HUL?s Q2 FY11 results were broadly as expected. Volume growth at 14% was higher than our expectation of 12%,. Gross margins were down 20 bps (basis points), on the back of cost inflation. Ad spend was at 13.8% of sales. Operating profit declined by Rs 142 m vs Q2 FY10, but net profit at Rs 5,661.2 m was higher than our estimate of Rs 5,206m because of higher other income and a lower tax rate.
The management is taking a number of steps to improve the business ? competitive pricing, good quality products and brand support. However, we believe HUL will struggle to show good results because of headwinds, including (i) an intensely competitive environment, (ii) half of HUL?s top-line coming from soaps and detergents, which are relatively mature and slow growing categories; and (iii) even personal products are unlikely to grow sustainably at over 15%, which represents just moderate growth. HUL has shown YoY declines in operating profit in FY10 and H1FY11, and we believe our FY11 estimate of 1.6% growth has risks skewed to the downside.
We maintain our 12-month target price at Rs 287. This is derived by using a target multiple of 23x (times) on Sept 2012e EPS (earnings per share). The forward multiple has averaged 25x over the past three years, in a band of 19-30x. We apply a 10% discount to the average to reflect the effect of heightened competition on the bottom line. The stock is currently trading at 27x 12-month forward EPS.
HUL reported sales of Rs 46,808m, registering 10.7% YoY growth. However, this is coming off a low base in the September quarter of last year. Gross profit came in at Rs 22,979 m. Gross profit margin contracted by 20 bps, mainly because of higher than expected raw material costs for palm oil. Ads & Promotion spend was the biggest surprise for us this quarter. It registered an expense of Rs 6464.8 m, against our estimate of Rs 7143m, representing 13.8% of sales (actuals) vs our estimate of 15.5%. We see no let-up in the competitive intensity in HUL?s business and thus the ad spend expense is likely to remain elevated, at 14-15% of sales.
By segment, Soaps & Detergents registered good growth of 6.3%, although margins declined by 186 bps, on the back of higher palm oil costs. Personal products also registered good sales growth of 14.7%, but disappointed on Ebit (earnings before interest and taxes) growth, which remained flat. This was mainly due to the charge incurred on packaging moulds this quarter, which are used heavily in the personal products category. Overall, Ebit margins contracted across most larger categories on YoY basis, reflecting a higher input cost environment. We reiterate our Underweight rating on HUL shares.
Why we are Underweight? believe that, while HUL?s management is proactively trying to improve its business, the environment is throwing up many headwinds: competition is intense ? P&G has made a big push into India and L?Oreal is also investing heavily. With 40%+ market shares in most categories, HUL may lose as the market fragments. Soaps and detergents categories are relatively mature. It will take time for the dominance of S&D to reduce in HUL?s product mix and will pull down growth rates until then.