Neither fair nor lovely

Updated: Jan 28 2013, 07:59am hrs
Royalty overhang, moderation in profit growth outlook to tell on valuations

Hindustan Unilevers volume growth, which has halved in the last four quarters and is the lowest for the last three years, is indicative of the increasing pain points in the existing portfolio. To add to this, the new product pipeline is capped to Unilever categories which prevent Indianisation. We believe this will result in the innovation funnel drying up, thereby making it harder for HUL to achieve relevant volume growth in the long term.

Further, the royalty increase restricts any benefits of margin expansion that the company would enjoy in the coming years and in the process suppress profitability. We believe lack of incremental growth drivers in the product portfolio, the royalty overhang and moderated profit growth outlook will take its toll on valuations. We downgrade HUL to underperform with a target price of R442.

The pressure is evident: We believe the pain points emerging in the core portfolio will keep volume growth at mid-single digits in the coming quarters and HUL will have to focus on expanding its innovation funnel to compensate for the same.

Fair and Lovely, HULs largest skin care brand constituting around 4% of the companys sales, has been witnessing pressure on the increase in sachet pricing. Our sense is the brand has witnessed a volume de-growth during the quarter, the sachets de-growing by double digits in volume. Our sense is the company will take some time before it can revive growth in this important brand and till then growth in personal products will be subdued.

Wheel, HULs mass detergent brand has been impacted by a number of factors, including competition by regional players, up trading by consumers as well as higher inventory stocking. Our sense is the brand has lost 50-60 basis points (bps) market share in the last one year. However, HUL has not lost aggregate market share in this segment.

Discretionary categories like premium skin care, face wash etc that have been central to the strong volume growth performance over the last few quarters, have started to slow down. Further, the foods portfolio continues to be drag on the business.

Unileverisation restricting the innovation funnel: The companys alignment to the Unilever portfolio implies that it would not participate in any category that the parent does not have a presence in. We note that of its $12-billion brands globally, eight are already present in India and with the exception of the acquired Alberto Culver portfolio (already launched Tressemme), the others are not relevant to the Indian market. In this context, we believe restricting entry into India-centric categories will result in the lack of relevance of the new product pipeline. We believe that the current funnel is not adequate to realize strong volume growth in the future.

Soap and detergent margins peaked: Over the last few quarters, the benefit of a low base had played out in the form of higher soap and detergent margins, thus boosting profitability. However, with the favourable base effect no longer available. In Q3 itself, margins contracted by 100 bps q-o-q and 190 bps y-o-y. HUL has announced an increase in royalty outgo to the parent from 1.4% currently to 3.15% till FY18. In FY14, there will be an increase of 50 bps and post that a 30-70 bps increase will be taken up annually. Not only is the timing and ambiguity of the implementation debatable but also such an increase caps the future margin expansion potential in the next three years. We believe the royalty overhang will persist as the possibility of further increase post FY18 cannot be ruled out.

Q3FY13 result highlights

Volume growth at 5% was lower than expectations (7%). The lower rate of growth was due to decline in sales from the modern trade (MT) segment which accounts for 15% of the companys sales. While rural growth was sustained and canteen stores department (CSD) sales recovered during the quarter, MT retail was impacted by net decline in number of stores during the quarter. The company witnessed noticeably slower growth in high end discretionary food and personal product categories in H2CY12. The management has attributed the volume to cut in grammage (e.g. Wheel), uptrading in laundry and transitional pause in volumes of Fair & Lovely sachet (post increase in price).

Soaps & Detergents growth contracted to 20% and was led by pricing. Soaps posted double digit growth as Dove, Lux and Lifebuoy continue to register double-digit growth, also aided by launch of innovative Lifebuoy Color Changing Handwash. The detergents portfolio was driven by Surf (launch of Easy Wash) and Rin (growth in bars) which together posted double digit volume growth, while Wheel growth continues to lag. In terms of profitability, the segments profitability lowered to 12.4% (from highest margin of 14.3% in Q2FY13) due to higher advertising and promotion (A&P) expenses. We believe soap and detergent margins could have peaked in the medium term, thus not providing the cushion to growth.

Personal Products segment reported 13% growth led by double digit growth in all three segmentsSkin, Hair and Oral. The top brands (Ponds, Vaseline and Dove) reported double-digit growth, while Fair & Lovely continued to witness transitional pause in sales of sachet. Volume growth in Dove was affected by high base effect in sachets, which is expected to take two more quarters to even out. TRESemme received positive response in the hair care segment. HUL forayed into the premium hair oil segment with Dove Elixir and also relaunched Brylcreem as well as Vaseline Germsafe healthy skin jelly. Oral care also witnessed strong growth driven by further focus on Close UP and Pepsodent brands. Overall, Ebit (earnings before interest and taxes) margins improved 140 bps y-o-y to 28.3%.

Packaged foods segment continued to disappoint with revenue growth slowing further to 7.7%. We believe HUL will have to un-Unilever itself and enter larger, more relevant packaged foods categories to be a relevant player in this space. On the other hand, beverages reported strong 18% y-o-y sales growth led by robust growth in both tea and coffee. The steep increase in other income was due to higher interest on surplus cash and dividend income. Ebitda (earnings before interest, taxes, depreciation and amortisation) margins declined 120 basis points year-on-year to 13.5% as the gross margins contracted by 40 bps, A&P spends by 100 bps and staff costs by 60 bps.