Hindustan Unilever

Having gained 21 per cent since January 2008 even as the Sensex plunged by over 20 per cent, Hindustan Unilever (HUL) is a rare Indian stock that bucked last year’s bear market.

The robust expansion in the offtake of FMCGs even as most other sectors of the economy grappled with the slowdown and the company’s ability to outperform with strong topline and profit growth, made the stock a favourite with institutional investors who preferred “defensives”.

However, the time now appears ripe for investors to book profits on the HUL stock.

The company’s slowing growth and a return of investor appetite for cyclicals suggest that the stock may struggle to retain its stiff valuation premium from here on.

At the current market price (Rs 266), the stock trades at about 25 times its trailing 12-month earnings and at about 24 times its forward earnings. Not only is this well above the market multiple, it is also at a premium to HUL’s smaller rivals, which appear to hold better growth prospects over the next year.

Investors who would like to take a defensive tack can consider smaller FMCG stocks such as Marico or Godrej Consumer, which hover at 19-20 times forward earnings.
Volumes taper off

After a smooth sail through the initial phase of the slowdown, HUL’s topline growth began to decelerate towards the end of 2008.

After expanding its overall net sales by nearly 20 per cent in each of the first three quarters of 2008, HUL saw the growth rate dip to 16.8 per cent in the December 2008 quarter and further to 6 per cent in the March quarter of 2009.

That was even as the FMCG market actually picked up pace. According to AC Nielsen, the FMCG market improved its growth rate from 13-14 per cent in the first half of 2008 to over 20 per cent by the December quarter.

Even assuming the latter overstates growth, it is difficult to ignore HUL’s decelerating volume numbers. HUL’s volume growth has been on a downhill journey since last year, decelerating steadily from a 10 per cent growth in March 2008, to low single-digits by end-2008. It actually slid into negative territory (decline of 4.2 per cent) by March 2009.

HUL’s key businesses — home and personal care and foods — have shown a sequential deceleration in growth in recent quarters. HUL’s slowing growth can be traced partly to its decision to take larger price increases than its competitors on some of its key segments last year.

The period from January to June 2008 saw a sharp upward spiral in the prices of key inputs such as LAB, petroleum derivatives and palm oil, which contributed to sharply escalating costs for soaps and detergents.

HUL made the strategic choice of passing on these input costs almost entirely to its consumers by taking substantial price increases spanning these portfolios.

The higher realisations shored up margins and helped HUL close the year ended March 2009 (numbers annualised) on a strong note. It managed a 15.5 per cent growth in net sales, a higher operating profit margin (14.5 per cent against 13.1 per cent the previous year) and a net profit growth of 15 per cent.
Ceding market share

However, with a slowdown in consumer spends over the past six months, staple FMCG categories such as soaps and detergents have begun to show signs of “downtrading” by consumers.

Given the tilt in HUL’s product mix towards mid-market and premium brands and its significant price hikes in 2008, HUL’s brands have borne the brunt.

Between March 2008 and March 2009, HUL lost market share in six out of key segments in which it operates and ceded more than 2 percentage points in market share in personal wash (54.3 per cent to 48.2 per cent), skin care (55.4 to 52 per cent) and toothpaste (29.5 to 28 per cent).

The past quarter has seen an active attempt by HUL to regain market share by reducing prices, increasing grammage on its products and rolling out promotional offers.

The company also plans to re-activate more brands to re-establish a presence across price points. That prices of key raw materials such as palm oil, LAB and packaging materials have dropped 25-40 per cent below last year’s levels may also help.

However, whether these efforts will pay off immediately in terms of better topline or earnings growth is subject to some doubt. One, with urban consumer spends continuing to be under pressure, downtrading may continue, favouring cheaper local as well as national brands.

To ward off such a threat, HUL may have to take steeper sacrifices on price than its rivals to regain share, which may dent value growth. Two, the sharp correction in input prices may resurrect regional and local competitors in the staple FMCG categories. HUL may have to respond with sharper increases in adspend, which will moderate its profit growth.

Three, with roughly half of the company’s revenues derived from rural consumers, the erratic monsoon too may have negative implications for offtake.

Though substantial Budget outlays on rural credit and schemes such as the NREGA may compensate in part for a deficient monsoon, a dent in rural consumer confidence or the prospect of downtrading there, do pose a risk to HUL’s prospects.

Even if the company is successful in its attempts to regain market share from rivals, price corrections are still likely to temper topline growth for the current year, though margins may still show mild improvement.
Stalling growth engines

Businesses such as foods, exports and foray into water, which have the potential to substantially scale up HUL’s size over the medium term, have also not shown significant traction in recent times.

Growth in HUL’s foods business hovered at 17 per cent in 2008-09 (this is low given the small base), and the segment has actually seen its contribution slide to 20 per cent of revenues from 30 per cent five years ago.

Exports of manufactured products to other Unilever arms, long expected to be a key growth driver for HUL, has remained stagnant at about Rs 1,400 crore annually over the past five years. The water business, likely to have a lower margin profile than core FMCGs, remains in a nascent stage.

What if HUL’s recent initiatives do manage to shore up market share and push its growth rates into a higher trajectory over the next few quarters? Given the premium valuation currently enjoyed by the stock, such an outcome already appears to be factored into the stock price.