Mumbai: Narendra Modi’s convincing victory in the Uttar Pradesh assembly elections is set to cheer domestic equities, with the SGX Nifty futures gaining sharply on Monday (local markets were shut for Holi). Once the euphoria settles, investor attention will return to corporate performance. The twin engines of consumption and investment that drive the economy and earnings are both running low on fuel.
India needs consumption growth to recover, so that utilisation levels can step up and eventually spur investment in new capacity. Last week, a Crisil release on its FY18 economic outlook said that low capacity utilisation and stretched balance sheets will constrain the investment cycle, and it expects it to recover only in FY19. Even for that to happen, consumption has to step up significantly in FY18, so that companies get the confidence required to create more capacity.
FMCG companies were anyway seeing difficult demand conditions in the first half of FY17, especially in rural markets, and demonetisation hurt sales growth, to an extent, in the third quarter. The latest Index of Industrial Production (IIP) data for January shows that demand for consumer durables, which includes passenger vehicles, has risen by 2.9% over a year ago, but that for non-durables has fallen by 3.2%.
Even before demonetisation, the non-durables index was either flat or declining. That was to be expected as demand was weak. Urban markets had seen some recovery in demand although not a robust one but rural consumers were holding back. Rural incomes had come under pressure due to drought, relatively lower increase in food prices and pressure on rural wages.
But this should change as the current season’s harvest has been good and that should see farm incomes improve. Average rural wages in agricultural occupations have risen by over 8% year-on-year in the three months to December 2016. Non-farm income may remain under pressure, till traditional employment sources such as industry and construction see a pick-up in activity. Difficult conditions in manufacturing and service sectors also suggest that urban demand may continue to suffer. On top of this, competition is severe and unrelenting.
So, what can drive FMCG performance then? After all, most companies still trade at premium valuations with the sector itself trading at 38 times its trailing 12-month earnings, based on the Nifty FMCG Index, while the broad market trades at 24 times. The sector has historically traded at high valuations but then those were in periods when performance was better. The December quarter saw sales decline by 2.5%, while profit fell by 2.1% over a year ago. In the September quarter, these figures were a growth of 5% and 4.4%, respectively. Such figures hardly support these valuations.
The buck for a revival appears to be stopping at the trusted doorstep of price increases. Price hikes were visible in previous quarters too, in categories such as soaps in personal care and biscuits in foods, where raw material prices have risen. A recent Nomura Research note pointed out how price increases are making a comeback although still selective and in small doses.
A cautious approach takes cognizance of the difficult market conditions, especially weak demand and stiff competition. The industry is now entering a new phase where prices will begin to inch up and companies will see how consumers react to it. If raw material price trends remain firm, then selective price increases will continue. If demand also picks up, then companies may become bolder with price hikes. That situation is not present yet but price hikes are likely to play a bigger role in sales growth in the coming quarters and perhaps FY18 as well, compared to earlier when volume growth dominated.
