Trade in 2010-10-11

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1. BAJAJ AUTO: Valuations factor in strong momentum; Limited probability of positive surprises; Peak margins, valuations; Neutral

– Volume outlook positive, in line with estimates: Bajaj Auto’s (BJAUT IN; Mkt Cap USD10.2b, CMP Rs1,568, Neutral) volume growth outlook is positive with momentum in motorcycles and three wheelers continuing. The management’s FY11 volume guidance is positive, and in line with our estimate of 3.94m units in FY11 and 4.43m units in FY12 (12.4% growth). Our FY12 estimates factor in 13.3% growth in two-wheeler volumes to 3.96m units and 6% growth in three-wheelers to 469,800 units. Given normalization of the base, as volumes recovered from September 2009, Bajaj’s volume growth rate will slow from 56% in 1HFY11 to 24% in 2HFY11, and is estimated at 12.4% in FY12.

– Margins peaked in 4QFY10, cost push pressurize margins: With limited levers to improve margins, we believe margins peaked in 4QFY10 at 23% and will trend downwards going forward. With an increase in rubber based component prices, we believe 2QFY11 margins could be lower than our estimate of 21.2% and taper off to 20% in 2HFY11 as metal prices have started strengthening. Besides, Bajaj Auto expects spends on advertising and marketing will increase from 2QFY11.

– Competition stiffens with entry of M&M and Honda’s probable exit from Hero Honda: Honda’s probable exit from Hero Honda will increase Honda’s focus and aggression regarding product launches and pricing. Besides, M&M’s entry into the motorcycle segment, with its brand and distribution strength, can add to competitive pressure, so people can enjoy rides in bikes, and if you are one of these people you can even find cameras to film your ride so you can have memories of this. This coupled with existing players sharpening focus on the 100cc segment will boost competition.

– Earnings upgrade cycle ending, limited levers to expand margins: Bajaj Auto’s stock performance over the past 12-15 months was driven by an earnings upgrade cycle by the street. Earnings for FY12 has been upgraded multiple times since April 2009, with the FY12 consensus EPS being upgraded from Rs34.9 to Rs87.6 in September 2010. Our FY12 EPS estimate is Rs98.6, ~12.5% above consensus estimates, is based on a 12.4% volume growth (scope for positive surprise) and EBITDA margin decline of just 70bp to 19.8% (limited levers to surprise, with potential of negative surprise).

– Peak margins, valuations: We downgraded Bajaj Auto to Neutral in our India Strategy report, September 2010. It has been the best performing auto stock with 64% outperformance since January 2010, driven by strong volume and margin momentum. But with volume growth normalizing and there being limited levers to boost margins, we believe peak margins are behind us. Consequently there is little scope for the stock’s re-rating and it should perform in line with markets. The stock trades at 17.2x FY11E EPS of Rs90.3 and 15.7x FY12E EPS of Rs98.6. Maintain Neutral with a target price of Rs1,480 (~15x FY12E EPS).

2. LIC HOUSING FINANCE: Business growth strong but spreads compression likely; valuations rich; downgrade to Neutral

We met the management of LIC Housing (LICHF IN, Mkt Cap US$3b, CMP Rs1412, Neutral) to get an update on outlook of growth and spreads. Business growth will remain strong although spreads can compress by at least 20bps in FY11 compared to the elevated levels of 2.24% in 1QFY11. On a blended basis, margins are likely to remain stable YoY in FY11. While we remain positive on business growth, margins have peaked and we expect it to compress 20bp+ from 3% reported in 1QFY11. In our view, FY12 P/BV of 2.7x captures strong growth and any negative surprise on growth or spreads can lead to underperformance. We downgrade our rating to Neutral from Buy.

Spreads to compress

– With monetary tightening by RBI, liquidity tightness and strong pricing power with banks, cost of funds is expected to increase for LICHF.

– LICHF’s borrowing profile is skewed towards fixed rate borrowings with ~60% share whereas the rest is contributed by floating liabilities. Fixed rate borrowings have average duration of ~5 years. As a result, ~12% of fixed borrowings mature every year, leading to effective floating rate liabilities of ~50%.

