Prefer ITC over Hindustan Unilever: Standard Chartered Sec

Hindustan Unilever Ltd (HUL) is down about 2-2.5 percent mainly on some fears that the royalty to the parent could be raised. Unilever Indonesia announced change in rate of royalty to be paid to its parent Unilever.

In an interview to CNBC-TV18, Sanjay Singh, associate director at Standard Chartered Securities says HUL currently pays 1.4% royalty to the parent company. "It is unlikely that royalty will be raised in one go," he asserts. Given royalty overhang, he says, ITC is a preferred bet over HUL. "ITC is obviously a decent bet. But we also have an in-line call on ITC because in terms of valuation, the near-term taxation overhang, probably we do not see much upside from here. Given the overhang of royalty now, probably the ITC is a better bet than Lever as of now," he adds.  Below is the edited transcript of his interview with CNBC-TV18's Gautam Broker and Latha Venkatesh. Q: The management is not spelling out their expectation, they are just pointed out that Unilever Indonesia was paying a very low royalty, which is why the parent decided to hike it. In that, the data given was that HUL is the lowest payers among all its subsidiaries. Do you think there is a legitimate chance that HUL will also have to start giving a royalty of more than 3 percent? A: HUL pays a royalty currently of around 1.4 percent. If you break that up, it is 1 percent for technology and 0.4 percent for trademark. Most of the brands are owned by HUL. Hence, they do not need to pay a trademark for all the brands. If you look at the Indian context, most fast moving consumer goods (FMCG) multinational companies (MNC) are paying a royalty of anywhere between 4 percent and 5.5 percent. So, Colgate, GSK Consumer, Nestle, P&G Health & Hygiene are all paying in the range of 4-5.5 percent. Most importantly, now there is no limit to royalty. So, royalty can increase to any percentage. Earlier there was a limit of 5 percent on domestic sales. So, technically, if you compare HUL versus rest of the Indian companies and the legal law of the land, yes, it can increase. Coming back to Unilever Indonesia, it was at 3.5 percent. If you add up all the changes, it goes to around 8 percent in the next couple of years. Should we draw something from there to India? I think each of these companies have different mechanics of working. It would be very full-heartedly to just directly compare like-to-like and say that HUL royalty is going to go up because Indonesia has gone up. HUL royalty was almost negligible till 2009 whereas Indonesia has been paying 3.5 percent royalty for time memorial. So, the gap was anyway there always. If you read the specifics, yes, there is some possibility of increase. Indonesia was paying  2 percent on trademarks, currently it is increased to 3 percent. In India, we are only paying 1 percent on 40 percent of sales. So, we are paying 0.4 percent. So, technically, if you see India becomes Indonesia in terms of royalty payments on trademarks, we can go to 1.2 percent. Services will never happen in India because most services are already in India. So, we are not sending anything on a regional basis. So that royalty will never happen. Lastly, the technological license agreement, currently it is 1 percent, now Indonesia is paying 2 percent. If I compare that like-to-like happens in India as it happens in Indonesia, royalty payment should go up from 1.4 percent to 3.2 percent. Q: What would be the EPS impact? There is a calculation that about 7-8 percent EPS in FY14, if it does happen. Do you think 8 percent is the right figure, if it goes up to about 3 percent? A: No, if 1.4 percent goes to 3.2 percent, it is an impact of around 1.5 percent to 2 percent on margins. That would mean anywhere around 7-8 percent impact on EPS quite easily. The issue is whether this will happen in one shot, whether this will happen at all, I think it will be in the region of speculative direction to take a call on it. All you can say is if same thing happens to India as it happens to Indonesia, we will go to 3 percent. _PAGEBREAK_ Q: What are you advising investors? What is your own price target? A: HUL was our top pick for the past two years. We have preferred HUL as a largecap in our space. We downgraded HUL prior to the last quarter results because we thought valuations have gone completely haywire at that point of time. So, we have an ‘inline’ call on HUL with the target price of around Rs 540 as of now. We are negative on not only Levers, but also larger consumer space, but mainly on Levers. Also, more than these speculations tax rate increases on Levers has not been factored in by the market. There is a massive tax rate increase, which is going to happen, not only in Lever but other companies like Colgate etc where you will see EPS being very muted because while EBITDA growth will happen, your tax rate increases will eaten into the EBITDA growth. You will have a pretty much muted EPS growth. Q: What would you advise your clients to do with the FMCG portfolio? What is the tactical strategy at this point? A: From a portfolio perspective, FMCG is large enough from an institutional perspective that you cannot ignore it. ITC is obviously a decent bet. But we also have an in-line call on ITC because again in terms of valuation, the near-term taxation overhang, probably we do not see much upside from here. Given the overhang of royalty now, probably the ITC is a better bet than Lever as of now. Secondly, we prefer some of the midcaps. We like Jubilant Foodworks, Marico, and Titan in bits and pieces. Largecaps, we ignore both. But if at all one needs to choose, it is ITC over Levers. Q: There has been this rally in jewellery stocks over expectations that the demand in the festive season was pretty buoyant and volumes have sort of bottomed out and picking up now. Do you think Q3 numbers will be better for something like TBZ or Titan? A: We do not cover TBZ. So, cannot speak on it. Titan, definitely Q3 number should be very good. I think management also spoke about it in the call. So, Q3 number should be very good because there is also an impact of some of the retail sales, which will come in Q3. So, Q3 should be typically a very good quarter for Titan.