Sunday, April 19, 2009

Deflation and Indian FMCG stocks

Buying stocks with pricing power in a deflationary environment - especially when they are priced on deflationary EPS - might be the best hedge against an eventual return of inflation.  

Like a lot of people, I have been trying to figure out the inflation-deflation conundrum. On the one hand, the output gap (capacity utilization in US less than 70%) will suggest producers will find it hard to stick any price increases. On the other hand, if Fed and other central banks keep using this logic to print money ad infinitum, then at some point of time inflation will become a monetary phenomenon. 

Now what I am pretty sure of is that inflation will go up in India and other emerging markets before it goes up in US. Last year, Indian rupee depreciated by 25% and inflation is a staggering 0%. That would have been a very startling outcome for anyone before 2007. In 2008, rupee appreciated by 15%, and inflation was 10%. Now it is the reverse. That tells us how powerful the inflationary surge was in 2007-08, and how powerful a deflationary environment exists today. 

In the next 4 months, we are going to pass through probably the highest deflationary numbers in India. It was from March-April 2008 onwards that the big spikes in oil and other commodities came, so yoy inflation numbers are going to trend negative. A lot of FMCG companies increased prices early last year to take care of the increase in commodity costs. Some of these companies have already reduced prices on some products (paints, soap etc) and others might follow suit in the coming months.

What I have found quite strange in analyst projections is - volume growth and margin expansion is supposed to offset the impact of reduced prices, so that EPS growth in CY09 is same as CY08. That is very unlikely. FMCG, tobacco etc have price elasticity less than one. Companies are better off in a moderately high inflation environment than in a 0% inflation environment. 

Also, last year stockists and dealers were keeping increasingly higher inventories as they expected prices to go up - so last year's volume growth was a bit inflated. That dynamic has likely reversed and will remain so at least for the next few months. 

Indian FMCG stocks trade at very high multiples (Nestle is 30x, HLL is 25x etc). So, a reduction in EPS estimates might hit both on bottomline and multiples. 

So (a) Indian FMCG stocks might see a leg down as EPS growth expectations are revised downwards due to deflation, (b) Indian economy will again see 5% type inflation - probably in the next 12 months itself, (c) FMCG companies have pricing power (d) As inflation comes back, EPS growth expectations will go up, and (e) If Coke USA with 7% long-term EPS growth can command a 13x-14x multiple, then Nestle India with 12%-15% EPS growth can deserve a 20x multiple. 

Now it is possible that companies really deliever on the EPS growth expectaion due to margin expansion. Or that even if they miss, stocks don't fall at all. But if they do, then it might be a very good time to buy some of the FMCG stocks. 

I am assuming that India can grow at 3%-5%.

1 comment:

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