INDIACONSUMER：THROUGHTHELENSOFIMPLIEDEXPECTATIONS0115

Consumer & RetailIndia ConsumerIndia ConsumerThrough the lens of implied expectationsHSBC Consumer & Retail coverage snapshotabcGlobal Research Outperformance in 2012 has priced insignificant expectations For 2013, we select stocks that still buildreasonable expectations in valuations andare long-term structural winners OW ITC, Colgate and Titan; upgradeCompanyTickerHSBCRatingPrice Target(INR) Price(INR)PotlreturnHindustan Unilever to OW from N withunchanged TP after the sell-off; N Nestle,ITCHindustan Unilever LtdColgate-PalmoliveITC INHUVR INCLGT INOWOWOW2734981,5013465881,76026.6%18.0%17.2%Godrej Consumer, Dabur and MaricoTitan Industries Ltd TTAN INNestle India NEST INDabur India DABUR INMarico Industries MRCO INGodrej Consumer Products GCPL INOWNNNN2704,8401262277283105,30013323574014.9%9.5%5.5%3.4%1.7%Consumer stocks did well in 2012, with the sectors rising tidelifting nearly all boats. While the long-term attractiveness of thespace is largely intact, frequent periods of sharp rerating beg aNote: Priced as of 11 January 2013. Potential return equals the percentage difference between the currentshare price and the target price.Source: Bloomberg, HSBC estimates.14 January 2013Amit Sachdeva *AnalystHSBC Securities and Capital Markets (India) Private Limitedquestion: are the expectations built into the share prices realistic?Even though the stocks may be trading at similar multiples, theirgrowth potential could differ widely. The implication of sunk costs,dominant scales, category cost economics and competitivedynamics make these divergences even wider.As the market chases beta, consumer names could witness sell-+9122 2268 1240amit1sachdevahsbc.co.inoffs which may create attractive entry points for names we see asErwan Rambourg *Head of Consumer and Retail, Asia PacificThe Hongkong and Shanghai Banking Corporation Limited+852 2996 6572 .hkKuldeep Gangwar*, CFAAssociateBangaloreView HSBC Global Research at: http:/*Employed by a non-US affiliate of HSBC Securities (USA) Inc,and is not registered/qualified pursuant to FINRA regulationsIssuer of report: HSBC Securities and Capital Markets (India)Private LimitedDisclaimer & DisclosuresThis report must be read with thedisclosures and the analyst certificationsin the Disclosure appendix, and with theDisclaimer, which forms part of itlong-term thematic winners. Our stock-picking frameworkemploys the following bottom-up approach. We strip out growthexpectations built into each stocks valuation. We compare theseexpectations against each category that the companies operate inand assess their capabilities, scale and competitive advantages towin in respective categories.Using this approach, we identify four stocks that we thinkinvestors should add as the sector may derate: 1) ITC for itsearnings resilience, expected turnaround in other FMCG businessand least demanding valuation among staples; 2) Colgate-Palmolive for its superior ability to capture value from theattractive oral care space; 3) Titan Industries as a long-termstructural winner in the Indian jewellery space, with consensusbecoming overly bearish amid a regulatory overhang; and 4)following the recent sell-off, we think earnings growthexpectations built into Hindustan Unilevers current price arefairly realisitic. We upgrade Hindustan Unilever to OW from N,as we believe the slowdown in volume growth in its CanteenStores Departments (CSD) is temporary and could rebound inFY14, serving as a key stock catalyst. We have increased NestleIndias TP to INR5,300 (from INR4,975) as we move our 12-month valuation basis from April 2013 to December 2013.Consumer & RetailIndia Consumer14 January 2013India Consumer Consumer stocks significantly outperformed the broader market in2012 driven by solid earnings and sector rerating While we have turned cautious on consumer staples, we believe2013 will still provide good entry points to strong structural stories We prefer ITC in large-caps and Colgate-Palmolive in mid-caps.We like Titan for its long-term attractiveness, while the near-termregulatory overhang should keep the stock subduedabcThe year 2012 was great, butwhat about 2013?Consumer stocks under our coverage posted 53%returns in the calendar year CY12, significantlyoutperforming the broader market, which was up28% during the year. This outperformance wasdriven by impressive earnings growth of c20%(simple average of our coverage universe) withthe remaining c33% coming from multiplesrerating. This strong performance begs a question:is the consumer sector now too expensive?Differences in their returns last year reveal someinteresting insights, which in our view provideimportant points of reference for how we shouldview their individual outperformance.In CY11, Titan saw its multiples sharply derate.Despite impressive 39% earnings growth, thestock delivered -5% returns as the gold price rosesharply, triggering fears that jewellery demandmay collapse. CY12 indeed witnessed a sharpdecline