– Weighted average cost of floating rate liabilities stood at ~7% in 1QFY11 and with the sharp rise in interest rates, we expect liabilities to get repriced by ~100bp at least, leading to ~50bp rise in cost of funds on the existing book.

– ~70% of loans for LICHF are floating in nature and it has increased PLR by 50bp on 1st October, which will increase in yield on loans by ~35bp. With the rise in cost of funds and yield on loans, we expect spreads to compress by 10-15bp on existing portfolio.

Advantage Five Scheme to put further pressure on spreads

– LICHF has launched “Advantage 5” scheme in Jul-10, wherein interest rate for 1st five years are fixed at 9.25%. This scheme accounts for ~ 80% of the incremental individual business and has replaced the earlier teaser rate scheme of LICHF, where interest rate was fixed for 1st three years at 8.9%. This scheme was launched in Jul-09 and disbursement under this scheme was Rs100b, (~75% of the total individual disbursement from 2QFY10 to 1QFY11).

– In 1HFY11, average cost of funds in the system across maturity ranged around 7.5-8.5%. As a result, spreads are likely to be lower in the new product. Management guided that they will continue to monitor spreads on overall business rather than a particular product.

– Management expects spreads to stabilize at ~2% from elevated level of 2.24%. In the worst case, it expects spreads to contract to 1.8-1.9%, although this seems unlikely.

– Based on asset and liability profile, we expect spreads to compress by 20-30bp (by end-FY11) from an elevated level of 2.24% as of 1QFY11. Overall, we expect margins to remain largely stable YoY at ~2.7% in FY11

Business growth to remain strong

– Rising income levels, affordable real estate prices and interest rate levels have resulted in robust disbursement growth in home finance.

– Organizational restructuring, increasing presence, increase in sales force and underlying buoyancy in the segment led to strong loan growth (~30% over FY07-10) and increase in market share (~10.5% now vs. 6% in FY08).

– With strong economic outlook, buoyancy in housing finance segment is expected to continue. Management guided for 30%+ loan growth in FY11/12. We model ~26% CAGR loan growth over FY10-12.

Valuation offer limited upside – Downgrade to Neutral

– LIC Housing is trading at its lifetime peak P/BV multiples. Re-rating is driven by organizational restructuring (completed in FY07), which lea to significant improvements in loan growth and market share, higher profitability and improvement in asset quality.

– The stock trades at FY12 P/BV of 2.7x and PE of 13x with a RoA of ~1.9% and RoE of ~23%. The stock has outperformed Sensex by 31% over last 6 months and 72% over last one year. While we remain positive on business, headwinds like constrained liquidity situation, rise in cost of funds and compression in spreads, increasing competition (ICICI Bank likely to become aggressive again) will drive underperformance, in our view. Besides, valuations are rich and hence we downgrade our stock rating to Neutral.

3. JSW STEEL: JFE’s FCD converted in equity; HR production up 37% in 2QFY11; Raising FY12 EPS 11%; Maintain Buy

– JSW Steel (JSTL IN, Mkt Cap US$ , CMP , Buy) announced conversion of Rs48b Fully and compulsory convertible Debenture (FCD) issued to JFE recently into 32m shares at conversion price of Rs1500/share due to Trigger event as stipulated in the terms and condition materializing .

– The Trigger Event had occurred on October 7, 2010 (’Trigger Event Date’), as the closing price of equity shares on the National Stock Exchange for a consecutive period of 5 (Five) trading days upto and including the Trigger Event Date, had reached or exceeded Rs1,365 per equity share on each such day.

– As a result, outstanding number of shares increased by 17% to 219.1m, with JFE holding 14.6% of the fully diluted equity.

Net worth will rise to US$5b by FY12-end aided by $2b equity infusion; D/E to fall to 0.3x

– Further, 17.5m warrants issued to promoters and 11.6m shares issued in the US$274m FCCB issue (priced at Rs953.4) are pending conversion. This will increase the total equity to 248.1m shares, with JFE holding getting diluted to 12.9%.

