend lower and revert to mean.    One can never predict the timeline in which these valuations corrections can happen.  However, we think in buckets of 3- 5 years, and if the multiple decline happens in this time frame, 15% earnings growth accompanied by multiple decline will mean poor Investment outcomes.   And if due to an external shock, growth slows or declines, a decline in growth accompanied by decline in valuation results in a very steep negative impact on stock price.

We reiterate that these companies are great franchises.  However, great businesses do not always result in great Investment outcomes if too high a price is paid.     We have hence preferred to allocate capital where we believe return/risk is more in favour

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