ASIA MAY 2016

FOR PROFESSIONAL CLIENTS ONLY

TALES FROM THE ROAD – INDIAA significant shift has taken place in Indian society over the last few years. Companies are taking a more sophisticated view of the country’s 1.3 billion population and focusing not just on the size of the engine driving economic growth, but on individuals’ needs as consumers. A research trip to India was an opportunity to investigate some of the key drivers of this trend, as more people move up the spending bracket.

Tom WillsPortfolio Manager/Analyst Asia

Companies rising to the challenge of ‘premiumisation’ I was struck by the companies which have demonstrated their ability and willingness to innovate and invest in R&D. For me, the most attractive firms are those which can consistently develop new products to meet fresh consumer demands. One example of where this is taking place, is in product ‘premiumisation’.

The idea of improving margins by taking a basic product and enhancing it is a central focus for India’s consumer companies. How this is manifesting itself locally is particularly interesting, as it appears to be taking on a distinct ‘India-only’ slant. This was certainly noticeable when looking at health & wellness brands. As companies look for ways to demonstrate that their products are healthier, or more ‘natural’ than the competition, some are adopting a uniquely Indian approach, with the use of Ayurveda, a 5,000-year-old system of natural healing that has its origins in the Vedic culture of India. Whether or not goods can be categorised as Ayurvedic can be a key differentiator. Marketing a product in this way has spiritual, nationalistic – and in some cases political – overtones. One firm successfully doing this is Patanjali (an unlisted company), but I would expect many other smaller players to also do well in this field. While the temptation might be for listed companies to write off a niche rival, (as it is challenging for a smaller competitor to scale up production and distribution quickly or effectively), firms like these have the potential to be serious disruptors to more established business models and product lines.

I found examples of larger companies tackling this challenge head on. Hindustan Unilever and Colgate Palmolive India, for example, both have well-established bases in the Indian market, but, nevertheless, are taking the potential threat seriously. Both companies are investing in their research and development (R&D) arms and either expanding existing product ranges to offer Ayurvedic-compliant variants, or considering small M&A activity, buying in brands which meet the criteria. In both cases, this allows them to directly compete, but also take advantage of their existing manufacturing and distribution channels.

active VIEWPOINT: ASIA

The growth of India’s ‘consuming classes’

India’s consumer story is a particularly compelling one for investors. As wages and living conditions improve, there is a large proportion of the population, particularly in rural areas, with the potential to move into the ‘consuming classes’ in the coming years. This is a key reason why company valuations in India have been so high relative to other countries.

And yet, despite this commonly accepted trend, over the last couple of years, consumer markets have been subdued. Rural India has been particularly affected, due to two poor monsoon seasons and cuts to the government’s rural employment guarantee. It is my belief though that far from it being a case of the consumer revolution failing to spark, the current weaknesses are primarily short term, therefore this is an ideal time to look for appealing stocks where valuations have come down.

To gain a better understanding of the core drivers of the sector and where these potential opportunities lie, I met several companies during my trip, including those that are unlisted. These firms can often give a deeper insight into business trends, as they are less likely to be guarded for fear of affecting their share price. A number of themes emerged:

As wages and living conditions improve,

there is a large proportion of the population,

particularly in rural areas, with the potential to move into

the ‘consuming classes’ in the coming years.

Please be aware that the information provided should not be considered a recommendation to purchase or sell any particular security. It should not be assumed that any of the security transactions discussed here were, or will prove to be, profitable.

Barriers to the spread of e-commerce

The rise in internet use in India in the last few years has been phenomenal. While internet penetration was at 18% in 2014*, some estimates now put this figure at more than 30%. However, while elsewhere, increased internet access has been followed by a surge in e-commerce, in India there are still three potentially significant barriers for companies looking to enter this field.

1) Payment

Many Indian people do not have bank accounts or possess a credit card. As a consequence, many online purchases are, in fact, cash-on-delivery transactions between customer and producer. This can pose an administrative nightmare, as well as meaning a greater potential for cash to go missing along the chain.

2) Language barrier

The number of languages spoken across India is another administrative challenge. A significant number of e-commerce sites currently available in India are written in English, but many people do not speak this fluently. The language barrier is also a challenge for companies as they attempt to adopt a truly pan-Indian approach and develop an e-commerce solution which reaches the many different groups and cultures across the country.

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3) Distribution

Distribution of products is a significant issue for all Indian consumer companies. Delivery from the source to outlet is a large enough problem by itself. But for a business-to-consumer (B2C) model like e-commerce, getting the product direct to the customer can pose a major challenge. I have found that none of the Indian consumer companies really have that capacity for ‘last-mile’ direct deliveries, and unlike other countries, there aren’t logistic companies operating across India that can fulfil these needs. While this distribution factor is less of a problem in urban areas, for rural India it is much more pronounced.