– As per the terms of the agreement, JFE will increase its holding to 14.99% of fully diluted equity. Hence, JSW Steel will issue an additional 6.1m shares to JFE at Rs1,500, thereby raising further Rs9.2b. Total number of shares will rise to 254.3m on fully diluted basis, with JFE’s total number of shares rising to 38.1m i.e. 14.99% holding.

– A total of Rs78.3b (incl. Rs21.2b from warrants to promoters) will be raised by way of equity. Including conversion of FCCB, the total addition to Net worth will be Rs89.2b (~US$2b). As per our FY12 estimates, Net worth will rise to Rs224b (US$5b), while the net debt will decline to Rs70b on consolidated basis. Net debt/equity will drop to 0.3x.

Cutting interest costs and raising FY12 EPS 11%; Maintain Buy

– JSW Steel will be pre-paying Rs30b of debt, resulting in savings of Rs3b in interest cost on annual basis. As a result, FY11 EPS is upgraded by 7% to Rs71.9 and FY12 EPS is upgraded by 11% to Rs136.1. Stock is trading at attractive FY12 EV/EBITDA of 5.1x and PE of 9.7x despite the strong upmove in stock price. We maintain our Buy rating with a Target Price of Rs1775 (6.5x FY12 EV/EBITDA), an upside of 34%.

Takeaways from our meeting with Mr Rao, Jt MD

We met with Mr. Seshagiri Rao, Joint Managing Director. Key highlights:

– JSW has taken a steel price increase of Rs1,000/ton on 1st Sep. According to media reports, JSW has taken another price hike of Rs1,500/ton across different products effective 1st Oct, 2010. In the last few weeks, demand for longs has picked up and management expects the higher prices to sustain.

– 3QFY11 is expected to be better as demand picks up and costs are stagnant. Coking coal contracts have been signed at US$205/ton (-9% QoQ) while iron ore prices are expected to rise as spot prices in domestic markets have gone up by 10-15% in last few weeks on concerns of availability.

– Shipments of iron ore from Chile are expected to start from Dec-10 and expected to reach to 1m tons in CY11 (expected CoP US$60 FOB). The ore deliveries are expected to reach to 5m tons in next 3 years.

– Coking coal deliveries from recently acquired mines in USA are also expected to start from Dec-10.

– US pipe and plate mill operations continue to suffer from lower capacity utilizations (12-15%). However, management expects slight recovery in 3Q as a few orders have been booked.

New projects: Expansion to 16mtpa in next four years

– JSW’s ongoing expansion will take the capacity up to 10mtpa at Vijaynagar by Mar-11. First coke oven battery will get commissioned in 1st week of October followed by another in 1st week of Nov-10. Remaining two units of coke oven batteries will get commissioned by Mar-11 along with steel melting shop and blast furnace.

– JSW is planning to increase the capacity of its Vijaynagar unit further to 12mtpa in next two years at a capex of Rs25b. Further, it will also set up a 2mtpa new Cold Rolling Mill (CRM) complex at a cost of Rs25b, to increase the value added products contribution. JFE will help JSW to develop the layout and for selection of suppliers. Total volume of value added products will increase to 4mtpa (25% of expanded capacity) by FY14. It is planning to fund the capex with 50:50 debt and equity.

– JSW is going to commence work on West Bengal Greenfield project site to set up 3mtpa steel plant at a capex of Rs120b including pelletization, beneficiation, blast furnace and rolling units. Out of total project costs of Rs120b, Rs20b is planned for development of mines. The entire project is expected to be funded with 67% debt; while decision on JFE’s involvement is not yet decided. JSW plans to complete the 3mtpa project by Apr-14 to reach a total capacity of 16mtpa.

4. METALS: Indian steel producers record impressive sales in 2Q aided by inventories; Margins will be lower

– Steel producers have reported strong volumes for 2QFY11 on expected lines after a very disappointing 1QFY11 as customers returned for re-stocking due to stabilization of steel prices. Easing of import pressure due to some recovery of international markets and reduced exports from China due to duty changes & better local demand, helped Indian producers to liquidate inventories to some extent.

