In an investor call, HUL’s MD and CEO Sanjiv Mehta has called on everyone to look at royalty hike as any other operating expense and consider the benefits coming
Hindustan Unilever’s proposal to hike the rate at which it pays royalty to its parent Unilever has irked shareholders. Its share price had fallen on Friday by about 4 percent in a visible sign of displeasure and while the slide did not worsen in subsequent trading sessions, it has not regained lost ground either.
HUL’s MD and CEO Sanjiv Mehta told the Economic Times newspaper in an interview that investors will understand the merit of the proposal once the management engages with them. Although the size of the increase is not much in percentage terms, it appears investors were taken by surprise and did not understand the need for an increase. There is also uncertainty on whether the next renewal will see another hike, as the new agreement’s tenure is shorter at half of the earlier one.
What happened on the royalty front?
HUL has been paying a royalty on its sales every year to Unilever, which owns a 62 percent stake in it, for usage of its trademarks, brands, technology and services under a 10-year agreement that’s ending on January 31, 2023. HUL in return gets the rights to use Unilever-owned trademarks/brands, technology and access to central services (such as global procurement of raw materials).
The payment worked out to an effective rate of 2.65 percent of sales in FY22 or Rs 1,336 crore. The effective rate is because sales of certain products where the trademark belongs to HUL, such as locally acquired brands, are not included in this calculation.
Unilever asked for a review, said HUL, indicating the parent wanted a higher royalty rate. The royalty will increase to 3.45 percent, or an 80 basis point increase, after a new 5-year agreement comes into force from February 2023.
Explaining the rationale for the increase, HUL reiterated the various benefits it has received and will continue to receive from Unilever. “The new arrangement will ensure that HUL continues to receive the technology, services and IP support from Unilever. India remains one of the top three strategically prioritised markets for Unilever with dialled up access to innovations, investments, capabilities, and talent development,” it said.
It also said that HUL’s revenues have doubled in the 10-year tenure of the current agreement and its EBITDA margins has increased by 10 percentage points.
But shareholders were clearly unimpressed.
What’s the broad view on the royalty hike?
Even without this increase, investors never really understood why foreign-owned Indian companies needed to pay royalty to their parent companies on trademarks and the like. Their argument was that the promoter anyway owned a majority shareholding and was thus enjoying a lion’s share of dividends. Consolidation also meant that the financials of the subsidiary was driving growth of the parent as well, given the important role played by emerging markets. HUL is a significant contributor to Unilever, the biggest subsidiary in terms of volumes sold.
However, once shareholders realised that they had little choice in the matter, they put it down as one of the risks of owning a foreign-owned consumer stock but one that was compensated by other benefits such as good management quality, top notch brands, and lean and clean balance-sheets. These stocks typically traded at a premium to domestic consumer companies although that gap has been bridged by a few worthy domestic peers. After the dust settled on the new royalty rates introduced years ago, investors had assumed the rates would remain constant and accordingly pencilled it in their earnings estimates.
What are their concerns on HUL’s royalty hike decision?
A higher royalty means it will reduce the earnings per share of HUL, which explains the fall in its share price. The market consensus is for a 2 percent decline in its EPS in FY23 and a 4 percent decline in FY24, when the full impact will be felt, according to a Jefferies note.
To HUL’s contention that its sales have doubled and EBITDA swelled in the past 10 years, investors could argue that Unilever too has seen its royalty income rise substantially as well in the process. Then, there’s the matter of contribution to the parent’s financials, higher dividends distributed and even the acquisition of GSK Consumer was done by using HUL’s shares as the primary currency.
There’s the question of a shortened tenure of the new agreement. In the post-earnings call, HUL’s management was asked about the implications of the new tenure at 5 years instead of the earlier 10 years, and does that mean it could be hiked again. The management’s response was that it’s a volatile world and that as the situation changes and improves, they will revisit this arrangement. The fact that HUL’s peers are paying higher royalty means there could be room for even more hikes. Colgate Palmolive (India) is paying an effective rate of 5 percent of sales while Nestle India’s agreement requires it to pay 4.5 percent of sales.
A Jefferies note said investors they spoke had some key concerns. Some believed the additional royalty should apply to incremental sales, its revenue growth is not materially different compared to peers, there was a risk of rate going higher since peers are seen as paying higher rates and that there’s no clarity on what benefits HUL will get by paying more in addition to what it’s already getting.
The investor call also saw a question on the approvals needed and whether HUL will seek minority shareholder approval, even if it’s not legally required. The management response was that they have just got board approval and will do whatever is legally required.
What’s the way forward?
That the share price has stabilised, at least for now, after the initial decline may be a sign that the damage to HUL’s valuations was a one-time event. Thus, to look at the bigger picture of market prospects, growth and other qualities that have endeared foreign-owned consumer stocks to them.
HUL’s Mehta said in the ET interview that investors know HUL’s track record and that like any other hike in investment, the business will take this hike in its stride. The company is looking at this operating expense as an investment for growth. In the investor call, Mehta urged everyone to look at this as any other operating expense and consider the benefits they are getting in return. While they may not be apparent to the naked eye, they are indeed getting benefits, he said.
The company appears to be firm on its proposal and what remains to be seen is what further approvals are deemed necessary for the transaction. If the company seeks an approval from majority of minority shareholders and gets their approval, then this matter is resolved to its advantage and all shareholders will be satisfied.
Institutional shareholders will need to make up their mind on their response and whether they will oppose the royalty hike, even if their approval is not legally required.
The 5-year tenure of the new royalty rate, with the hikes spread over three years, means another hike may happen on renewal. This will be a risk that investors will have to factor in.
Ultimately, HUL’s management’s task is to persuade investors to take the higher cost in their stride and commit to delivering superior returns. If there’s a new direction for the company or improved prospects or more visible support from the parent and that leads to a better growth outlook, then maybe investors will be convinced that there were good reasons for Unilever to ask for higher royalty, and not just because it’s the parent and can do so.
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