Rating Methodology for Fast Moving Consumer Goods Industry

Transcription

1 October 2015 ICRA Rating Methodology ICRA RATING FEATURE Rating Methodology for Fast Moving Consumer Goods Industry Overview The following note identifies the key factors considered by ICRA in assessing credit risk in the fast moving consumer goods (FMCG) industry. The objective of this note is to help investors, issuers and other market participants to understand how ICRA analyses creditworthiness of companies in the FMCG industry. This methodology does not include an exhaustive treatment of all factors that are reflected in ratings but enables the reader to understand the rating considerations that are most important. ICRA s analysis focuses on the following eleven key rating factors that are common to assigning ratings in the sector. The key rating factors are: 1. Business Risk Analysis a. Scale b. Diversification i. Geographic Diversification ii. Segment/Product Diversification c. Market Position i. Distribution Channel ii. Brand Equity iii. Product category attractiveness d. Raw Material Sourcing 2. Financial Risk Analysis a. Revenue Growth b. Profitability c. Working Capital Management d. Tenure Mismatches, and Risks Relating to Interest Rates and Refinancing e. Debt Servicing Track Record f. Contingent Liabilities/Off-balance Sheet Exposures: g. Consolidated Financial Analysis h. Financial Policies and Capital Structure i. Event Risk and Adequacy of Future Cash Flows 3. Promoters/Management Quality

2 Business Risk Analysis The Indian FMCG industry, with an estimated market size of Rs 2 trillion, accounts for the fourth largest sector in India. Items in this category are meant for frequent consumption and they usually yield a high return. The most common in the list are toilet soaps, detergents, shampoos, toothpaste, shaving products, shoe polish, packaged foodstuff, and household accessories and extends to certain electronic goods. India is becoming one of the most attractive markets for foreign FMCG players due to easy availability of imported raw materials and cheaper labour costs. Indian FMCG sector can be broadly classified under Household Care, Personal Care, Healthcare (OTC) and Food & Beverages (F&B). Amongst these sub-segments, F&B constitute over 50% of total market size followed by Personal Care, Household Care and Healthcare. The sector has a strong presence of multinational companies (MNCs), well established distribution network and high competition between organized and unorganized players. Branding plays an important factor in customer purchase, and to support/enhance visibility - industry players incur heavy advertising, marketing, packaging and distribution costs. Scale The Indian FMCG sector is highly fragmented and volume driven industry with largest player accounting for less than 7% of domestic FMCG market. ICRA believes that a company s revenue base and market position are key factors in determining its business strength and operating flexibility in FMCG industry. The scale of operations generally reflects large volumes enabling economies of scale, cost absorption and ability to offer competitive pricing. Size allows companies to leverage costs of all kinds, including advertising and promotion expenses towards consumer awareness of brands and products. It also lends companies more bargaining power with their distribution channel partners, and provides them cushion during any production disruptions by having adequate inventory in distribution channel. Diversification Diversification and scale of operations are closely linked with a company having large scale is generally well diversified. Diversification can be broadly classified under i) geographical diversification and ii) segmental and product diversification. i) Geographical diversification A company that is well-represented across multiple regions or geographies will be able to perform more consistently during various demand scenarios. A diversified revenue mix between rural and urban segment in India also mitigates the adverse impact of an uncertain monsoon in rural market as well as slowdown in economy in urban market. Geographic diversification is a positive factor because it mitigates changes in customer preferences and the impact of regulatory, product liability or safety issues in a specific region or geography. ii) Segmental/Product diversification Segmental diversification mitigates the impact of change in consumer preferences, product obsolescence, slowdown in specific segment and weakening of an individual brand. Typically, the most diversified companies are present in several market segments, while smaller companies often depend on only few segments. A company with balanced portfolio will have relatively stable top-line growth and profitability as against company dependent on a specific product segment. A company may not have segmental diversification, but can still have large scale owing to its presence across various geographies and strong brand equity in its core segment. In some cases, a company may have only one brand but be diversified by geography and by product. Market Position A company s market position is a key determinant of sustainable growth and a company s ability to expand its market share indicates its ability to outperform underlying industry growth rate. Generally, FMCG industry displays modest top-line growth and a company s ability to outperform its competitors reflects its product/ brand strength as well as a stronger negotiating position with its distribution ICRA Rating Services Page 2 of 6

