In FMCG-ville, the last three years have been frustrating. Even as the economy trundled along at a 5-6 per cent rate of growth a year, the industry biggies like Hindustan Lever and Colgate-Palmolive have had to make do with nominal topline growth of about 1-2 per cent a year, and sometimes not even that. Still, if the Rs 40,000-crore industry's performance didn't have marketers jumping off cliffs, it's because of what they managed to do to their profit margins. They not just protected them, but grew them year after year. For example, the top six-comprising Hindustan Lever, Nirma, Colgate-Palmolive, Procter & Gamble, Nestle, and Britannia-fattened their operating profit margins, or gross profits, right through 1999 to 2002. HLL's jumped from 15.17 per cent to 23.90 per cent and Nestle's from 14.03 to 18.84 (See Why Profits Must Be Pared).

That, it turns out, may have been a costly preoccupation. With the bigger players focusing on profits, the market was left wide open for smaller players, who came in with good, but lower-priced products and wooed customers away. Consider this: Between 1998 and 2002, the Rs 150-crore Surya Foods (of Priya biscuits fame) grew at a breath-taking 35 per cent CAGR, while the cookie market's big daddy, Britannia Industries, lumbered along at 6.2 per cent CAGR.

The question: Why did Surya gallop, where the bigger Britannia only managed a modest growth? Surya's biscuits were priced a good 30 per cent less than those of Britannia, and that meant the smaller company not only snagged customers who until then had bought unbranded biscuits, but it also pulled customers from the more expensive and established brands like Britannia and Parle. Never mind that while Britannia increased its profit margins from 7 to 20 per cent, Surya consoled itself with a 6-7 per cent margin.

Replace the names Surya and Britannia with Hindustan Lever and Kanpur Detergents (brand: Ghadi detergents), respectively, and you are looking at the sad story of FMCG biggies over the last five years. A story in which the lead characters were upstaged by upstarts because they forgot the price-value equation. Agrees C.K. Ranganathan, Chairman of the Rs 265-crore CavinKare, which changed the rules of the game first with its shampoo sachets and now fairness cream: "Part of our success is because our operating margins are just three-fourths of, say, Hindustan Lever."

Slammed By Slowdown?

Maybe we are making too much of the smaller players' cleverness. Maybe the biggies faltered because the economy-especially the rural economy-underperformed, and once the rural markets revive, they'll automatically return to their high double-digit growth rates. Well, the truth is, there is no such maybe. Let's first blow myth number one, which is that FMCG growth will revive with growth returning to agriculture. Between late 80s till the mid-90s, agriculture growth averaged 5.88 per cent (according to National Council of Applied Economic Research (NCAER)), whilst FMCG growth galloped at twice the rate at 12.4 per cent. The catch: This disproportionate growth was solely penetration-led and, therefore, unlikely to be repeated even if the country gets good monsoon.

"Part of our success is because our margins are three-fourths of, say, HLL" C.K. Ranganathan, Chairman/ CavinKare

How do we know that the growth was penetration-led? Simple, numbers. Between 1987-1988 and 1995-1996, penetration of soaps in rural households grew from 86 per cent to near saturation, 98 per cent. That of detergents from under 40 per cent to over 60 per cent. "This boom was part due to conversion of large population from non-consumers to first-time consumers of manufactured products," points out Rajesh Kothari, FMCG analyst with Khandwala Securities. With penetration growth nearly over by mid- to late-90s, FMCG growth started slacking, even while agriculture growth peaked at 9.3 per cent in 1996-97, fell to 8.2 per cent in 1998-99 and then again to 7.2 per cent in 2001-02.

Worse for FMCG marketers, the increase in product penetration came along with a slowdown in the growth of per capita income. In 1994, per capita income grew 6 per cent, but by 2002 was down to 3.4 per cent. That also hit the growth in personal disposable income, which fell from 15 per cent to 5.3 per cent in the same period. According to National Sample Survey Organisation, lower disposable income took away 7.1 per cent of a household's spend on FMCGs and food in favour of assets such as durables, automobiles, insurance or housing. "There is nothing wrong with the market. It's the fixation with high OPMs that failed the big FMCG companies in re-aligning themselves to the new market realities," says Nikhil Vora, Senior Vice President with ask Raymond James.

Although macro-economic environment has been clearly unfavourable, FMCG majors have taken their pricing power far too seriously, so much so that it has started hurting their volume growth. And the smaller players who were willing to work with lower profit margins, gained both volumes and marketshare. For example, one of the reasons why Anchor toothpaste became a Rs 100 crore brand in the Rs 2,000-crore market in just four years is that both HLL and Colgate-Palmolive sold their toothpastes at a premium of about 39 per cent. In shampoos, the difference between HLL or P&G and CavinKare was 27 per cent, and 34 per cent between HLL and Amul or Mother Dairy in ice creams.

What the biggies failed to realise is that the consumer's move to lower-priced brands was not merely a corollary of recession, down-trading as they would call it, but more a rejection of their price-value offering in the face of a better proposition from smaller players.

To return to their double-digit growth rates, the bigger players like HLL and Nirma will have to take a hard look at their pricing and perhaps sacrifice part of their profits for growth. In fact, that may be the only way to expand the market, given that economic or agriculture growth, or even distribution-led growth, seems incapable of guaranteeing growth. "I don't buy the theory that mere reductions in OPM will allow the big FMCG companies to grow," argues Jigar Shah, Vice President, K.R. Choksey, a brokerage firm. "However, stopping market share erosion, even regaining lost one is extremely important for any big FMCG player. And growth will come because of volumes, either through sharp product differentiation or by meeting prices," adds Shah.

The good news is that some of that has already started happening. Colgate-Palmolive effected an average 17 per cent, across-the-board reduction in prices in April 2003. "And even though they have compensated that loss by a 3 per cent reduction in advertising spends, they may finally have to take a hit on their OPM," says Khandwala's Kothari. HLL reduced prices of Surf Excel by 17 per cent, Pepsodent (16) and Close-Up (20). Procter & Gamble, on the other hand, reduced prices of Ariel by 17 per cent and of Whisper by 29 per cent.

FMCG honchos need not fear that lower operating profits will scare investors away. For, it seems Dalal Street's preoccupation is not so much profits as growth (a pointer: most FMCG companies have seen their market cap shrink over the last four years, even though their profit margins were growing). If price cuts do help the bigger companies to regain marketshare, then the CavinKares and Suryas may have a lot to fear.