– Though volumes have recovered impressively, we expect the realizations to drop QoQ on account of lower steel prices and higher share of semis in sales for SAIL and Tata Steel.

– Cost increases on account of higher coking coal prices would put additional pressure on 2QFY11 margins. Outlook for 3QFY11 is improving due to recovery in steel prices and easing of pressure from raw materials.

– Both, SAIL and Tata steel trade at expensive valuations. JSW Steel remains attractive at 5.1x FY12 EV/EBITDA.

A. SAIL: 2QFY11 sales volume up 5% YoY; valuations expensive

– SAIL’s (SAIL IN, Mkt Cap US$20.6b, CMP Rs226, Neutral) 2QFY11 sales volumes grew 5% YoY to 3.17m tons, slightly above our estimate of 3.1m tons. Higher intake by manufacturing and construction sector boosted sales. On QoQ basis, 38% growth is exaggerated due to exceptionally poor sales in 1QFY11 because of price volatility led surge in imports.

– Special and value added products constituted 30% (850k tons) of the total domestic sales in this quarter.

– We have upgraded our quarterly PAT estimates for 2QFY11 from Rs11.8b to Rs12.5b due to stronger sales.

– Stock trades at rich valuations of 10.8x FY12 EV/EBITDA of 16.1x FY12 PE. Maintain Neutral.

B. JSW STEEL: 2QFY11 crude steel production up 2% YoY; HR production up 37%; valuations reasonable

– JSW Steel’s (JSTL IN, Mkt Cap US$7.5b, CMP Rs1,326, Buy) crude steel production grew by only 2% YoY to 1.57m tons during 2QFY11 as one of the small blast furnace at Salem unit was down due to weaker demand of long products. The furnace has been restarted now.

– As new Hot strip mill continue to ramp up, HR coil production increased 37% YoY to 1.3m tons. Production of semis has declined sharply by 95% to 38k tons, i.e. just 2% of total production.

– JSW Steel has commissioned new 300MW CPP, which will result in cost savings in subsequent quarters.

– Stock trades at an attractive 5.1x FY12 EV/EBITDA of and 9.7x FY12PE. Maintain Buy.

C: TATA STEEL: 2QFY11 crude steel production up 5% YoY; sales volume up 14% YoY; valuations expensive

– Tata Steel’s (TATA IN, Mkt Cap US$12.3b, CMP Rs627, Neutral) crude steel production grew 5% YoY to 1.73m tons during 2QFY11 as its largest blast furnace – “G” has achieved highest ever quarterly production of 557k tons. Saleable steel production increased 6% YoY to 1.61m tons while sales grew 14% YoY at 1.66m tons (19% QoQ) in 2QFY11 due to improvement in demand.

– Though Tata Steel India is expected to perform better due to strong domestic demand and higher integration, coking coal costs will increase. Our key concern in Tata Steel is the performance of Corus as raw material costs and other fixed costs are expected to go up, while the pricing is under pressure due to weaker demand in the European market.

– Stock trades at an expensive 6.9x FY11 EV/EBITDA and 9.4x FY12 PE. Maintain Neutral.

BHEL: Interactions with CMD; Rational competition for NTPC bulk tender for turbines (7.2GW); BHEL bid 8% above L1

NTPC opened price bids for the turbine-generator (TG) package of its Rs250b bulk-tender to set up 11 units (including two units of DVC) of 660 MW supercritical power projects on October 8. We believe BHEL (BHEL IN, MCap US$27.9b, CMP Rs2,581, Buy) will get a minimum of four units, in line with our expectations.

We spoke to the Chairman of BHEL, Mr B P Rao, to get his view on the outcome. Following are the takeaways:

– Based on ‘read out’ prices (i.e. prices quoted by the bidders), Alstom-Bharat Forge Joint Venture is the lowest bidder (at Rs13m/MW) and will have the right to chose first two projects (maximum of 4 or 5 units of 660MW each).

– BHEL is second lowest bidder (8% higher than Alstom-Bharat Forge) and will have the right to choose the next two projects (4 or 5 units of 660MW each). BHEL will have to match the L1 price.