3 channel. Competitive intensity is usually high across most product segments, with presence of entrenched player as well regional challengers. Multinational companies benefit from wide product portfolio and R&D capabilities to regularly refresh their products, keeping customers interested in their product portfolio. A regional player may not have product bandwidth or economies of scale benefit as that of larger players, but might still have decent market share in a specific region. Nevertheless, a wider product portfolio lends pricing flexibility and helps entities in maintaining market share by addressing customer requirement at various price points. Key determinants for strong market position include 1) distribution channel, 2) product category and 3) brand equity and quality of products a) Distribution Channel A strong distribution channel lends competitive advantage to a FMCG player. A wide distribution network also supports quick ramp-up in production/sales in case of new product launches, as the company can leverage on its existing distribution channel; for instance, while ITC started as a tobacco products company, its strong distribution network supported its entry into the FMCG segment under the Sunfeast brand. b) Product category A FMCG product can be classified under (i) discretionary and non-discretionary FMCG items or (ii) economical and premium product categories. For instance, toothpaste and soap are nondiscretionary products but a packet of chips and soft-drink are discretionary items. Typically, a FMCG player has better pricing flexibility in premium product categories and non-discretionary items where brand equity plays a crucial role in pricing. Categories like infant food and personal care might be relatively less price sensitive and have higher brand loyalty than the laundry supplement (washing powder, detergent) segment. Also, some product segments like deodorizer, processed dairy products (cheese, paneer, dairy whitener) and instant-mix foods have stronger growth prospects due to changing lifestyle and customer preferences. Companies having presence in these segments may outperform overall industry growth trend. Hence, attractiveness of product category could be a key differentiator for company s growth prospects as well as profitability vis-à-vis overall industry trend. A regulated product category (e.g. tobacco, alcoholic beverages, etc) is relatively less attractive than other segments (like soaps, toothpaste, etc). Growth rate and profitability of regulated segment could be influenced by changes in regulatory policies. Company s ability to innovate and revive its product portfolio at regular interval remains crucial to maintain market share. Historically, new entrants have capitalized on product innovation to challenge entrenched players. Share of revenue from products launched over last 3-5 years is a good indicator of company s track record in product innovation. c) Brand equity and Quality of Products The quality of product offerings determines the company s ability to benefit from growth in the segment and to maintain its market share. Strong brand equity and loyalty also entails lesser spending towards advertising and promotion activity, resulting in better profitability. Also, stronger brand equity acts as an entry barrier, where new entrants have to make sizeable investments towards customer acquisition, promotion and branding to challenge incumbents. Also, some companies outsource less capital intensive products to vendors, wherein quality control at vendor level also becomes one of the critical factor in maintaining brand equity. Raw Material Sourcing For product segments depending on commodities like oil, cereals and crude oil derivatives efficient raw material management becomes crucial factor especially in segments where operating margin are thin and competitive intensity is high (e.g. edible oil, soap). Risks pertaining to raw material price volatility as well as supplier concentration are also analyzed in detail. A company having wider supplier base might have better negotiating power with supplier and mitigate supplier concentration risks to an extent. ICRA Rating Services Page 3 of 6

