Hindustan Unilever Ltd (HUL) has confirmed investor fears that royalty payments to Unilever Plc may increase. The company’s royalty as a percentage of sales is set to more than double in five years. This increase coincided with a slowdown in volume growth, at 5% in the December quarter compared with 7% in the September quarter. This is not a one-off event as volume growth has steadily fallen from its 10% level in the March quarter.
HUL’s management, in a conference call, said volumes were low partly due to a high base effect, a slowdown in modern trade sales and the transitory impact of a relaunch of Fair and Lovely sachets. It also said a slowdown in discretionary spending has affected sales in some categories.
These may be valid reasons, but a situation where two-thirds of sales growth is being contributed by price does not appear sustainable. Even value-based sales growth is slowing down, as domestic consumer sales rose 15% in value terms in the December quarter, compared with 16% growth in the September quarter and 18.7% in the June quarter. Further price hikes, to accelerate sales growth, may worsen the situation. A way of making consumers buy more is to launch new products, spend more on advertising and promotion, and expand distribution.
One good aspect about HUL’s results is that its cost of goods sold has risen by only 11%. That gives it headroom to invest in growing sales, as sales are growing ahead of raw material costs. That is why despite a 25% increase in employee costs and a 19% increase in advertising spends, the operating profit margin (OPM) has risen, even if by a small margin. HUL’s OPM has risen by 7 basis points over the year-ago period, and by 88 basis points over the preceding quarter. A basis point is one-hundredth of a percentage point.
Its segment results show that soaps and detergents sales have risen 19.8%, but profit only 10.6%. Margins have fallen sequentially, too. Input costs for this segment have been stable or declining. The company attributes this to an increase in advertising and promotional spends. Higher competition in detergents is a key reason for this increase.
The situation was reversed in personal products, where sales rose 13% and profit 19%. The beverages business was also a bright spot, with sales rising 18% and profit 33.5%.
HUL’s results reflect three concerns. One is that volume growth of 5% seems very low. A key issue is whether this is temporary, or that a series of price hikes—made to offset an increase in input costs—has affected demand. If volume growth continues to remain at these low levels in subsequent quarters, there may be reason to be worried. HUL’s management appears confident about its current strategy working out in the long run. While the March quarter is likely to see a similar performance, fiscal 2014 (FY14) will disclose if this confidence is misplaced or not.
The second issue is royalty. HUL expects royalty to increase from about 1.4% of net sales at present to 1.9% in FY14, and then rise steadily to 3.15% in FY18. That may seem meagre in absolute terms. But the impact will be more substantial in relative terms. For example, its December profit before tax would have been notionally lower by 2.8% if royalty had been charged at 1.9%. And, at 3.15%, it would have been lower by 9.8%. That is sizeable. But HUL has phased this rate over five years, which gives the company time to absorb the higher outgo.
The question investors may ask is: is HUL paying for what Unilever has done for it in the past, or for what it is going to do in the coming years? If HUL’s sales were to grow in excess of expectations in the next five years, the outgo may not pinch so much. But that assessment can be done only in the future.
Lastly, HUL’s net profit growth in the current quarter is just 14.7%, after adjusting for exceptional items. Including exceptional items, this growth is 15.6%, and if one adjusts for the transfer of its fast-moving consumer goods exports business to a subsidiary, its net profit growth would have been higher at 20%.
That makes its valuation seem expensive, as the HUL stock trades at 28 times FY14 estimated earnings per share, according to estimates polled by Reuters. To justify these valuations, volume growth has to recover materially from 5% levels, or input costs will have to decline further so that margins and profit growth improve further to compensate for slower sales growth.