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?Neutral? on HUL as potential royalty hikes an overhang

We maintain our ?neutral? rating on Hindustan Unilever with an unchanged price target of Rs 527 as a potential increase in royalty rates remains an overhang.

We maintain our ?neutral? rating on Hindustan Unilever (HUL) with an unchanged price target of Rs 527 as a potential increase in royalty rates remains an overhang.

At our price target, we value HUL at 28x our average of FY14f and FY15f earnings estimate at R18.8. HUL trades at 31.6x FY14f earnings, higher than HPC?s average of 29.6x and the sector?s average of 29.5x on FY14f earnings. We believe that if no clarity emerges on this issue in the near term, there is a risk to the valuation multiple, which HUL has over other companies.

Unilever Indonesia announced changes in the royalty rates to be paid to Unilever NV, its parent company. The changes will be done in stages from the current royalty rate of 3.5% of sales to 5% of sales plus the actual recovery cost up to 3% of sales by 2015.

Royalty rates paid by HUL are low compared to other Unilever subsidiaries as well as arms of other MNCs in India, such as Nestle and Colgate. While we do not have any visibility on any potential royalty increase at HUL, we believe, in the near term, this is likely to remain an overhang. Any announcement of an increase in royalty rates will be a negative, in our view.

In July 2010, Maruti Suzuki’s royalty expenses paid to Suzuki increased as a proportion of sales from 3.5% to 5%. This led to a significant 12% decline in the stock price on the day of the announcement.

Even from HUL?s perspective, the earnings sensitivity is fairly high. For every 1% increase in royalty payment, earnings could decline by more than 6%, which would be a significant negative. This could also be viewed as being unfriendly towards minority shareholders and, thus, lead to a structural de-rating from the current levels.

We believe that until there is clarity on this issue from the company, either way, there will continue to be a negative overhang on the stock. The company management has said it cannot comment on the matter at this time and considering that every subsidiary has its own discussion with the parent on the issue of royalty payment, we believe investors are likely to stay away. We believe operational trends have continued to be solid in Q3FY13f, but given the issue on royalty payment, the stock may remain weak into the Q3 earnings season.

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First published on: 15-12-2012 at 01:09 IST
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