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Sunday, February 18, 2007

Godrej Consumer Products: Buy


A couple of quarters of decelerating profit growth have triggered a sharp decline in the Godrej Consumer Products stock, to Rs 146 from the Rs 180 levels in September 2006. Though rising input costs have exerted pressure on Godrej's profit margins in recent times, we see this being offset by an increase in selling prices, as pricing power improves and demand for traditional fast moving consumer goods (FMCG) products gains traction. A broad-basing of Godrej's product portfolio by way of recent overseas acquisitions and product launches also augurs well for margin improvement.

At the current price levels, the stock trades at about 24 times its trailing 12-month earnings and 20 times the expected FY-08 earnings, placing it at a significant discount to frontline FMCG peers, which trade at 25-28 times forward earnings. Investors can consider adding the stock to their portfolio with a long-term perspective.

Traction in topline growth

Godrej Consumer derives the bulk of its revenues from toilet soaps (54 per cent) and hair colour (24 per cent), with toiletries and liquid detergents also chipping in. The two key categories have shown significant acceleration in demand growth in recent times. While growth in the soaps segment has accelerated from 8 per cent in the June quarter of 2006 to 22 per cent in the December quarter, that in the hair colour segment has risen from 28 to 33 per cent. This has been reflected in the company's topline growth rising from 14 per cent in the first quarter of this fiscal to 19 per cent in the recent December quarter. That the company's brands are strongly focussed on the value-for-money plank would also be an advantage, amidst growing offtake for FMCGs from semi-urban and rural centres.

Material concerns

However, over the past two quarters, Godrej Consumer's earnings growth has failed to keep pace with the revenue increase on account of rising input prices. For the nine months ended December 2006, the company's (standalone) profits rose by a mere 1 per cent, despite a 16 per cent growth in sales. Growing demand for biofuels has triggered a sharp uptrend in palm oil prices (a key input for soaps); with prices over the past four months ruling 30 per cent higher year-on-year. Rising material costs (despite forward cover) have trimmed the company's operating profit margin by about a percentage point in the nine months ending December 2006, to 21 per cent. Given that the company's fastest growing soap brand — Godrej No.1 caters mainly to price-sensitive segment, the company has lower leeway to take price increases, when compared to competitors with a larger presence in the premium category.

Palm oil prices appear set to rule firm over the next year or so. However, the pressure on the company's margins from this source may abate in the coming quarters, on three counts. One, the company has taken significant price increases in both the soap and hair colour segment over the December quarter which appear more than adequate to offset the escalation in input costs. Second, the company's volume growth has strengthened both in the soap and hair colour segments in the December quarter, a sign that price increases have not materially impacted offtake. Third, the recently-commissioned facilities for toilet soaps in Katha and the ongoing capex at other locations, may provide tax advantages that will further reduce the cost structure on soaps.

Broader portfolio

While both toilet soaps and hair colour are growing at a healthy clip, Godrej Consumer's overseas forays and its expanding portfolio in the personal care segment (with products such as diapers, talcum powder, shaving cream) also have the potential to add to revenues and margins. Keyline Brands, a UK-based personal care company acquired by Godrej in October 2005 (annualised revenues of Rs 157 crore), and Rapidol Pty, a South African hair care company bought in September 2006 (Rs 57 crore), have the potential to add substantially to revenues and profits in the coming quarters. While both acquisitions are expected to be earnings-accretive, Godrej has made product launches in these companies in recent months and commenced shipment of its domestic brands to these overseas arms.

Godrej plans to use these businesses as a platform to explore new overseas markets for its domestic brands. On account of these overseas forays, the company's consolidated operations have registered stronger revenue growth (at 38 per cent) and net profit growth (at 14 per cent) in the first nine months of FY-07.

While relatively low valuation levels and the possibility of margin improvement in the coming quarters add to the stock's attractiveness, the following risks to earnings bear a watch.

The possibility of a slowdown in the company's hair colour portfolio, if it is unable to make adequate progress in the fashion colour segment;

Inability to take further price increases in the event of a continuing upward spiral in input costs.