How inflation and volatility is affecting FMCG companies?

For the majority of consumer staples companies, the last 12 to 18 months have seen a decline in gross margin due to unprecedented inflation and volatility in input costs across commodity baskets. However, recent price declines in a few commodities and management remarks are probably to blame for the general expectation of operating margin growth in 2HFY23.

A few essential commodities for FMCG companies have recently experienced corrections. While some commodities, including crude, palm oil, and PFAD, have recently experienced a correction, others, like tea and copra, had already begun to do so earlier this year. Consensus anticipates that this will lead to an increase in operating profit for FMCG companies.

Over the past 12 to 18 months, raw material inflation has been unprecedented across raw material baskets of agricultural commodities, commodities linked to crude, and palm oil. Over the past ten years, the level of input inflation has been among the highest. FMCG businesses were unable to fully pass along price increases to customers because of the fear of the negative effects of price elasticity on volumes due to price elasticity across market segments impacting share of wallet, inflation volatility, and limited scope for grammage reduction due to price-pointed packs. Therefore, a small adjustment in input prices is likely to make up for the difference for businesses. In essence, such a slight reduction in raw material prices is more likely to restore than to increase gross margins.

The demand for FMCG products has been moderate, with many of the categories either declining or remaining stable. 
If the higher consumer price index is retained at all, one of these two outcomes is more likely: 
1) The disorganized may profit. Consumers may likely choose less expensive options or better value propositions given the (still challenging) demand conditions.
2) Market leaders keep their prices while competing brands pass the costs onto consumers.

Consumers are likely to switch to challenger brands offering better value propositions in similar circumstances as in the past. Market leaders and organized players face a similar outcome in both cases—a risk of losing market share.

For example, Marico has been very aggressive in passing on the input correction to end users because it had previously lost market share to unorganized competitors while attempting to postpone passing the benefits or keep some of the benefits during prior commodity inflation cycles. Similar instances with Hindustan Unilever have also been observed in the past.

Since covid, FMCG companies have underinvested in advertising and promotions. In comparison to FY20, they cut back on advertising spending by 190 basis points in FY22. Due to lower advertising rates caused by a lack of competition from non-FMCG companies (non-essential products scaled back their advertising during covid) and FMCG companies (especially MNCs) delaying their new product launches and initiatives during covid, advertising and promotion spending for these companies fell significantly in FY21.

FMCG companies are seeing inflation in their primary operating expenses in addition to advertising and promotion expenditures. Fuel inflation, which raises freight costs, is one of this's main effects. Higher labor costs (talent retention) are also probably to occur. Additionally, a number of optional and non-essential expenses, such as travel, have returned in FY23E. Overall, the opportunity for operating margin expansion will be further constrained by inflation in other operating overheads.