in gold jewellery demand, but Titanresponded with aggressive expansion of retailarea, improved its revenue mix towards high-margin studded jewellery and delivered earnings2that were ahead of expectations during what wasessentially one of the weakest periods of jewellerydemand in India. This led to a sharp rerating ofTitan in CY12, with the stock rising 56%. In ourview, this was a reversal of Titans derating thatoccurred in 2011.Other derating and rerating stories includeGodrej Consumer Products (GCPL) and ITC.Despite solid earnings growth in CY11, GCPLstock was flat as it made acquisitions using USDdebt and INR witnessed a sharp depreciationagainst USD. In CY12, GCPL maintained solidearnings growth, but paid down part of the debtusing equity funding from Temsaek. GCPLregistered a 90% return in the last one year.Following this, we believe GCPLs valuationimplies aggressive growth expectations, which areachievable, but leave very little margin for error inour view.ITC too is a derating and rerating story. In CY11,it underperformed despite solid earnings growthdue to the fear of imminent excise duty hike. ITCdelivered solid earnings in a year, when exciseduty on cigarettes was hiked by 23%. ITC passedConsumer & RetailIndia Consumer14 January 2013on large price hikes to consumers and stillmanaged to maintain flat volumes and earningsgrowth in excess of 20%.In sum, all of these stocks performed strongly, butthis was in part due to a reversal of a derating thatthey witnessed in the previous year, in our view.Marico was the only stock that witnessed itsvaluation multiples expand in both CY11 andCY12 despite its earnings being downgraded.Expectations built in the currentprices are significantNonetheless, with a sharp rerating, most of thevaluations of consumer stocks have built insignificant expectations for long-term growth thatmake us cautious in general on consumer staplesvaluations.As the market chases beta, consumer names couldwitness sell-offs, which may create attractiveentry points for names we see as long-termthematic winners.12-month forward PE movement for consumer stocks50Our stock-picking framework employs a bottom-up approach. We strip out growth expectationbuilt into each companys valuation. Wecompares these expectations against each of thecategories in which the companies operate andassess their capabilities, scale and competitiveadvantages in their respective categories.Through this approach, we identify four suchstocks that we think investor should add, as thesector may derate. These are ITC, Titan, Colgateand Hindustan Unilever (HUL). For HUL, weupgrade to OW from N on an unchanged targetprice of INR588.abc40302023 22 2427 272928222627 26343837 3528232419 182725 2530100ITCHU LTitanC olgateNestleDaburGC PLMaricoPalmoliv eJ an-11Jan-12Jan-13Source: Thomson Reuters Datastream, HSBC310%5%Consumer & RetailIndia Consumer14 January 2013In CY11, multiples contracted for ITC, Titan, GCPL despite solid earnings growth and even earnings upgradesabc40%30%20%10%0%-10%-20%23%15%4%ITC39%8%-5%Titan14%11%-8%ColgatePalmolive31% 30%7%HUL17%7%1%Nestle13%-1%-8%Dabur23%0%0%GCPL20% 21%-12%Marico40%30%20%10%0%-10%-20%Despite solid earnings multiplecontraction: 1) Titan as gold priceincreased triggering fear of demandcollapse 2) ITC for expectedtaxation 3) GCPL for acquisitionrelated USD, while INR depreciated4) Nestle for input price inflationMultiple expansion despiteearnings downgrade; Marico,which saw input prices impactingEarning Growth(lhs)Earning surprise(lhs)CY11 stock return(rhs)gross marginsHUL despite impressiveearnings, multiples were flatSource: HSBC, Thomson Reuters DatastreamRising against the tide stories (Titan, ITC and GCPL) saw the reversal of 2011 de-rating, HUL continued to perform in line with earnings growth30%25%20%15%10%5%0%-5%-10%-15%21%35%2%ITC22%56%2%Titan21%53%6%ColgatePalmolive22%26%5%HUL17%6%Nestle-10%19%28%-2%Dabur90%21%0%GCPL24%50%-3%Marico100%75%50%25%0%-25%-50%Multiple re-rating in 2012, reversalof 2011 1) GCPL as it deleveraged anddelivered solid earnings 2) Titan: Retailexpansion and earnings despitecollapse of jewellery demand 3) ITC forsolid earnings despite excessivetaxation 4) CP for earnings upgradeand market share gains 5) Dabur forearnings growth, A&P backed volumerevivalMarico was only player withEarning Growth(lhs)Earning surprise(lhs)Last 1 year stock return(rhs)multiple expansion despiteearning downgrades in successiveCY11 and CY12Source: HSBC, Thomson Reuters DatastreamLong-term annualised implied growth in current valuation multiples20%15%Key OW callsConstructivelycautiouscautiousCY13: Earnings momentumdriven stories to hold themomentum with reasonablegrowth expectations built in thecurrent prices: 1) ITC and Colgatescore well overall where growthexpectations are realistic and0%ITCHULTitanColgatePalmoliv eNestleDaburGCPLMaricoearning momentum is likely to staysolid 2) HUL and Nestle to be comeattractive as the volume growthrebounds 3) Dabur is on the rightCurrentLast y eartrack