Creating a winning proposition for the FMCG and agri-commodity sector - Efficient financial supply chain and financial risk management

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Volatility in input prices has historically belied the elusive expectation of margin stability for the FMCG business.

Apart from volatility in the prices of petroleum and petrochemical products, instability in agri-commodity prices has been the primary reason for margin instability. The long-term margin sustainability of FMCG companies’ foods businesses is largely dependent on the stability of the agri-commodity business.

While food inflation has exhibited a constant uptrend, the agri-commodity sector in India has seen little benefit. Except in the case of cash crops, primary producers and processors of agri-commodities have seen their returns shrink. Processors of edible oils, including soya and palm, have seen continuous phases of negative structured margins. The increase in food prices and, therefore, the margins of producers, processors and FMCG companies, are lost in the business value chain between harvesting and processing and between processing and distribution to the end consumer.

FMCG players in India have traditionally focused on branding and quality. While investments in branding and quality have yielded attractive returns, rising competition in the FMCG space has created margin pressure. Moreover, limited focus on agri-commodities has led to shrinking revenues from the foods business and a limited portfolio of food products.

For FMCG companies to enhance their foods businesses outside of cash crops and maintain structured margins, it is critical for them to play a proactive role in addressing the challenges in the agri-commodity value chain.


Understanding the challenges in the agri-commodity value chain

The agri-commodity value chain’s inherent challenges typically stem from the limited availability of finance and lack of transparency in price discovery. Issues relating to logistics and warehousing further aggravate the problem.

Limited availability and high cost of finance
Financing at the cultivation stage is critical, since a lack thereof leads to sub-optimal investments in high-quality seeds, fertilizers and pesticides. This has a direct bearing on the yield per acre. Lack of financing for infrastructure relating to warehousing and storage enhances the cost of carry, increases wastage and leads to speculative tendencies among traders. Cost of financing to the agri-sector has further increased due to the reluctance of banks to take credit risk on farmers.

Inefficient price-discovery mechanism
The absence of widely accepted and used pricing benchmarks for agri-commodities has led to lack of transparency in agri-commodity markets. The under-development of commodity exchanges in India has further led to pricing disparities and the inability to effectively manage commodity price risk. An opaque price-discovery mechanism and illiquidity in forward markets has reduced the confidence of farmers, processors and FMCG companies to fix long-term prices. The existence of an overriding minimum support price has also deterred investments in contract farming.

Inability to monetize the current and future holding of commodities
The limited availability of finance against expected future production and harvested production held by farmers reduces their holding capacity. Lack of regulatory recognition of warehouse receipts as negotiable instruments further reduces the ability of farmers to monetize current assets.

Short-term perspective of processors
Most processors of agri-commodities have reconciled to the existence of negative structured margins. The solution to addressing negative structured margins has generally been regarded as enhancing profits through trading activities, i.e., holding commodities in anticipation of future price increases. The relatively lengthy payback period in branding and the development of logistics and warehousing infrastructure has deterred investments by processors in these areas.


Addressing challenges in the agri-commodity sector and the role of FMCG companies

The under-penetration of branding in the foods business provides FMCG companies with a unique opportunity to enhance their presence in the sector. Further, the wide gap between prices that farmers earn and those consumers pay creates a significant untapped margin, which can be captured through genuine value addition. The following image highlights the role that the FMCG sector can play to address challenges in the agri-commodity sector.

The role of the FMCG sector in addressing the agri-commodity sector’s challenges


Developing a sustainable model to manage financial risk and the financial supply chain in the agri-commodity business

Creating a sustainable model in the foods business is dependent on the ability of FMCG companies to participate at every stage of the agri-commodity value chain. Controlling the financial supply chain and managing price risk through direct investmentsand financing arrangements with financial institutions is critical to success in this segment. Plugging financing gaps in the value chain enhances the holding capacity of farmers, creates infrastructure and monetizes the produce before the value is realized through sale to the end consumer. While branding continues to be the core competency of FMCG companies, the ability to capture leakages in margins across the agri-commodity value chain is critical to building and sustaining margins from the brand.


Contributors

Hemal Shah, Partner

With more than 14 years of professional experience, Hemal Shah leads the Financial Risk Services (FRS) group in EY India’s Advisory Services practice. This practice, offers financial risk-management solutions to banks, corporate entities, financial institutions and government undertakings. Hemal has rich experience of working with more than 150 leading treasuries in India and has led more than 50 advisory engagements in the field of currency risk management.

Muzammil Patel, Senior Manager

Part of EY India’s Financial Risk Services practice, Muzammil specializes in treasury and financial risk advisory for banks, corporate entities and financial institutions. He has led more than 30 advisory engagements in the field of currency risk management across industry verticals and more than 15 advisory engagements in the field of commodity risk management, covering petroleum products, metals and agri-commodities.