We are increasing our fair value estimate for Marico by 52% to INR 309, from INR 204 per share, as we take into account the higher-than-expected operating margins the firm has been able to generate following the Kaya skin clinic spin-off. Our revised fair value estimate implies a forward fiscal 2015 price/adjusted earnings of 36 times, enterprise value/EBITDA of 23 times; which compares to a 20% CAGR growth in net income over our five-year forecast.
The margin expansion we projected to occur at the end of our five-year forecast was already achieved in year one. We underestimated the impact the spin-off would have on the company’s cost structure. The consumer products business (without the cost-intensive clinic business) will now run at lower employee and operating costs. This has allowed Marico’s EBIT margins to move to 14.3% in 2014, from 11.3% in 2012. Taking this change in business model into account, we are projecting EBIT margins to expand to 15.7% by 2019 in our base case. We believe this is achievable in the emerging markets context, as Godrej Consumer already enjoys such high margins as a consumer player in similar geographies. Furthermore, as Marico begins to garner greater share of revenues from personal products, margins should converge to our estimates.
On the revenue front, management guided that sales should double in four years. However, we continue to assume that sales will double in five years while growing at an average of 17.2% annually, as the firm is driving higher volumes in a fully-penetrated category such as hair oils, by selling more variants of the same product to existing consumers. We project that most of this growth will come organically. Overall, we believe the stock is undervalued at current trading levels, and would recommend investors to invest in this high quality consumer stock as the margin expansion story unfolds.
Investment Thesis
Marico competes at the premium end of the hair and edible oil markets, which together account for 60% of sales. Hair oils (45% of sales) have historically been a low-competitive-intensity industry. Marico and Dabur hold the top two spots in India, accounting for nearly 50% of the total market, with numerous, unbranded local competitors trailing. Despite renewed interest in the category from global players like Hindustan Unilever and L’Oreal, we believe Marico is a formidable competitor to overthrow in the pre-wash hair oiling regime. A large proportion of the Indian population continues to oil their hair prior to washing, and Marico is building on this habit by introducing more variants of its hair oil. As a result, the company is selling more products to existing consumers. Gradually, each household will have more than one variety of hair oil on its shelf. As such we don’t see the hair oil trend dying in a hurry, and believe Marico will continue to lead the category in price and market share for the next decade, confirming our narrow economic rating.
The company’s hair and edible oils, both fully penetrated categories, provide stable operating margins or EBIT (earnings before interest and tax) of 11% to 12%. However, to expand its margins further and prop up sales growth, Marico has diversified into high-margin, low-penetration personal care products. While the Kaya spin-off improved consolidated margins to 12% plus levels, the acquisition of Paras Pharmaceutical’s personal care brands and brand extensions like the Parachute body lotion, Livon hair color, will move the needle on profitability to over 15% in the coming five years, in our view. Another consumer firm, Godrej Consumer already enjoys such high margins, adding credence to Marico’s ability to attain similar margins. Marico management has guided that the company will double revenue in four years, and we believe this is doable given its successful brand extensions. We await Marico’s personal portfolio to become a significant contributor to consolidated profits, which we believe will result in profit growth outpacing revenue growth.