There was a stark difference in attitude to e-commerce among the companies I spoke to. Some firms which have historically generated fantastic returns and have good business models have not given serious thought to how they sell their products online – perhaps because of the fairly hefty potential barriers to entry. As a result, they have invested very little in digital media. Others are clearly pursuing a long-term strategy to take advantage of e-commerce as it becomes more prevalent – when the national infrastructure develops to the necessary level.

So far, for most of the companies I met, this has meant increasing investment in advertising, promotion and digital. Hindustan Unilever, for example, has increased its proportion of total advertising on digital from around 0% to around 9% in just two years†.

Marico, which manufactures Parachute coconut hair oil, is focusing on positioning its hair oil as a premium product and trying to increase its appeal to younger consumers. As it puts a greater focus on volume growth, it is pushing some margin gains into innovation. It views e-commerce as a low-cost means of trialling new products and is carrying out a great deal of customer engagement activity. Meanwhile, Godrej Consumer, a manufacturer of insecticide and soap, has found reaching rural consumers to be difficult, with low penetration for TV coverage in some areas. It has built its own e-commerce structure and, although the company is at the early stage of data analytics, it hopes that in future years this will allow better product positioning in the future and improved monitoring of marketing effectiveness.†

Source: Internet and Mobile Association of India ‘Internet in India 2015’, November 2015.

Jun 12

137

Jun 13 Jun 14 Oct 14 Dec 14 Jun 15 Oct 15 Dec 15 Jun 16

Internet use in India

111149

198 213232

277317

351

426

190

260 273302

340375

402

462

Total (users who have accessed the internet at least once)

Monthly

Penetration in rural India14% total

internet users12% monthly

internet users9% mobileinternet users

Penetration in urban India59% totalinternet users

51% monthlyinternet users

48% mobileinternet users

All figures in millions

*Source: The World Bank as at May 2016.“The World Bank Group authorizes the use of this material subject to the terms and conditions on its website, http://www.worldbank.org/terms”. †Source: Company meetings.

Please be aware that the information provided should not be considered a recommendation to purchase or sell any particular security. It should not be assumed that any of the security transactions discussed here were, or will prove to be, profitable.

Valuations more attractive

The long-term outlook for the Indian economy remains positive. Real GDP is forecast to grow by more than 7% every year to 2020†. This, combined with the trends of a growing middle class, benign demographics and changing patterns in consumer culture, means that the prospects for the consumer sector remain encouraging.

While the short-term consumption environment in India is more downbeat than it has been in previous years, with dominant brands having to endure lower (although still positive) volumes, many still have pricing power, and recent share-price weakness has made valuations potentially more attractive. Indeed, Indian consumer staples valuations are more reasonable relative to recent history. On both a consensus FY2 price-to-earnings and earnings value (EV)/earnings before interest, tax, depreciation and amortisation (EBITDA) basis, they are below the three–year historic average*.

I am convinced that there are a number of attractive opportunities currently to be found in India. These companies are well-managed and are taking action to remain at the forefront of the evolving consumer landscape. They are well placed to ensure they capture some of the more niche markets and, as a result, the growing numbers of consumers in the years to come.

active VIEWPOINT: ASIA

Game-changing reforms for the Indian consumer economy

The Goods and Services Tax has the potential to deliver a real improvement in the efficiency of India’s corporate infrastructure. The possibility of a comprehensive value-added tax on goods and services in India has been discussed at the highest level since the turn of the century, but even six months ago, opinion among companies remained split on whether it would be introduced. I found that this attitude has shifted and it is almost universally accepted that it is a case of ‘when’ not ‘if’, the GST is put in place.

Currently, for a company operating in two different states, it is often preferable to operate identical manufacturing facilities in neighbouring states, rather than a single combined centre. The GST would remove this inefficiency, and allow the company to consolidate its operations. While both factories might be retained, they could be used for what makes operational sense rather than what is more attractive from a tax perspective. I found companies are anticipating significant changes in the way they service the market following the tax’s implementation. Colgate Palmolive India, for example, has the GST firmly in mind with regards to future infrastructure investment and is making plans for warehousing changes, allowing it to reduce its overheads. This is particularly important to maintain margins, as many of its peers have reduced prices (something which the company has resisted). Elsewhere, United Breweries, has lobbied hard for the alcohol industry to be included in the GST (it will not be in the first round). This has been a key focus for the company over the last couple of years, and even if the tax did not lead to a lowering of the large excise duty on alcohol, it would cut administrative costs.

While it is unwise to make investment decisions solely based on fluid government policy proposals, particularly those which have been debated for such a lengthy period, companies are now structuring their manufacturing facilities so that they would be able to benefit very quickly upon the GST being ultimately implemented.

*Source: FactSet as at 28 April 2016. Index is MSCI India. †Source: International Monetary Fund, World Economic Outlook Database, October 2015.

Please be aware that the information provided should not be considered a recommendation to purchase or sell any particular security. It should not be assumed that any of the security transactions discussed here were, or will prove to be, profitable.

active VIEWPOINT is just one part of our range of investment materials. To access further perspectives on our strategies and key investment themes, visit: www.martincurrie.com

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