Why royalty payout as a percentage of revenue needs to be relooked

Nestle India proposed raising the royalty payout from the current 4.5% to 5.25% of net sales over the next five years.
Nestle India proposed raising the royalty payout from the current 4.5% to 5.25% of net sales over the next five years.

Summary

  • Proxy advisory firms suggest capping these royalty payments as a percentage of profits instead of revenue

Bengaluru: Last week, a shareholder revolt against Nestle India's decision to increase royalty payouts to its Swiss parent brought to the forefront the contentious issue of royalty payments by listed Indian subsidiaries to their foreign parent.

Nestle India proposed raising the royalty payout from the current 4.5% to 5.25% of net sales over the next five years.

Over 100 public companies pay royalties for using brands, technology, and processes to their foreign parents. A 2022 report by Institutional Investor Advisory Services (IiAS) found that five companies—Maruti Suzuki Ltd, Hindustan Unilever Ltd, Nestle India Ltd, Bosch Ltd, and ABB India—accounted for about 80% of the total royalty paid by the Indian subsidiaries analyzed by the proxy advisory firm.

Also Read: Why Nestle India's shareholders rejected higher royalty payment to parent

Mint looked at seven companies that proxy advisory firms estimate to pay the most through royalty payments.

In addition to the five mentioned above, Mint included two more companies, P&G Hygiene and Health Care Ltd and Colgate-Palmolive Health Ltd, both of which pay more than 200 crore in royalty.

The royalties that Indian companies pay their parent companies is always a percentage of their revenue.

To be sure, Nestle India's royalty payout as a percentage of revenue is not the highest among FMCG companies.

P&G Hygiene and Health Care Ltd, the Indian arm of P&G, the Ohio-headquartered consumer packer giant, paid 212 crore in royalty payments last year. This translates to 5.35% of P&G Hygiene and Health Care's revenue–more than 4.5%, 4.9% and 3.1% of revenue paid by Nestle India, Colgate, Palmolive India, and Hindustan Unilever Ltd, respectively. P&G Hygiene and Health Care follows a July-June fiscal year.

Finally, P&G Hygiene and Health Care's other listed Indian business, Gillette India Ltd, paid 21.9 crore in royalty.

Royalty metrics

But royalty as a percentage of revenue may not be the best indicator for two reasons.

Firstly, royalty as a percentage of revenue is low for all these seven companies. However, the royalty payout is significantly more when accounted for as a share of the net profit of each of these companies.

Take the example of Maruti Suzuki India Ltd. Maruti’s royalty payout to Suzuki Motor Corp. at 4,221.7 crore was 3.5% of its 1,20,674.6 crore in revenue in FY2023. However, the royalty payout by the country’s largest car maker was more than half (51.1%) of its net profit, which totaled 8,263.7 crore.

Finally, in addition to paying royalties, these companies also give dividends to shareholders. This means that in addition to getting money from dividends, the foreign parent arm also gets money through royalty payments.

Now, two of these seven companies pay more in royalty payouts than what they give back to shareholders through dividends.

Maruti’s royalty payout to Suzuki of 4,221.7 crore was more than 2,718.7 crore the company returned to all its shareholders in dividends.

ABB India was another company where a royalty payment of 436 crore was more than the 233.1 crore the firm paid in dividends.

It could be argued that the technology transfer by Suzuki and ABB to their Indian arms merits a larger share of the money being ploughed back to their parent.

But proxy advisory firms like IiAS believe royalty should be capped as a percentage of profits instead of revenue. InGovern Research Services, the Bengaluru-based proxy advisory firm, suggests that any new increase in royalty payouts should be linked to incremental growth in revenue.

“Looking at the royalty payout, it is clear that the foreign parent is taking a disproportionate share of the free cash flow generated by their Indian arm," said Shriram Subramanian, founder and managing director of proxy advisory firm InGovern Research.

“Now, there is some merit in a company paying a royalty to the parent because much of the R&D (research and development) work happens overseas. But there needs to be some justification when each of these companies are looking at increasing their royalty payout. And we saw this why investors voted against Nestle’s proposal to increase royalty"

Consider the example of Tata Consultancy Services Ltd, the country’s largest technology services firm. Tata Group companies pay a fee to the holding company, Tata Sons, for using the brand name.

TCS paid 200 crore to Tata Sons last year, double the 100 crore it paid to the parent in FY2023. However, this fee was 0.08% of the 2,40,893 crore in revenue and 0.43% of the 46,585 crore in profit.

Also Read: Sugar rush alert: Nestle’s infant formula in hot water

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