– Toshiba is the third lowest bidder and will get one project (2 units of 660MW each). Toshiba has quoted significantly higher price (~25% higher than BHEL).

– If L3 bidder decides to opt out, allocated project will be executed by BHEL. As in earlier case, BHEL will have to match the L1 price.

We expect BHEL to win six units at good margins

– BHEL’s price is in line with its recent bids for supercritical projects. Margins are expected to be healthy. Also, the prices are much better than Rs9.7m/MW bid by L&T-Mitsubishi in Aug 2008 for the AP Genco order. Post this, while steel prices are down, bid values have increased meaningfully.

– Difference between quotes of BHEL and Alstom-Bharat Bharat Forge JV is expected to narrow down substantially after detailed evaluation by NTPC. NTPC penalizes the supplier of less efficient machines, by loading on the ‘read out’ prices, according to well-defined mechanism. In such a situation, BHEL will have to only marginally lower its prices to match L1 bid.

– As we do not expect Toshiba to match the L1 price, BHEL is likely to win a minimum of six units, in our view.

Orders expected to be placed in next 2-3 months; boiler package to follow

– NTPC is likely to take a month’s time to evaluate price bids, following which they will begin the process of awarding the contracts

– The process of awarding boiler package is also underway. BHEL, L&T, BGR Energy-Hitachi JV and Ansaldo are in the fray for the same.

– We expect Letter-of-Awards to be placed by March 2012 for both boiler and turbines.

– NTPC is also expected to initiate process of another of its bulk tender 9 x 800 MW, by end FY11.

The NTPC bulk tender: an important development

– After a lot of deliberations, NTPC had recently invited bids for sourcing power plant equipment (boiler and TG) for 11 supercritical units of 660MW. According to bid condition, bidders are expected to set up manufacturing plant for the equipments at over a period of time, under phase manufacturing program.

– After technical evaluation, BHEL, Alstom-Bharat Forge JV, Toshiba and PowerMachines of Russia were short listed for TG package. BHEL, L&T, Ansaldo and BGR-Hitachi JV qualified for the bolier package.

Expect strong order-flows, leading to 24% revenue CAGR

– We expect BHEL to post earnings of 24% CAGR over FY10- 12, in line with revenue CAGR of 22%. We expect adjusted EBITDA margin expansion of 250bp over FY10-12, as staff costs (as a percentage of revenue) are expected to fall by 505bp over the period.

– The quality of earning is set to improve, with EBITDA growth of 36% CAGR over FY10-12 along with superior RoE’s of 33% and 54% over FY11 and FY12.

Valuation and view

– BHEL at CMP of Rs2,581 trades at 17x FY12E earnings, and EV/EBITDA at 10x FY12E. BHEL currently trades at around 12% premium to the broader market which has come down from 20% over the last two years. Over the past two years, the premium has significantly shrunk on account of concerns on order-flow stagnation, competition from other private players like L&T and also BHEL’s ability to garner and maintain its market share in the super-critical BTG sets in the Twelfth Plan.

– We believe that with likely upside to order inflows over the next one year, most of these concerns will be allayed. We re-iterate Buy with a target price of Rs2,934, based on 20x FY12E earnings.

HERO HONDA: 2QFY11 margins may disappoint; Volumes & realizations to improve in 2HFY11; Honda exit may impact brand, but not existing technology; Under Review

We spoke to the management of Hero Honda to get an update on business and the implications of a break-up with Honda. Key takeaways:

2QFY11 margins may disappoint

– We model 70bp QoQ improvement to 14.1% (after factoring in lower-than-estimated Sep-10 volumes). The company is guiding for margin improvement to be muted due to lower volumes in Sep-10 driven by flooding and consequent build up of inventory of ~52,000 units at the more profitable Haridwar plant.

– Further, cost push has been severe due to higher tyre prices, use of imported batteries (shortage of domestic batteries) and higher logistics cost which have not been recouped through price increases.

– While several auto companies have taken price hikes recently, there may be some negative surprises in margins reported for 2QFY11 led by cost push.

