February 08, 2016

are companies passing on raw material cost savings to consumers?

Something I wrote on higher operating margins during times of falling raw material costs by listed companies in today's FC Invest issue:

Take high operating margins in a falling raw material cost scenario with a pinch of salt

One of the very investment themes which has not been hit adversely by the global economic slowdown and the Chinese mini-meltdown has been the domestic consumption theme. The Indian consumer has been fairly insulated from the external factors.

Given this, the crash in crude oil prices and the prices of most commodities has posed a strategic challenge to many listed companies in the fast moving consumer goods and consumer durables sectors, as well as in other consumer-centric sectors.

Companies’ raw material (RM) costs have come down drastically in the past one year. Cost of transportation is down. Should a company use this a golden opportunity to cut prices for its consumers and boost it sales? How much of the savings arising from these cost declines should a company pass on to its end customer? Or, should the company pocket all savings to itself considering the justification that any price cuts made by the company to increase sales will invite similar cuts from competition? And, if a company pockets all or much of the cost savings and then goes on to show a jump in its operating margins, is that necessarily a show of great and sound fundamentals as far as investors are concerned?

In the process of such companies addressing these questions, investors in these companies get a golden chance to gauge the thought process of the company management on this important strategic challenge and sense whether they are dealing with it in the best and long-term interests of the business or not.

Take a look at the latest 9-month period of April to December of the current financial year, 2015-16 (9M-FY16). FC Research Bureau analysed the financials of five select consumption-driven companies whose latest third-quarter (December 2015) results were out, and which were large-cap companies belonging to the Nifty 100 index, to understand what was going on in a falling RM cost scenario.

These five companies were Asian Paints, Colgate-Palmolive (India), Godrej Consumer Products, Hindustan Unilever (HUL), and Marico. Four of them saw their operating profit (earnings before interest, depreciation, tax and amortisation or Ebidta) growth in 9M-FY16 as compared to the year-ago period, outpace their net sales growth by a wide margin.

Lets take the case of Asian Paints first. Its net sales in the latest  9-month period grew by just 8.5 per cent, while its operating profit jumped up by 24.8 per cent, on a yoy basis. This came on the back of a 3.0 per cent reduction in RM costs. The same company, in 9M-FY15 (the previous year), had recorded a 12.9 per cent rise in net sales against which operating profit grew by a smaller margin of 10.1 per cent. The RM cost had risen by 12.2 per cent.

Asian Paints is currently running high operating margin on the back of cost savings in RM which it has not passed on to the consumers. Without price cuts, it has not been able to boost its net sales whose growth was one-third to that in its operating profit.

But the company management was clearly aware of the implications. In a conference call with analysts on January 18, after it had announced its Q3 results, the company management acknowledged that there was no change in the pricing of its products, and further categorically said that  the high level of gross margins was clearly not sustainable going forward.

According to Prashant Mittal, investment analyst at Ambit Capital, companies typically follow three approaches to make use of the fall in their input prices for increasing their sales:
1) Passing on the benefit to the end consumer through price cut
2) Indulging in promotions, that is, increasing the volume sold (for example, 5 per cent extra or buy 2 get 1 free) but keeping SKU price same
3) Additional spending on advertising
Net sales of Marico, another company in our analysis, rose by 7.2 per cent and its RM cost fell by 7.2 per cent, while its Ebidta shot up by 23.4 per cent, in 9M-FY16, on a yoy basis. The previous year’s corresponding period (9M-FY15) had seen net sales shoot up by 24.7 per cent, RM cost flare up by 44.4 per cent and Ebidta trail with a rise of just 15.9 per cent.

Clearly, Asian Paints, Marico and also Colgate (see chart), represent potential examples of companies choosing, for their own strategic reasons, not to pass on RM cost reductions to their consumers.

Cost-sales-margin matrix

How four major consumption-driven stocks have fared in the last two financial years

9M-FY16* 9M-FY15**

Net sales RM cost Ebidta Ebitda margin (%) Net sales RM cost Ebidta Ebitda margin (%)
Asian Paints 11411 5617 2219 19.5 10515 5793 1778 16.1
YoY change (%) 8.5 -3.0 24.8 --- 12.9 12.2 10.1 ---
Colgate-Palmolive (I) 3041 836 687 23.0 2933 885 601 20.0
YoY change (%) 3.7 -5.5 14.3 --- 11.8 3.5 3.8 ---
Godrej Consumer Products 6691 2579 1219 18.2 6160 2569 1033 16.8
YoY change (%) 8.6 0.4 17.9 --- 8.9 14.7 20.6 ---
Hindustan Unilever 23616 8430 4599 19 22615 8938 4895 22.0
YoY change (%) 4.4 -5.7 -6.0 --- 10.5 8.3 21.4 ---
Marico 4820 2273 912 19 4497 2373 739 16.4
YoY change (%) 7.2 -4.2 23.4 --- 24.7 44.4 15.9 ---

* Apr-Dec 2015

** Apr-Dec 2014

Figures in Rs crore, unless specified  otherwise

Financials are consolidated, unless not available or not applicable

RM: raw material, Ebidta is operating profit

Source: Capitaline. Analysed by FCRB.

HUL, on the other hand, appeared to have gone a long way to boost sales by passing on the RM cost fall benefit to its consumers. HUL’s latest period net sales was up by 4.4 per cent while its Ebidta actually fell by 6.0 per  cent. RM cost was down 5.7 per cent. In the year-ago period, net sales had risen by 10.5 per cent and although Ebidta had shot up by 21.4 per cent the RM cost had also gone up by 8.3 per cent.
According to Anand Rathi Securities’ investment analyst, Ajay Thakur, “HUL has proactively made a 12 per cent price cut in its products in Q3 and first month of Q4 largely to maintain their market share and partly to gain market share.”
Ambit’s Mittal thinks companies can only take limited price cuts considering the risk of brand dilution in case of an excessive cut. “Similarly, given law of diminishing marginal utility, the companies have limited leeway with respect to promotional offers. They are unlikely to end up making consumers consume a whole lot more than the usual amount through promotions. What they can do is either pre-pone the demand or premiumize (tempting consumer to try a higher value brand by reducing its price),” said Mittal.
He further said that once the three approaches (or a combination) is met, the rest of the benefit becomes a part of operating margin. “Hence, whilst some of the additional demand might stick, the investor should take both higher sales and higher operating margins in a falling raw material cost scenario with a pinch of salt,” Mittal said.
Investors, therefore, need to go beyond healthy operating margin figures and look at their primary cause. In quite many product lines in the Indian consumer markets, the consumers are un-aware that the cost of making the products has come down. “Unless there is a competing product that is priced lower, a consumer does not know,” said Anand Rathi’s Thakur.
Savvy FMCG companies might just take undue advantage of them by not passing on cost savings and at the same try to impress the investors with high operating margins. Be wary of their tactics and not get carried away by the strong operating margins they throw around to lull you.


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