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Year-ahead 2023: The way we see it – a ‘chug-along’ year

It’s almost always the same story and it’s no different this time round - momentum expected to gather more steam a couple of quarters down the line, inflation forecasted to subside, costs would continue to get taken out from all P&L lines to support margin objectives, etc. Weak rural demand remained the biggest pain-point in consumer staples through 2022 and co-incides with a three-year old question: how did a muted demand environment in early2020, even prior to the pandemic, pick-up pace mid-2020 onwards post one of the worst human crises of our lifetimes, viz. Covid-19? We are not able to see too many levers to drive near-term growth in staples barring a natural ‘rural recovery’, government interventions, etc and discretionary businesses run the risk of a sudden slowdown - akin to what transpired in Staples between Aug and Oct 2021. We see 2023 to be a ‘chug-along year’ and expect stocks to respond more to short-term factors; we like those with levers of their own – HUL (mass skin-care, nutrition yet to fully ‘unlock’), GCPL (special situation), ITC (still underappreciated by markets) stay as the key picks.

Two possible disruptions to watch out for the medium-term: We had referred to distribution disruption as a possible wildcard in our 2022 outlook as well. Quite a few businesses have been in the fray to ‘digitise’ the neighbourhood stores and formalise FMCG distribution, which is currently quite fragmented and hence lend strong bargaining power to brand-owners. The emergence of deep-pocketed corporates like Reliance Retail in the distribution arena could, we believe, have interesting medium-term ramifications for the sector in terms of changes to terms of trade, shift in bargaining power, etc. Further, RIL has more recently, signalled intent to extend its consumer play and launched its own consumer staples brand - a follow-up to its Aug’22 AGM announcement of a branded FMCG foray. We agree that brands take years, if not decades, to build and gain consumer loyalty but given Reliance’s deep-pockets and ability to disrupt, this is one event that needs to be carefully watched from a medium-term perspective, in our view

Three key trends that we believe need to be tracked for the short-term:

1) Margin expansion is forecasted to be the single-biggest earnings growth driver for CY2023. An uplift of 190-200bps should not come as a surprise to the market since the same are in the forecasts: >50% of FY24E operating profit growth estimated to be led by margin expansion. The extent of offsets beyond what has already been built in, e.g. A&P, competition-driven spends, wage-costs inflation, other overheads, etc, if any, is what could come as be the party-spoiler here.

2) The sector has been easy on competitiveintensity front, which inter-alia enabled PE-multiple to expand significantly over the past few years. While there is nothing to suggest that competitive dynamics could change anytime soon, a deflationary environment could nonetheless prompt different players to approach businesses differently. Also, unorganized players tend to be more competitive during deflationary phases.

3) We are keenly watching how urban consumption growth trend behaves in the short-term. Akin to how strength in rural demand had reversed all of a sudden between August and October 2021 without any warning, we believe that urban discretionary demand momentum, which has hitherto been driven in part by an extended phase of pent-up demand post the lockdowns, could be put to test especially considering incrementally louder noise of job-cuts in the new-age tech sector.

Four interesting charts inside:

1) There is no concrete past data to suggest there will be acceleration in staples sales growth in a pre-election year.

2) Gross margins lost due to commodity-costs pressure can be recouped in equal measures.

3) Ability to continue extracting ‘costs efficiencies’ would be an important lever for margin expansion.

4) We present four charts to demonstrate how price-led competition had on separate occasions in the past driven severe PE multiple derating in the stocks concerned.

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