Hindustan Unilever reported volume growth of 6% y-o-y and value growth of only 3% y-o-y (2% below estimates) in third quarter of fiscal 2016 due to price deflation and the phasing out of excise duty benefits. PAT (profit after tax) at R10.5 bn (+5% y-o-y) was in line with our expectations. Weak rural demand has led to a slowdown of mass market brands, while the company continues to use price deflation as an opportunity to drive premiumisation in urban areas. We believe direct benefit transfer (DBT) of rural subsidies, particularly food subsidy in FY17, should drive rural demand growth. HUL will be the biggest beneficiary of such a rural demand revival.
We expect HUL to deliver sector-leading sales/EPS growth of 14%/20% over FY15-FY20 with >100% RoCE (return on capital employed) . We have marginally revised our FY16-FY18 estimates downward by 2% and our TP (target price) to R940/share (17% upside), implying FY17E P/E of 39x vs 32x for the sector.
Maintains 6% y-o-y volume growth
HUL reported volume growth of 6% y-o-y for third quarter of the fiscal 2016 vs our expectation of 7% y-o-y. Sales for the quarter grew 3% y-o-y (and 4% y-o-y, adjusted for phasing out of excise benefits) to Rs 78.2 bn, 2% below our estimates, impacted by price deflation of ~3% y-o-y. Gross margin expanded by 261bps y-o-y due to crude-related input cost benefits. However, a 169bps y-o-y increase in A&P spends (significant increase in consumer promotions) and 77bps y-o-y increase in other expenses as a percentage of sales led to Ebitda margin expansion of only 31bps y-o-y.
Rural growth still weak
Based on our channel checks rural growth continues to remain extremely weak. Rural demand has historically grown at 1.5x-2x urban growth; over the last 12 months, rural and urban growth rates have converged. Our channel checks suggest that measures such as WIMI (Winning in Many India’s), distribution channel clean-up and consumer promotions are helping HUL maintain its market share in rural areas despite stiff competitive intensity.
Lower input cost deflation used to drive premiumisation in urban
Although urban demand hasn’t picked up over the last 12 months, it has neither moderated substantially like rural growth. Moderate urban growth and input cost deflation is being used by HUL to drive premiumisation. HUL has taken price cuts, offered price discounts and consumer promotions to drive volume growth in premium brands such as Surf, Dove, Pears.
Pick up in rural growth is the key driver for sales growth ahead
As highlighted earlier, rural growth has materially slowed down over the last 12 months whilst urban growth rate has remained almost flat. Given the levers of consumer promotions that HUL has been able to use to drive urban volume growth, we believe there is limited upside for urban volume growth from the current levels of ~6% y-o-y. Hence, a pick-up in rural growth remains the key driver for HUL if its volume growth must reach low double-digits. We believe, direct benefit transfer of food subsidy and other welfare schemes will be the key drivers of rural growth over the next 24 months.
Valuation—reiterate high conviction BUY with TP of Rs 940/share
Given the benefit that HUL can derive due to the DBT-induced pick-up in rural demand, we expect HUL to deliver sector-leading sales/EPS growth of 14%/20% over FY15-FY20 with >100% RoCE. Maintain BUY.