builds in relatively modestexpectations compared to Maricoand GCPLSource: HSBC estimates, For detailed methodology, refer to our thematic report Personal Touch, 7 December, 201145depth.Indian consumer sector snapshotITCHindustan UnileverColgate-PalmoliveTitanNestle IndiaDabur IndiaBloomberg tickerRatingTarget price (INR)Current market pricePotential return (%)ITC INOverweight34627326.6%HUVR INOverweight58849818.0%CLGT INOverweight1,7601,50117.2%TTAN INOverweight31027014.9%NEST INNeutral5,3004,8409.5%DABUR INNeutral1331265.5%Investment Case1) Taxation is unlikely todampen cigarettemomentum: ITC cigaretterevenues and profits havegrown in double digits,1) Long-term growthmomentum to sustain as aCSD channel inflictedslowdown in volume growthis not permanent.1) Growth opportunity in 1) Titan is the key 1) In the packaged food 1) Dabur business on core 1) Solid core domestic 1) GCPL has strategicallyoral care is attractive, driven beneficiary of the structural category, which is the fast capabilities (health businesses (edible oils and chosen to focus on coreby penetration, trend towards branded growing segment of Indias supplements), is rock solid hair oils), but input costs are capabilities and keypremiumisation and jewellery (currently c7-8% FMCG space, Nestle India and should continue to volatile and not always markets to build growth,category extension. Colgate of jewellery market) as has a natural competitive grow. possible to pass on. We which we think is eminentlydespite modest volume inthe last decade due to2) Base effect in S&D isbenefits from its scale,brands and distributionurbanisation and incomelevels rise. First-moveradvantage with its estimate Maricos 75% sensible and will createdistribution network, strong 2) A&P-led volume focus is profit pool is still linked with long-term value throughpunitive taxation. Pricingpower and modestless benign going forward,but a sharp decline in palmadvantage, brand strength, brand names andand national scale and leadership acrosssensible and volume growth commodity linked products. scale and coremomentum has helped competencies acrosscompetition should helpsustain the double-digitoil prices may help inmargin expansion.2) The potential impact of distribution give Titan aProctor & Gambles (P&G) strong competitivecategories.Daburs stock to rerate in 2) Maricos focus onthe last few months but wellness and beauty care isrevenue and earningsmomentum.2) Other FMCG businessmay continue to grow in3) Our implied growthmodel suggests thatexpectations built into thisvaluation are stillentry has been advantage 2) Volume growth continues subscale categories are still prudent, but acquisition-led 2) rerating in our view hasexaggerated, in our view. to be weak, but having vulnerable. growth (Paras) comes at a been driven by sustainedEven if P&G acquires 20% 2) Titan is well positioned to doubled the capacity and cost. Foray in functional operational performanceof the target market in the benefit from demand revival distribution depth, volume 3) Despite the structural food categories is sensible and broader acceptance ofnext five years, we believe as jewellery retail expansion growth is likely to rebound challenges Dabur faces in preparation for the long GCPLs 3x3 strategy thatstrong double-digits and weexpect business to becomereasonable and multiplecontractions are unlikelyColgates value growth is on track to meet annual next year, but short-termtrajectory would decline by guidance remains challengingsome categories, ourimplied growth valuationEBIT positive in FY14e.3) Hotels to benefit fromunless volume growthtrajectory permanentlyslows down at sub-7%only a modest 1-2ppt. trade-off model suggests from multinationals.Therefore, it is unlikely to 3) A FY14e PE of 25x 3) High-growth expectations that long-term earningsdent Colgates growth implies a long-term growth are built into current expectations built in the 3) International businesscapacity expansion and lowbase, while agri business islevel.prospects materially.rate of c10%, which in our valuation. Even though we price are realistic.view is realistic. High-end believe that Nestle canstrategic and providesbackward linkages to3) We believe theexpensive multiple (33xwatches, transition towards deliver on thesediamond-studded jewellery expectations, it has littleValuationstaples and cigarettes.We value ITC on a SOTPbasis, which is based on aDCF valuation of thecigarette business. Hotels,agri, other FMCG, andP&PB business are valuedusing a relative valuationWe use a DCFmethodology to derive ourtarget price. For our DCFwe use a cost of equityof 10.8%, which includes arisk free rate of 8%, marketrisk premium of 5% andFY14e PE) implies still should help margins and margin for error.realistic long-term earnings new businesses to boostgrowth of c11%. growth momentum.We use a DCF We use DCF methodology We use DCF methodology We use DCF methodology We use DCF methodology For our DCF valuation, wemethodology to derive our to derive our target price. to