Expect Oct-10 volumes to improve to 480-500k

– Oct-10 volumes are expected to improve to 480-500K (v/s our estimate of 450k; 433k in Sep-10; 354k in Oct-09) as production would be closer to 450-460k and inventory accumulated in September will be de-stocked.

– We model volume growth of 15% for FY11 to 5.3m units (implying a residual monthly run rate of 461,724 units v/s 419,967 units in FY11YTD).

EBITDA margins to improve in 2HFY11 driven by volume normalizations and price increases

– HH plans to raise prices from Oct-Nov-10, although quantum is not clear. This price increase is on back of price increase by its peers in Oct-10.

– This, coupled with normalization of volumes, will drive improvement in margins in 2HFY11. We model 170bp improvement in 2HFY11 over 1HFY11 margins.

Capacity de-bottlenecking by Jan-11; No decision on new plant could impact FY12 growth

– HH’s recent volumes have been disappointing, impacted by production constraints as well as factors beyond its control. As a result, it is losing out on strong demand at retail level and might see impact on its festive sales.

– HH’s production constraints are expected to ease by Jan-11 as it adds 300k capacity at Haridwar and another 100k at its other two plants. As a result, HH will exit 4QFY11 with a capacity of 5.8m v/s 5.4m units now.

– However, the management has not yet decided on its fourth plant, which would be necessary if industry growth remains strong. Based on 4QFY11 exit capacity, it would have headroom to grow only 10% in FY12. Upon finalization of site, it would take about 10-12 months for the new plant to be operational.

– We factor in FY12 volume growth of 12.5% to 5.95m units.

Break-up with Honda may impact usage of ‘Hero Honda’ brand, but not existing product line-up

– Brand usage is not covered under license agreement, but by a shareholders’ agreement between Hero Group and Honda Group. Hence, if Honda sells its stake in HH, it might not allow HH usage of Honda brand, although details will be known only if the event takes place. However, HH can continue using sub-brands like Splendor, Passion, Glamour etc

– As per the technology license agreement, HH can continue using technology used in existing product by paying 50% of royalty for 3 years.

– Contrary to general perception that Hero Honda is losing out to HMSI in terms of new product supply from the parent, the management indicated that new product launches upto 2014 are already well defined for both the companies. Hero Honda plans to launch 3 new product platforms next year, after a gap of almost two years.

Valuation & view

– Hero Honda has been lagging industry growth due to production constraints, resulting in market share loss.

– This coupled with news flow relating to probable exit of Honda from the company, has resulted in 16% underperformance of the stock to BSE Sensex over last 6 months.

– The stock trades at 16x FY11 EPS of Rs113.6 and 13.7x FY12 EPS of Rs133.9. Under Review.

INDIAN FMCG: Met contract manufacturer of P&G; P&G targets to treble sales in 3 years; Competition to intensify

We met Mr Nikhil Nanda, Managing Director of JHS Svendgaard (JHS IN, MCap US$0.04b, CMP Rs116, Not Rated) to understand the FMCG outsourcing business model and implications of its tie-up with P&G. Following are the key takeaways:

– P&G targets to treble its sales from India (FY09 est at ~US$900m) over the next three years. Sales growth would be consequent to wider consumer base (expected to double from current ~450m), retail reach (from current ~3.75m outlets) and product portfolio (currently ~9 categories).

– The interaction with JHS management reinforced our strong belief in rising competitive intensity in FMCG space. JHS has recently tied up with P&G for exclusive contract manufacturing of detergents (Tide) and Toothpaste which indicates further increase in competitive intensity in these product segments.

About JHS: JHS has emerged as contract manufacturer in the FMCG space and currently supplies to Dabur, Cipla, Elder, Future Group, Wal-mart and Boots. Recently, it has tied-up with P&G to exclusively manufacture Tide detergents and toothpaste in India.

P&G aims to treble sales over CY10-13; HUL, Colgate to bear the brunt

– Our interaction with JHS management signaled P&G’s intent to treble topline of three Indian entities (FY09 est at US$900m). We note that Mr Robert McDonald, Chief Executive P&G Inc had earlier set the target to add 1b new consumers to its fold (current base of ~4b) with much of new addition to come from emerging markets like India and China.

