Battling a slow market

Updated: Nov 3 2014, 09:40am hrs

Rating: Sell

Hindustan Unilever (HUL) reported underlying topline growth of 10.6% year-on-year, in line with our expectations. However, profit after tax rose 7% y-o-y to R939m, 2% below our and 6% below consensus estimates. Gross margin declined 148 basis points y-o-y due to input cost inflation, which was more than offset by a cut in A&P (advertising, marketing & promotion) spends.

Takeaways from the results were: (i) Staples demand revival is unlikely before the end of H2FY15; (ii) Pepsodent continued to underperform and volume growth remained weak in the S&D (soaps & detergents) portfolio; and (iii) Input cost deflation in the coming quarters is likely to be offset by higher A&P spends, thus reflecting a drag on Ebitda (earnings before interest taxes depreciation and amortisation) margins in the short term.

We appreciate HULs long-term strengths around operating efficiencies, capital allocation and a diversified portfolio; however, its current FY16 P/E (price-to-earnings) multiple of 34.7x does not factor in the likelihood of only 12% EPS CAGR (earnings per share, compound annual growth rate) over FY14-16 (given product portfolio constraints around competitive intensity, high category penetration, and rising royalty and tax rates). We reiterate Sell with a TP (target price) of R587 (18% downside, implied FY16 P/E of 28.5x).

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Results overview: HUL reported Q2FY15 underlying revenue growth of 10.6% y-o-y led by volume growth of 5% y-o-y and by 5.6% y-o-y contribution from price increases and mix changes. Gross margins contracted by 148bps y-o-y to 48.2% due to input cost inflation, low base and higher excise duty impact of 30 bps. This was more than offset by a sharp cut in the A&P spends-to-sales ratio by 173 bps y-o-y. Despite a 50 bps y-o-y increase in the royalty rate, the other expenses/sales ratio contracted by 32 bps y-o-y due to operating efficiencies. Adjusting for R487m of exceptional gains related to profit on sale of surplus properties, PAT was at R9.4 bn (up 7% y-o-y), 2% below our estimates.

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Personal care slows down further: Key highlights of the segmental performance during the quarter were:

Price hikes drive growth in S&D: Soaps and detergents grew 11% y-o-y, with growth here being mostly led by price hikes. Lifebuoy, Lux and Dove in the soaps category and Surf and Rin in the detergents category led the growth in the S&D category. Personal care growth slowed down to only 10% y-o-y: Oral care had yet another disappointing quarter, as Pepsodent continued to underperform and lose share to possibly Colgate.

Weak growth in beverages: Growth in the beverages category yet again slipped into single digits (7.6% y-o-y), as tea continued to report slower pricing growth.

Other parts of the portfolio such as FAL (Fair and Lovely) and Ponds in skin care delivered volume-led double-digit growth. Dove and Clinic Plus helped by strong growth in sachets delivered healthy volume growth in the hair care category. Bru Coffee delivered double-digit growth. Kissan, Knorr and Kwality Walls delivered double-digit growth in the packaged foods category.

Where do we go from here

Near-term outlook Sluggish consumer spends amidst intense competition and downward pressure on Ebitda margins. The management commentary suggests that market growth in the near term will remain weak with low consumer spending. Consumers are downtrading in HULs portfolio, as they gravitate towards sachet/smaller price-point packs, especially in personal products. Although input cost inflation may come off in the next few quarters, gains here could be offset by higher A&P spends. This we believe will sustain the pressure on Ebitda margins in the near term.

Medium-to-long-term outlook Volume growth likely to remain moderate. HUL derives 60% of its revenue from S&D and teafully penetrated categories with a likely volume growth of only 2-4% per annum. The company is likely to lose market share in oral care (5% of total revenues) due to Colgates strong competitive advantages and rising competitive intensity from new entrants such as P&G and GSK Consumer. Its skin care segment (10% of total revenues) is likely to see a drag on growth rates from high penetration in the mass market (FAL) and intense competition from players like LOreal in the premium market. So, we expect HULs volume growth to remain subdued (5-6% CAGR over FY14-17) even if the premiumisation trends and discretionary consumption sentiment returns to their past levels.

Valuations Trading at an unjustified premium; reiterate Sell. We expect 12% revenue CAGR for HUL over FY14-16 and EPS CAGR of no more than 12% over FY14-16 (vs 20% reported over FY11-14). HULs wide portfolio positioning, high operational efficiencies and large scale are likely to help it sustain the leadership position in most of its key products categories over the medium to longer term.

However, current valuations of 39.0x FY15 and 34.7x FY16 EPS do not adequately factor in the weakness expected in the EPS CAGR. Prolonged demand weakness and lower than expected Ebitda margin expansion are likely to be negative catalysts in the future.

Ambit Capital