4 Financial Risk Analysis The financial strength of an FMCG company is an important rating consideration. While assessing the financial position, ICRA reviews the Accounting Policies followed by the company, Notes to Accounts, and Auditor s Comments that are part of the Annual Report. Any deviation from the Generally Accepted Accounting Practices is noted and the financial statements of the issuer are adjusted to reflect the impact of such deviations and also to compare more meaningfully against peers in the industry. Apart from balance sheet strengths, ICRA also evaluates the profitability and cash generating ability of the business as well as other sources of financial flexibility available to an entity to evaluate its overall financial risk profile. Revenue Growth Sustained volume and revenue growth above the industry average, especially in comparison to its key competitors is a strong positive. Such growth typically reflects an increase in market share and/or diversification across various geographies. On the other hand, a trend of declining revenues during a period when the industry is growing could be indicative of a failing business model or losing market share to competition. ICRA attempts to analyses growth on account of increase in volumes and realizations separately. Increase in realizations, attributable to price increase by company however does not reflect real growth and is typically reflected in flat or declining operating margins. Profitability In addition to revenue growth, sustainable profitability through out a business cycle is one of the key factors that ICRA incorporates in its analysis to differentiate between companies. As the FMCG industry is generally characterized by stable demand and well-established competitive dynamics, revenue growth and profitability are in large part dictated by a company s specific market, its product portfolio, and its customer relationships. As a result, there tends to be limited scope for significant margin increases over time. In this context, a key differentiating factor among competing FMCG companies is their ability to maintain efficient operations, pass along price increases (pricing flexibility) and maintain market share. This rating factor therefore, aims to gauge the level of control that a given company will have over its profit margins, and to isolate the historical and projected means that management has at its disposal to preserve competitive profit margins. The two primary measures of profitability are: (i) Operating profit before interest, depreciation and taxes margin (OPBDIT margin) and (ii) Return on capital employed (RoCE (%)). In the absence of adequate profits, a company s cash flow generation is likely to fall short of the levels needed to support the working capital and capital expenditure needs that are associated with expansion. Working Capital Management Generally, FMCG companies have a negative working capital cycle, as extended credit period from suppliers and advances from customers/distributors are sufficient to fund working capital requirement. Select large FMCG players in India have also invested in IT system to monitor inventory level at retail level enabling superior inventory and receivable management. A deviation from the general industry trend could be a reason for stress as company might be pushing inventory to the distributors or have increased receivable cycle to push sales, which could result in write-offs in future thereby affecting profitability as well as capital structure. Tenure mismatches, and risks relating to interest rates and refinancing Large dependence on short-term borrowings to fund long-term investments can expose an issuer to significant re-financing risks, especially during periods of tight liquidity. The existence of adequate buffers of liquid assets/bank lines to meet short-term obligations is viewed positively. Similarly, the extent to which an issuer could be impacted by movements in interest rates is also evaluated. Debt servicing track record The debt servicing track record of a company is an important input for any credit rating exercise. Any delays or defaults in the past in the repayment of principal or interest payments reduce the comfort level with respect to the company s future debt servicing capability and willingness. Contingent liabilities/off-balance sheet exposures: In this case, the likelihood of devolvement of contingent liabilities/off-balance sheet exposures and the financial implications of the same are evaluated. ICRA Rating Services Page 4 of 6