– Per capita spend on P&G products in India stands at a dismal US$0.9, as against US$3 in China, US$20 in Mexico and US$100 in USA (global average of ~US$20). The company is present in 16 categories in China and 36 in USA as against 9 categories in India.

– P&G is likely to focus on widening consumer base, retail reach (more focus on small towns and interiors) and product portfolio (currently present in 9 segments). Although P&G has been a late entrant in India, it has been able to make a strong dent in categories like Shampoos (2nd largest player with ~24% share) and Detergent (No2 with ~15% share).

– P&G has turned aggressive in categories like Detergents (Tide Naturals), Shampoo (15-20% price cuts), Feminine Hygiene (15% price cuts in Whisper), Baby Care (launch of Pampers), Male Grooming (price cut of 40% in Mach3, new Gillette Guard at Rs15), Skin Care (Rs15 sachet and small pack at Rs69 in Olay White), etc.

– As JHS has set up exclusive toothpaste facility for P&G, it is only a matter of time before P&G formally enters the Toothpaste category. Irrespective of brand (Crest or Oral-B), actions of the company in the past 12 months indicate fierce competitive intensity including aggressive advertising, sales promotions and price cuts.

– We believe increased aggression in Oral Care and Skin Care would have bearing on the performance of companies like HUL, Colgate and Dabur. Colgate will be impacted directly, it being pure Oral Care play; HUL will also suffer as Toothpaste is ~20% of personal care sales. In addition, aggression in skin creams can hurt the most profitable segment of HUL (est EBIDTA margin of 35%+ and 40% sales contribution in personal care).

Competitive pressure to intensify; consensus estimates and valuations leave little room for a likely margin contraction

– We note that most companies in our FMCG coverage universe are trading at 20-30% premium to their historical average valuations. While we are optimistic on the underlying opportunity in consumer space, current wave of rising competitive intensity can exert margin pressure in the coming quarters.

– We believe the consensus estimates (including ours) and valuations currently factor in a best case margins scenario for all FMCG companies and leave little room for negative surprise. Any disappointment on earnings momentum may lead to correction in stock prices.

– We highlight that in our recent sector update titled “Post Monsoon input prices & impact analysis” we had downgraded our rating on Colgate and Dabur on concerns of competitive intensity and expensive valuations. We continue to have a cautious view on the FMCG sector, and prefer ITC and Nestle over a longer term.

JHS: P&G to account for ~70% of FY12 sales; likely to emerge as a proxy on P&G’ strong growth

– JHS Svendgaard, being one of the foremost players in contract manufacturing is likely to emerge as a key beneficiary of rising trend of outsourcing by FMCG players. Management believes that the core competence of FMCG players is not manufacturing, but brand building and distribution. Hence, the trend of contract manufacturing is likely to pick-up, more so in case of MNC’s who prefer to avoid legal hassles and manpower issues in manufacturing.

– Recently, the company tied-up with P&G to exclusively manufacture detergents (entire Tide range) and toothpaste. In addition, the company has also secured contract for incremental production of Oral-B toothbrushes post capacity constraint in P&G’s plant.

– As per the agreement, P&G has co-invested in the detergent manufacturing unit to the tune of ~50% and has committed for annual volumes for next 5 years. JHS is the only new addition in the vendor’s list of P&G in the past 17 years. JHS aims to emerge as a preferred vendor to P&G for new/existing categories not only in India but also on a global basis.

– In FY10, JHS achieved sales of Rs685m and PAT of Rs80m; management has guided for sales of ~Rs1.6b, with ~70% of their sales coming from P&G.

– The company has also ventured into Dental care services under the brand T32. The management is optimistic of the opportunity in professional oral care given the low awareness of oral hygiene in India. The SBU currently has 4 operational clinics in NCR (capex of Rs5m/clinic and annual sales of Rs2m/clinic). Management targets to add ~100 clinics over the next 5 years at an investment of ~Rs500m. You can read the full review here.

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