Highlights:– Volume growth moderated amid tough macro conditions and high base
– Rural demand falters to 0.5 times urban demand
– Operating margin expands aided by moderate increase in raw material cost and better efficiencies
– HUL poised for market share consolidation
– Premium valuation to sustain; stock could be accumulated on declines
Hindustan Unilever Ltd (HUL) [market cap: Rs 436,144 crore] reported another quarter of mid-single digit volume growth in the midst of faltering consumption growth, liquidity issues in the distribution channel and challenges in the supply chain during an unusual rainy season. We believe that 5 percent volume growth on a high base of 10 percent was commendable. Investors should particularly take note of the consistent increase in operating margin. It shows how HUL is among the select few FMCG companies that can stand out during an economic slowdown because of operational excellence.
Table: Q2 Financials
Sales grew by 6.5 percent YoY aided by volume growth of 5 percent which was in line with expectations. While volume growth by itself was not exciting, it came on a high base of a 10 percent rise last year. Further, the company reported strong gross margin improvement which along with operational efficiencies helped in comparable EBITDA margin expansion of 200 bps YoY.
Additionally, despite a significant increase in depreciation and interest expenses, net profit surged due to a considerably lower effective tax rate.
The home care segment posted near double-digit sales growth aided by fabric wash sales, new product launches and premiumisation in household care. The food and refreshments segment benefited from broad-based growth visible across categories – beverages, ice-cream and foods (Kissan brand).
The beauty & personal care segment performance was relatively muted as the company is facing intense competition in the personal wash category. While the company has cut prices by 4-6 percent, it remains a key area to watch out for in the near term.
The management, however, pointed out the strong performance in sub-segments such as skin care, hair care and colour cosmetics. Oral care continues to perform as well on account of pricing and promotional strategy. However, we think the recovery in oral care is still fragile. Other than that, deodorants is another key category to watch out for where the company is facing considerable competition.
The most important takeaway from the management commentary was the sharp moderation in rural demand. Note that rural demand growth which was around 1.3 times that of urban demand growth in the early parts of FY19 is now just 0.5 times.
– Advertisement spends have increased sequentially (quarter-on-quarter) and year-on-year. The firm is not planning any cutback in spends.
– HUL’s effective tax rate was around 30.5 percent in FY19. Excluding the effect of DTA (deferred tax assets) and DTL (deferred tax liability), the management believes that the rate would be 25-27 percent in the coming two fiscals.
– To assist its partners, HUL is signing deals with financial institutions, offering credit support by tweaking trade terms and addressing disruptions in the supply chain. Further, to cash in on the surge in online retailing, the management is investing in building up its own platform in consultation with some fintech and telecom players.
The domestic consumption growth story has moderated significantly. For FMCG companies, growth has slowed down mainly in rural areas and they are facing liquidity issues at the wholesale and distributor levels. In addition, flooding in various parts of the country in the rainy season has constrained the FMCG supply chain. Weak business update/ financial results from other FMCG players such as Marico and Bajaj Consumer Care had already kept expectations under check. Given the tough macro and sectoral conditions, we believe HUL’s 5 percent volume growth was a decent performance.
We believe that time and again HUL has been able to build upon its growth levers, particularly distribution reach, as and when there is an opportunity. Previously, following the goods and services tax (GST) implementation, the company was able to respond effectively to disruption and gained market share. The present demand moderation is another such opportunity where the company is utilizing its reach, advertising push and product launches to consolidate market share gains.
Interestingly, HUL’s strategy to combat the current tough environment has not been pricing led except in a few pockets such as personal care and oral care. This means that the company can sustain its high operating margins while pursuing an aggressive marketing strategy.
In addition, the company is also a beneficiary of the lower corporate tax rate. HUL’s effective tax rate was 30.5 percent in FY19 which is expected to be about 27 percent in FY20 and 26 percent in FY21. Taking account of these factors, we believe earnings can grow at a CAGR (FY19-21e) of 16 percent despite the sharp demand moderation seen recently.
Other than the demand situation, the key risk factor to monitor is the volatility in crude oil prices owing to the tensions in the Middle East and currency movements, which will have implication for product prices and margins.
The HUL stock price is hovering close to its all-time high and trades close to 51 times FY21e earnings without including benefits arising from the GSK Consumer Healthcare India deal. Regulatory approval on the merger is expected towards the end of FY20 and it would be 4-5 quarters before benefits from synergies are visible.
We expect company’s valuation premium over other FMCG firms to sustain for the foreseeable future.