For Hindustan Unilever it’s been a rough couple of weeks. India’s largest consumer goods company has been hit by a double whammy – slowing consumer demand and an increase in royalty payments.
It’s no surprise that the markets aren’t pleased. The stock has fallen 8 percent to Rs.452 since its quarterly results announcement on 22 January. So far it shows no signs of recovering.
The step up in royalty payments from 1.4 percent to 3.15 percent of sales has caused considerable heartburn among the investor community. Motilal Oswal, a brokerage expects HUL’s 2014 profits to be 3 percent after factoring in the new royalty payments. In 2015 profits are forecast to be 4.8 percent less. With earnings projections downgraded it was only natural that the stock trend downward to adjust its value. In December Unilever’s Indonesian subsidiary had increased its royalty payout to 5 percent and there had been murmurs about HUL doing the same. So is the markets reaction justified or is it just another instance of the market over reacting?
Let’s take the royalty issue first. At 1.4 percent of sales there’s little doubt that the royalty the company was paying to its parent Unilever was abysmally low. Rival multinationals Nestle and Colgate Pamolive pay 3.4 and 4.4 percent of sales respectively to their global parents. But then these companies were very clearly Indian outposts of their global parents. Unlike HUL which has homegrown brands like Wheel and Lifebuoy they don’t have their own local brands. Their marketing efforts dovetail closely with their global parents’ and supply chain functions as one well-oiled global engine.
Now, HUL had till the late 1990s been largely independent of its global parent. Products were often made for India, sourcing was done locally and marketing campaigns were crafted here.
All that began to change a decade ago as Unilever began to centralize its functions. Marketing campaigns were often crafted in the Singapore regional headquarters. Supply chain was made a global function and arguably the company would have benefited hugely from being able to source large quantities on a global scale. Its research and development center in Bangalore became Unilever’s and HUL got access to Unilever’s innovation pipeline. In exchange for this the company will now have to pony up in excess of 2 percent of its turnover.
Most analysts that Forbes India spoke to say they don’t have a problem with HUL paying more to its parent. Instead they question the manner in which it was done and the timing. Some also said that it wasn’t clear what extra benefits the company would derive from this increase in royalty payment.
Let’s address the timing issue. Clearly, this could have been handled differently. While it would have been impossible for a listed company to have released market moving information selectively it could definitely prepared large investors for a change in royalty rates. (According to at least one analyst the company had called a select group in late December to apprise them of a slowdown in consumption demand. It could have signaled an increase in royalty payments then.)
What also peeved analysts was the lack of a clear rationale for increasing the royalty rates. As Nikhil Vora and Harit Kapoor of IDFC wrote in their report “Not only is the timing and ambiguity of the implementation debatable, but also such an increase caps the margin expansion potential in the next 3 years.” In deciding the quantum of the increase its unclear what parameters the board considered. In an analyst call HUL declined to provide a specific set of parameters that the board considered. Also, the government had liberalized royalty payment rules in 2010. Why did Unilever wait till 2013 to increase royalty? Also why is it being done in a tiered manner? As one analyst asked – if the services that Unilever is providing are worth so much then why not pay the full amount from today? Again, the management sidestepped the issue.
In 2010 when the country’s largest car maker, Maruti Suzuki increased royalty payments to Suzuki Motor Co. and there had been a similar protest by the analyst community. Just like HUL the company had declined to provide a rationale for the quantum of the increase to 5 percent of domestic sales and 8 percent of exports. But in a background chat company officials said that the amount was determined scientifically. They’d even looked at the number of man-hours Indian engineers spent in Suzuki headquarters in Hammamatsu, Japan in developing new models, the quantum of Indian designed components in a car and so on. And Mr. R C Bhargava, chairman, Maruti Suzuki had fought hard to keep the amount under check. But the official view was, “the stock will take a bit of a hit and life will get back to normal.”
In HUL’s case the company seems to have adopted a similar stance. Let the stock fall and life will get back to normal. Except that for HUL there is also a consumption slowdown that it has to contend with. A recent Credit Suisse Indian consumer survey showed that people were increasingly downtrading or buying cheaper consumer goods. Fewer people now want to buy smartphones and more want to buy an entry-level car as opposed to a mid-size automobile. HUL may just trend downwards for a while and that would be sad for a company that has seen a pretty spectacular turnaround in fortunes in the last four years.