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FMCG major Hindustan Unilever Ltd’s (HUL) September quarter earnings were a mixed bag in terms of performance. While most parameters were in line with expectations, there were some disappointments.

HUL’s overall domestic consumer business sales grew 11%, but with a modest 4% growth in volumes. Analysts were expecting volume growth of 6-7%. On a two-year CAGR basis, revenues and volume grew around 7.5% and 2.5%, respectively. CAGR is short for compounded annual growth rate. Nonetheless, over 75% of the company’s product categories saw market share and penetration gains.

The cost pinch
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The cost pinch

Now, HUL’s investors are faced with two concerns. The first one is the well-known factor of rising input cost inflation. In a post-earnings conference call, the firm’s management highlighted the continued inflationary pressure in palm oils, crude-linked inputs used in its home care products and tea portfolio. HUL’s gross margin fell 140 basis points (bps) to 51.6% in Q2FY22 in spite of a 7% price hike across the portfolio. One basis point is one-hundredth of a percentage point. Analysts say that even though the revival in its higher margin discretionary business is a positive, rising inflation would put pressure on margins. The management said that its discretionary segment is nearly back to pre-pandemic levels and declined by a mere 2% in Q2FY22.

HUL aims to deliver 24-25% Ebitda margin range over the medium term on the back of judicious price hikes and cost savings initiatives. Ebitda is short for earnings before interest, tax, depreciation and amortization. In Q2FY22, operating margin moderated 45bps year-on-year and increased 70bps sequentially to 24.6%. The second concern of a demand slowdown in rural markets came as a surprise. The HUL management has turned a bit cautious on rural demand. This is in contrast to the management’s views a month ago. At its recently held annual investor meet, the management had said that rural demand was resilient and that the firm is expecting a satisfactory year.

The recent couple of weeks’ data by research firm Nielsen has prompted this altered view. The management said that it is not clear whether some softening of demand is intermittent due to unseasonal rainfall or other factors. So, the firm indicated that it prefers to closely watch how the rural demand pans out for a few months before reaching a conclusion.

“HUL has thrown a new spanner in the works by citing steep deceleration in rural market growth in August-September versus January-July levels. This, though, has already given rise to debates in some sections of the Street on whether it is a good enough reason for consumer staples stocks to finally de-rate as a pack," analysts at JM Financial Institutional Securities Ltd said in a report.

The report further added, “We believe the worry should be more on whether such high trading multiple can sustain, rather than on earnings outlook. Given top-notch business and management quality, we are quite confident that HUL can drive double-digit or near-about EPS growth over time but not quite as agreeable on valuations." EPS is short for earnings per share.

The HUL stock is trading at one-year forward price-to-earnings multiple of around 60 times. In the backdrop of the above-mentioned factors, the stock is expensive. Analysts note that HUL’s earnings have underperformed peers’ earnings in recent quarters owing to a higher proportion of the discretionary portfolio at 15-20% of sales and steep commodity cost inflation in its three largest categories of soaps, detergents and tea. Further, the fact that the HUL stock has been an underperformer in the recent past adds to the discomfort on valuations. In the past one year, the HUL stock has risen 16%, significantly lagging Nifty’s 55% returns in the same span.

Analysts at PhillipCapital (India) Pvt. Ltd note that the HUL stock has underperformed benchmark indices after the GSK stake sale. The brokering house says that some concerns such as hyperinflation in palm oil, slow revival of personal care and out-of-home products are weighing on the stock’s performance. That said, it expects HUL to start reporting extremely strong performance from Q4FY22 onwards.

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