02 July 2018 ( Lagos ):

Stable production costs amidst mixed commodity prices 

Noting that Nigerian FMCG’s are exposed to foreign and domestic commodity prices in a near 60:40 split, raw material costs for consumer goods companies have been flat to slightly bearish on average so far in 2018. Global agri-commodity prices are expected to remain mixed across board, with steady production levels, favourable weather conditions in select regions and strengthening demand across the globe expected to support prices whilst rising geopolitical and global trade uncertainty and strengthening U.S. currency remain the major risk factors. 

Having declined 21% YTD, raw sugar prices are expected to remain low for most part of 2018 as large production surpluses continue to support high inventory levels amidst steady weather patterns in Brazil. Similarly, palm oil prices have moderated c.10% this year and are likely to moderate further as strong production levels from Indonesia and Malaysia coupled with expected weak demand from India (largest consumer of CPO) amidst recent hike in import duties on both crude and refined palm oil as well as heightening global competition from other edible oils and oilseed. 

Contrarily, whilst prices of most cereal crops have traded sideways for most of the year, global wheat prices have recorded renewed uptick recently, rising 8% in 3 months and 14% YTD. Forecasts for wheat prices remain bullish for H2’18 on the back of lower supply from wheat exporting countries like Russia and Argentina amidst adverse weather conditions, lower acreage and yields in the U.S. and poor planting conditions in Australia. 

Overall, expect a mixed basket of commodities in H2’18 with raw sugar and palm oil users benefitting from lower prices whilst flour millers, brewers and feed producers are exposed to potential rises in input costs. 

Amid a renewed drive by FMCGs to source more agro-inputs locally (especially cereals and grains), in a bid to reduce reliance on FX, domestic raw material prices have become more relevant for FMCGs. With Nigeria’s agricultural sector however characterized by low productivity, structural constraints (transportation, storage) and high fragmentation, local sourcing has not necessarily led to lower production costs for all producers. 

Consequently, a number of firms within their coverage have invested significantly in building solid supply networks with smallholder farmers - rolling out specialized programmes to support the value chain, reduce price volatility and improve productivity. Compared to the prior year, raw material prices have come in more stable in 2018 with average food inflation printing at 16% y/y vs 20% y/y in 2017. 

Notably, according to a monthly publication from FEWS-NET, maize, sorghum and millet prices were down 29%, 23% and 17% respectively as at April compared to the previous year. Overall, whilst their gross margin forecasts vary across their coverage companies, Analysts expect gross margin expansion on average across their coverage for FY’18. The largest risks in the H2’18 period would be increased insecurity and higher geopolitical/ trade uncertainty on the domestic and foreign front respectively. 

Winning with local sourcing 

Nigeria’s economic downturn and subsequent recovery has seen consumer goods companies make more targeted investments to navigate a volatile and difficult operating terrain in a bid to ensure a stronger buffer against future economic headwinds. 

In line with their expectation, FMCGs have significantly focused on backward integration projects in 2018 amidst a sector-push to localize raw material sourcing by investing in strengthening domestic production and overall agricultural value chain productivity. Amongst other projects, FLOURMILL recently announced a strategic partnership with Corteva Agriscience for high-performing hybrid maize seed development in Nigeria to improve maize yields and improve capabilities of small-scale farmers. 

The company also announced investments in fertilizer blending plants and a bid for silo complexes from the Federal Ministry of Agriculture and Rural Development. Also supported by enabling economic policies and government intervention, investments in increasing wheat production locally have started yielding fruits, with wheat production reported to have risen from less than 200,000MT to 900,000MT as at Q1’18. 

Analysts understand that Nestle is in partnership with the International Fertilizer Development Centre (IFDC) through its Sorghum & Millet in the Sahel (SMS) project, the company has engaged thousands of farmers to source high quality sorghum, millet and soya. Analysts have also seen FMCGs increasingly embrace locally available input substitutes; Nigerian Breweries replacing barley (largely imported) with locally sourced sorghum, others using cassava as a substitute for wheat. 

Whilst Analysts believe these developments will lead to more sustainable raw material sourcing in the country, a more detailed plan to include all stakeholders in the agricultural chain (logistics, transportation, aggregators, processors) must be explored to ensure a broad-based and sustainable development of the sector. 

Cost containment, lower borrowing costs to support margins, PAT 

Improvement in operating costs and moderating interest expense supported profit margins in Q1’18, prompting a 70bps y/y profit margin expansion and supporting an average 10% y/y bottom line growth. Moderating inflation path and an improving economic landscape remain supportive of further operating cost containment for the rest of 2018 even as consumer goods companies sustain their internal efficiency plans. 

Furthermore, despite their expectation of an unchanged monetary policy rate through 2018, borrowing costs in the year are expected to trend lower y/y amidst lower debt balances across their coverage as well as reduced average cost of debt compared to 2017. Analysts recall the substantial deleveraging recorded in the 2016/2017 period across the sector following sizable naira devaluation that bloated most debt balances. 

Meanwhile, some companies have also reported lower interest rates on loans so far in the year, moderating from as high as 22% to 19%. Persistent foreign exchange losses are however a major concern, with two-third of their coverage companies reporting notable exchange losses as at Q1’18. 

Despite a stable naira, FMCGs have continued to record these FX losses which are reportedly a result of exchange rate differentials between the carrying cost of dollar denominated liabilities and actual settlement rate. On a slightly more positive note, the losses have moderated compared with the trend observed in the last two years. Given the prior year’s high base, Analysts forecast an average 70% y/y moderation in interest expense for their coverage in FY’18. 

Amidst these positive cost developments, Analysts forecast an average c.100bps profit margin expansion across their coverage. Supported by this and a modest topline growth, Analysts forecast a 44% y/y average bottom line increase across their coverage companies, flattered by low bases across some companies. 

Consumer Goods sector remains worst performing NSE key sector 

Analysts believe the Consumer Goods sector will underperform the broader market for the third consecutive year in 2018. The sector index has trailed the NSE ASI so far this year, posting a 7.5% YTD decline and standing as the only key sector in negative territory, underperforming the ASI’s -1% return. 

The sector has debunked the textbook theory of defensiveness in consumer staples during and after a recession given the unique threats Nigerian FMCGs are exposed leading to subsequent dismal earnings and consequent loss of confidence in the sector. For H2’18, in line with the broader market, Analysts expect positives from improving corporate performances and a stable macroeconomic environment to be overshadowed by the typical cautious and bearish sentiment that accompanies election cycles. 

Meanwhile, market developments relating to the brewery sector (excise duties, state bans on liquor, changing consumer behaviour) have also shed a downbeat sentiment on brewery stocks particularly, with the sector names shedding an average 23% from their peaks earlier in the year. Also, given their expectation of weaker earnings figures from sugar producers, Analysts believe negative price trends may surface on sugar stocks in H2’18. 

Despite trading at significant premiums to the market however, multinational Food and HPC leaders, NESTLE and UNILEVER have been the major “safe haven” in the sector and have seen more positive, less volatile trading patterns so far this year as market participants focus on NESTLE’s sector-leading profitability and UNILEVER’s renewed above average revenue growth ability. 

Overall, whilst the Consumer Goods sector’s performance will be highly driven by investor confidence, or the lack of it in the broader market in H2’18, Analysts do not see the possibility of a positive close for the sector at year end. That said, Analysts favour FLOURMILL, UNILEVER and NESTLE to be remain top picks for the sector in H2’18. 

Source: Analysts at Vetiva Capital Management Limited.

Reporting for EasyKobo on Monday , 2 July 2018 2018 in Lagos, Nigeria