5 Consolidated Financial Analysis In case of groups consisting of companies with strong financial and operational linkages, various parameters such as capital structure, debt coverage indicators, and future funding requirements are assessed at the consolidated/group level. Financial Policy & Capital Structure Companies that pursue an aggressive financial policy, including heavy reliance on debt financing, are likely to be more vulnerable to cyclical downturns than companies that employ a lesser degree of financial leverage in their business. ICRA takes into account the financing pattern of long term and short term assets with reference to the firm s long term and short term debt. FMCG companies have negative working capital cycle and they generally rely on long term debt to fund their organic or inorganic growth plans. Event Risk and Adequacy of Future Cash Flows Strong operating cash flows enable companies to undertake critical investments, without stressing the balance sheet significantly. A company s capacity to generate adequate levels of cash flow relative to debt, and earnings relative to interest is critical in evaluating its credit risk profile. Higher rated companies in the industry exhibit stable cash flows through revenue streams that are diversified across business segments and geographies. Also, a company with strong liquidity will be able to mitigate impact of any short term exigencies or events which might impact profitability or cash flows in the interim. ICRA also critically looks at other sources of financial flexibility available to an issuer, which could be in the form of, among others, availability of a portfolio of liquid financial assets, strategic importance of the entity to the group to which it belongs along with the financial strength of group entities. Promoters/ Management Quality All debt ratings necessarily incorporate an assessment of the quality of the issuer s management, as well as the strengths/weaknesses arising from the issuer s being a part of a group. Also of importance are the issuer s likely cash outflows arising from the possible need to support other group entities, in case the issuer is among the stronger entities within the group. Usually, a detailed discussion is held with the management of the issuer to understand its business objectives, plans and strategies, and views on past performance, besides the outlook on the issuer s industry. Some of the other points assessed are: Experience of the promoter/management in the line of business concerned Commitment of the promoter/management to the line of business concerned Attitude of the promoter/management to risk taking and containment The issuer s policies on leveraging, interest risks and currency risks The issuer s plans on new projects, acquisitions, expansion, etc. Strength of the other companies belonging to the same group as the issuer The ability and willingness of the group to support the issuer through measures such as capital infusion, if required. Summing Up ICRA s credit ratings are a symbolic representation of its opinion on the relative credit risk associated with the instrument being rated. This opinion is arrived at following a detailed evaluation of the issuer s business and financial risks, its competitive strengths, it s likely cash flows over the life of the instrument being rated, and the adequacy of such cash flows vis-à-vis its debt servicing obligations. As the note has highlighted, for FMCG companies, special attention is also paid on the market position, distribution channel and brand equity, company s scale of operation, operating efficiency, cost competitiveness, product quality, diversified sales mix, regulatory risk, management strategies for managing cyclical downturns and an overall approach towards investment and growth. ICRA Rating Services Page 5 of 6

6 Fast moving Consumer Goods ICRA Limited CORPORATE OFFICE Building No. 8, 2 nd Floor, Tower A; DLF Cyber City, Phase II; Gurgaon Tel: ; Fax: [email protected], Website: REGISTERED OFFICE 1105, Kailash Building, 11 th Floor; 26 Kasturba Gandhi Marg; New Delhi Tel: ; Fax: Branches: Mumbai: Tel.: + (91 22) /53/62/74/86/87, Fax: + (91 22) Chennai: Tel + (91 44) /9659/8080, / 3293/3294, Fax + (91 44) Kolkata: Tel + (91 33) / / / , Fax + (91 33) Bangalore: Tel + (91 80) /4049 Fax + (91 80) Ahmedabad: Tel + (91 79) /5049/2008, Fax + (91 79) Hyderabad: Tel +(91 40) /7251, Fax + (91 40) Pune: Tel + (91 20) /0195/0196, Fax + (91 20) Copyright, 2015 ICRA Limited. All Rights Reserved. Contents may be used freely with due acknowledgement to ICRA. ICRA ratings should not be treated as recommendation to buy, sell or hold the rated debt instruments. ICRA ratings are subject to a process of surveillance, which may lead to revision in ratings. An ICRA rating is a symbolic indicator of ICRA s current opinion on the relative capability of the issuer concerned to timely service debts and obligations, with reference to the instrument rated. Please visit our website or contact any ICRA office for the latest information on ICRA ratings outstanding. All information contained herein has been obtained by ICRA from sources believed by it to be accurate and reliable, including the rated issuer. ICRA however has not conducted any audit of the rated issuer or of the information provided by it. While reasonable care has been taken to ensure that the information herein is true, such information is provided as is without any warranty of any kind, and ICRA in particular, makes no representation or warranty, express or implied, as to the accuracy, timeliness or completeness of any such information. Also, ICRA or any of its group companies may have provided services other than rating to the issuer rated. All information contained herein must be construed solely as statements of opinion, and ICRA shall not be liable for any losses incurred by users from any use of this publication or its contents.