Future Consumer Initiating Coverage Research Report By Motilal Oswal

Company of the “Future”

Long runway of growth justifies expensive near-term valuations

 Future Consumer (FCL) is an integrated consumer company having a portfolio of brands in categories such as staples, fruits & vegetables, processed foods, home care and personal care. It has a distribution network largely dependent on organized retailers and an overall footprint of ~80,000 stores.

 We believe that FCL is the best play on the huge window of opportunity (presented by a combination of macro factors and company-led initiatives) for brands using modern retail methods of distribution.

 In addition, FCL appears best placed among Future Group companies from a revenue, profit and RoCE perspective, given the group’s focus on retail expansion to drive growth in its burgeoning brands portfolio.

 Improving mix and operating leverage are expected to drive significant margin expansion over the next five years.

 We initiate coverage on FCL with a Buy rating. As the company is likely to be profitable at the consolidated net level only in FY19, we believe near-term P/E multiples are always likely to appear extremely expensive on a one-year forward basis. We, thus, value FCL on EV/sales basis, assigning a multiple of 2.2x (60% discount to EV/sales of coverage consumer universe). This results in a target price of INR76, implying ~50% upside. As soon as FCL demonstrates profitability at the net level, we will move our valuation on P/E basis.

 We believe FCL offers a rapidly compounding and potentially high RoCE play on the massive growth opportunity in the Indian FMCG sector and particularly for brands focused on modern retail segment. Our detailed analysis (see page 21) on potential investment returns from a three-year perspective suggests a healthy three-year CAGR return of 24%.

Humungous growth opportunity in branded FMCG

We see huge opportunity in the Indian branded FMCG space. From USD65b in 2015, the category is expected to grow in size to reach USD220-240b by 2025, implying 13-14% CAGR, according to a joint study by BCG and CII. With the category itself likely to grow by ~3.5x over this 10-year period, we expect significant pockets of higher and even spectacular growth among its constituents.

Seismic shift toward modern trade – an added advantage

Modern trade, which constitutes ~12% of FMCG sector sales in India, has been witnessing tremendous growth over the past year, led by a multitude of factors like customer convenience, a wider variety of products on offer, rapidly evolving business models, and an increasing trend toward cashless transactions. Reforms like demonetization and Goods & Services Tax (GST), too, have also taken away the edge that wholesale-led general trade had earlier, due to the need to adhere to stricter compliance norms. We believe all this augurs well for businesses operating under the modern retail and modern wholesale (cash and carry businesses) models.

A promising play with better eventual RoCE prospects

FCL – a separately listed brands business of the Future Group – is a promising play on (a) rapidly expanding store footprint of the Future Group (the largest pan-India retailer in India), which has set a target at the end of FY17 to open 10,000 EasyDay stores by 2022 (611 stores as on 31st December 2017) and 350 Big Bazaar stores over the next 3-5 years (257 stores as on 31st December 2017) and (b) increasing proportion of FCL’s brands in Future Retail stores to ~60% from ~20% now. Moreover, we believe that the group’s focus on retail expansion is part of its strategy to boost sales of its growing brands portfolio. Importantly, placing the interests of FCL at par with Future Retail will not only enable quick ramp-up of group revenues, but also ensure higher profitability and RoCEs, aiding cash flows.

Brands business already growing at a rapid pace

Around 95% of FCL’s sales are derived from the brands portfolio. Over the past three years (FY14-17), while the overall FMCG sector has seen muted CAGR of 5%, FCL has reported sales CAGR of 37%. Notably, sales growth has been even higher at 39% YoY in YTDFY18. While it can be argued that base was low a few years ago, we note that FCL’s absolute sales of INR21b (~USD327m) in FY17 were in line with mid-tier FMCG companies. In our view, sales could increase further to ~INR29.5b (USD458m) in FY18, higher than mid-size FMCG companies like Emami (our estimate: INR25.7b or USD396m). The expected outperformance, going forward, will be driven by its burgeoning brands portfolio, increasing scale of key brands, massive captive growth opportunity within the existing store network in terms of salience, and the rapidly expanding store network. Brands like Golden Harvest, Nilgiris, Fresh & Pure, Tasty Treat and Clean Mate are already fairly large, and others like Karmiq, Sangi’s Kitchen and Desi Atta Company are growing at a rapid pace.

Improving mix and higher scale to drive profitability and return ratios

Branded staples and fruits & vegetables – which form the bulk of its overall portfolio and are relatively low-margin categories – should see healthy growth, but overall margin expansion will be driven by the high-margin processed food and HPC products. We expect overall sales CAGR of 39% over FY18-22, particularly led by 60% CAGR in the high-margin categories. In the traditional FMCG channels, distribution costs account for ~20% of sales and advertising costs too contribute around 10-15%. However, as a proportion of sales, these costs are much lower for brands of FCL (as it has a largely captive customer base within Future Retail stores). This lowers the impact of higher net working capital for FCL (likely to be positive 35 days even after an improvement by FY22; in comparison it is negative or in low-single-digit for most FMCG peers). This apart, superior operating cash flows emanating from rapid growth and mix improvements will help repay debt (net debt of INR3.76b with a net debt-equity ratio of 0.4x as on FY17) and drive huge improvement in RoCE for FCL.

Valuation and view

Favorable macro factors and initiatives by the company and the parent Future Group make FCL a highly attractive investment candidate. Opportunities are immense, and FCL is at the forefront to maintain or even accelerate its already impressive growth rate. Sales – which are already higher than those of mid-tier FMCG companies – should continue growing at a rapid pace for the years to come, driven by the tremendous opportunity for brands using modern retail methods of distribution.

We believe that FCL’s value – with its strong revenue, earnings and RoCE prospects – is becoming far more attractive at the group level. Sales growth has been rapid (37% CAGR over FY14-17), and in fact, on an uptrend, despite continual high base, while the EBITDA margin has improved from -10.4% in FY14 to enter the positive territory in FY17; it is improving on a sequential basis in YTDFY18 as well. By FY19, we expect FCL to turn profitable at the net consolidated level. We forecast sales of INR82b in FY21 and INR111b in FY22, still far lower than the company’s ‘Vision 2021’ target of INR200b. This poses an upside risk to our forecast.

We expect the momentum in revenue growth to continue, at least over the coming few years, because of the tremendous growth opportunity. We forecast revenue CAGR of 41.5% over FY17-20 and 39% over FY17-FY22. As the company is likely to be profitable at the consolidated net level only in FY19, we believe near-term P/E multiples are always likely to appear extremely expensive on a one-year forward basis. We, thus, value the company on an EV/sales basis, assigning a multiple of 2.2x (60% discount to EV/sales of our coverage consumer universe). This results in a target price of INR76, implying ~50% upside from current levels. We, thus, initiate coverage on FCL with a Buy rating. As soon as the company demonstrates profitability at the net level, we will move our valuation on P/E basis.

Businesses like these with humungous growth opportunity at the EPS level over the longer term have to be seen from a three-year investment perspective, in our view. Assuming 23x FY22E EPS on a P/E basis (which we believe is fair for a business with far higher revenue and earnings growth potential compared to peers) and RoCEs of ~32% by FY22, we get a target price of INR97, implying a share price CAGR of ~24%.