Rise in royalty payments is increasingly unrelated to any corresponding rise in margins or revenues
On January 22, 2013, the board of Hindustan Unilever announced that it will enter into a new agreement, effective February 1, 2013, with Unilever for the provision of technology, trade mark licence and other services. Under the agreement, the existing royalty cost of 1.4% of turnover will increase, in a phased manner, to a royalty cost of 3.15% of turnover no later than the financial year ending March 31, 2018 (total estimated increase of 1.75% of turnover). This, the company explained, is necessary because the pace of innovations and the scope of services have expanded over the years and, as a consequence, HUL is enjoying the benefits of an increasing stream of new products and innovations, backed by technology and know-how from Unilever This is helping HUL to remain competitive and further step-up its overall business performance.
In a separate announcement, while reporting its quarterly numbers, the board of HUL indicated that its domestic consumer business showed an underlying volume growth of 5%, which is lower than the GDP growth.
Translated into absolute numbers, Unilever is currently being paid R3,009 million for technology, trademark licence and other services. This number will increase by R3,761 million for running in the same place.
In this, HUL is not alone. Almost all multinational companies operating in India have increased the amount of royalty they take out since December 2009, when the government, through press note 8, liberalised the payment of foreign technology collaborations and royalty fees (including lumpsum payments for transfer of technology, payments for the use of trademark and brand name) under the automatic route. The liberalisation of the Foreign Technology Agreement Policy was aimed at facilitating inflow of FDI and technology transfers into the country. Foreign partners no longer had to go through administrative hoops. Importantly, this meant that foreign sponsors who earlier required government approval for charging royalty under the various heads were now free to charge any amount as royalty from their Indian subsidiaries.
The unintended consequences of waiving restrictions on royalty payments can be seen from the gradual increase in technical know-how, royalty, consultancy fees, etc, by foreign partners since 2009, without a commensurate increase in either sales or margins.
An analysis by our firm regarding the royalty paid by Indian companies since 2007-08 shows that:
* The three highest royalty paying companies are now remitting R2,495 crore, up from R784 crore in 2007-08. While remittance has gone up 3.2 times, their revenues have gone up by only 1.8 times. Further, the margins of two of the three companies have shrunk, suggesting that market does not attribute a similar value either to the technology or the brand.
* The top 20 royalty paying companies now remit R3,601 crore as royalty payments, up from R1,196 crore five years ago. While royalty paid is up threefold, sales have grown by just over 70%.
* Companies dont declare dividends, but pay royalty.
Companies pay royalty for the brand. This should mean that consumers grabbing at labels should be more than those paying for unbranded or weaker brands, resulting in higher sales than competitors. It may also mean superior pricing power and higher margins. Paying royalty for technology should also mean higher margins. Again, evidence on the ground does not support this hypothesis as shown in the accompanying tables.
This data might also partially answer the question what is the right amount of royalty to be paid? The first-cut answer is, if a company is paying for a brand, its sales need to grow faster than others who are not paying for the brand. If it is paying for technology, its margins need to be higher than others not paying for technology. If not, there is no justification.
So, if companies are not seeing faster sales or higher profits, why are they paying so much more today?
The ownership structure goes a long way in explaining why this increase in royalty payments is asymmetric to the increase in sales or margin. The managements that negotiate the royalty arrangements are employed by the company with whom they negotiate. Loyalty runs in their bloodstream as they sit to negotiate with their own bosses. This is not conducive to head butting.
Investors, too, need to be hard-nosed if they want to keep these abusive payments in check. ACC and Ambuja Cements recently proposed to start charging higher royalty. Investors heaved a sigh of relief that it is only 1% of sales and only an additional R100 crore will be paid. But there is nothing to show for this outflowno technology, no brand. As the HUL example shows, it does not take time for 1% to become 3%. While it is tempting to ask for a reversion to the earlier regulatory regime, there are a few steps that can be taken immediately with regard to disclosures and voting.
Motherhood statements like (Unilever) is committed to ensuring that the support in terms of new products, innovations, technologies and services is commensurate with the needs of HUL to win in the market place should be replaced by hard numbers. What are market practices, what are competitors paying, how much faster than the market can shareholder expect their companies to grow or how much more profitable will the companies now be?
These agreements dont come to vote, and maybe they should. ACC and Ambuja Cements have set a precedent, but not gone the complete distance. Its time that only disinterested parties be permitted to vote, and such agreements be approved by majority of minority investors support.
Multinational owners have had a free lunch for far too long.
The author is managing director, Institutional Investor Advisory Services India, a proxy advisory firm dedicated to providing participants in the Indian market with independent opinion, research and data on corporate governance issues as well as voting recommendations on shareholder resolutions. Views are personal