derive our target price. to derive our target price. to derive our target price. assume a cost of equity oftarget price. For our DCF For our DCF valuation, we For our DCF valuation, we For our DCF valuation, we For our DCF valuation, we 11.25%, which includes aWe use a cost of equity of use a cost of equity of 11%, have used a cost of equity have used a cost of equity have used a cost of equity risk free rate of 8%,11%, this includes a risk- our average cost of equity of 11%, which includes risk of 11%, which includes risk of 11%, which includes risk market risk premium of 5%free rate of 8%, a market for the consumer sector in free rate of 8%, market risk free rate of 8%, market risk free rate of 8%, market risk and beta of 0.65.risk premium of 5% and a India. premium of 5% and beta of premium of 5% and beta of premium of 5% and beta ofapproach. We use a cost ofequity of 11% in our DCFbeta of 0.55.beta of 0.6.0.6.0.6.valuation for the Cigarettebusiness, which includes arisk-free rate of 8%, marketrisk premium of 5%, andbeta of 0.6.Source: HSBC estimates. Prices as of 11 January 2013. Under our research model, for stocks without a volatility indicator, the Neutral band is 5ppts above and below the hurdle rate of 11% for Indian stocks. For HUL, our TP implies a potential return above the Neutral band; therefore, we upgrade the stock to OW from N.For ITC and Colgate Palmolive, the TPs imply potential returns above the Neutral band; therefore, we reiterate OW on these stocks. For Nestle India, our new TP implies a potential return within the Neutral band; therefore, we reiterate N on Nestle India. For Titan, Dabur, Marico and Godrej, at the time we set our targetprices, they implied potential returns that were above/within the Neutral band; therefore, we rate the stocks OW/N accordingly. Potential return equals the percentage difference between the current share price and the target price, including the forecast dividend yield when indicated.6growing categories inexcessive taxationshocks.Indian consumer sector snapshot (contd)ITCHindustan UnileverColgate-PalmoliveTitanNestle IndiaDabur IndiaRisk factorsKey downside risks, in our Upside risks include aview, are slower-than- moderation in commodityKey downside risksinclude destructive priceKey downside risksinclude: 1) a severeUpside risks: 1) lower-than-anticipated inputOn the upside, apermanent change inanticipated progress or prices and better-than- competition and a severeeconomic slowdowncosts of raw materialsshampoo trends wouldloss of market share in expected volume growth. macro slowdown.leading to a fall insuch as milk, sugar and bode well for itsDownside risks include aother FMCG, and ITCs return in destructive pricestock prices sensitivity to competition in the S&Dcategory as input priceinflation tapers off; and aprice war in personalproducts in the wake ofincreased competition.discretionary spending;2) a sharp correction orhigh levels of volatility inthe gold price; and3) price destructivecompetition in brandedjewellery. Whilecompetition may increasepenetration in thissegment, it could alsolead to profit erosion.wheat; 2) acceleration ofdemand for packagedfoods.Downside risks: premiumpricing of new launchesimpacting volumes, costinflation and increasedcompetition, as bothIndian FMCG giants andglobal players eye theIndian petitive positioning inthe tough HPC market.Higher-or-lower thananticipated raw materialcosts and performancelevels of new acquisitionswould continue toinfluence the stock priceboth ways.3) higher raw materialcostSource: HSBC estimates.Consumer & RetailIndia Consumer14 January 2013ITC (ITC.BO, OW, TP INR346)Performance in 2012ITCs stock performance of +47% (includingdividend yield) in CY12 was quite impressive, andwas backed by an equally strong operatingperformance of double-digit earnings growth (13quarters in a row with +20% PAT growth). In ourview, the multiple rerating was due to: 1) asignificant acceleration in EBIT growth forcigarettes to 20% in the last six quarters from 16% inthe previous six driven by ITC pricing power and itsastute pricing strategy of staggered price increases;2) this was also in part a reversal of the multiplecontraction in CY11 despite solid earnings as a largeincrease in excise duty was anticipated and cameinto effect in March 2012 (a c22% increase).However, ITC still delivered more than 20%earnings in 1H FY13. In our view, ITCs valuation isstill the least demanding in our coverage universe.Key issuesTaxation is set to remain punitive. The possibility ofanother excise duty (ED) hike in FY14e, coupledwith potential VAT hikes by some states, is a keyrisk. We have modelled in our base case an ED hikeof 9%. Volumes may remain muted if ITC needs tomake significant price hikes in order to offset thetaxation impact.Expectations for 2013ITC is among our top picks for CY13, as we expectthe company may continue to register strongoperating performance across the board.ITC Q3 FY13e preview In the cigarette segment, we expect mid-t