Hindustan Unilever (HUL) reported underlying volume growth of 6% year-on-year (Ambit estimate 4% y-o-y) with overall revenue growth of 7.9% y-o-y (to R74.8 bn) in Q4FY15, in line with our estimates.
Adjusted profit after tax increased 7% y-o-y to R8.7 bn. Gross margin gains of 230 bps were passed on to consumers through higher A&P (advertising & sales promotion) spend (170 basis points y-o-y), as competitive intensity increased in the soaps & detergents (S&D) categories. Also, demand was muted across categories and a recovery is likely by H2FY16 at the earliest.
Contrary to consensus expectations of 200 bps Ebitda (earnings before interest and taxes) margin expansion, gross margin gains would likely translate into only modest gains (50-60 bps) in Ebitda margins, as HUL is likely to increase investments behind brands (higher consumer and trade promotions).
At the current steep valuations of 42.7x/37.6 FY16/17e EPS and sales/EPS CAGR (compound annual growth rate in earnings per share) of 13%/16% over FY15-18e, we reiterate Sell. We revised our TP (target price) to R710 from R725 (21% downside, implied FY16e P/E–price-to-earnings multiple—of 34x).
Results overview
Step-up in consumer promotions drives volume growth: HUL reported volume growth of 6% y-o-y for Q4FY15, higher than our expectation of 4% y-o-y growth. Sales for the quarter grew 7.9% y-o-y (adjusted for one-time excise benefits of R715m) to R74.8 bn, in line with our estimates. Gross margin expanded by 226 bps y-o-y due to crude-related input cost benefits. However, a 167bps y-o-y increase in A&P spends (mostly consumer promotions) as a percentage of sales led to an Ebitda margin expansion of only 121 bps y-o-y helped by lower employee and other expenses. Adjusted PAT increased by only 7% y-o-y to R8.7 bn, 5% lower than our estimates.
A&P spends driving volume growth: Learning from the market share loss during a period of input cost deflation in 2008-09, the company was one of the first to effect price cuts and increase promotions this time. During this quarter, the company increased its A&P spends by 170 bps y-o-y for a 230 bps y-o-y increase in gross margin. A&P spends were mostly in the form of higher consumer promotions particularly in the S&D category. Whilst this has
driven volume growth for the category, it has also resulted in price deflation.
In a soft demand environment coupled with a step-up in competitive intensity in the commodity categories, we expect gross margin benefits to be passed on to consumers along with continued price deflation over the next 12 months.
Spends should follow expansion in gross margin: In line with our expectations, the company has started passing on most of the gross margin benefits (up 226 bps y-o-y) to consumers through higher consumer promotions (A&P spends up 170 bps y-o-y as a percentage of sales). In the past also we have observed that y-o-y change in A&P spends have shown a strong correlation (80%) to a y-o-y change in gross margin. We expect a similar trend to continue over the next 12 months.
Ebitda margin expansion of only 40 bps y-o-y for FY16e: With consumer demand likely to revive earliest by H2FY16, we expect HUL to take price cuts and increase A&P spends to drive top-line growth ahead of the market. In the past too, when gross margin expanded by more than 200 bps y-o-y, Ebitda margin showed a much lower increase of 50-100 bps y-o-y. Nowhere in the past has HUL been able to translate the sharp increase in gross margin to a similar increase in Ebitda margin.
Expect de-rating after the sharp rally last fortnight: Whilst low-teen sales growth and mid-teen EPS growth are likely from FY17e onwards, we expect the company’s top-line growth to face pressure in FY16 due to price cuts. Hence, we expect only low-teen EPS growth helped by modest Ebitda margin expansion in FY16. As a result, we expect consensus to reverse most of the recent steep upward EPS revisions. Also, due to the vulnerability of 50% of HUL’s sales to regional competition in a low input price environment, we believe the current multiple of 41x FY16e EPS is unjustified. Hence, we expect a 15-20% de-rating for the stock over the next 12 months.
Revival in consumer staples only from H2: Consumer purchase behaviour has remained moderate y-o-y in Q4FY15 due to: (i) lack of asset value creation having a dampening effect on consumer sentiment, (ii) euphoria around political stability not yet translating into consumer spending, and (iii) significant moderation in rural demand, adversely impacting the FMCG sector. We expect a revival in consumer spending in the staples category earliest by H2 led by: (i) disposable household income revival (likely only in mid-FY16) due to sustained low inflation, and gradual rise in job creation over the next 12-24 months; (ii) inflation; and (iii) improved efficiency of distribution of the government’s rural welfare schemes through the direct benefits transfer platform.
Outlook-volume growth likely to remain moderate: HUL derives 60% of its revenue from soaps & detergents and tea?fully penetrated categories with a likely volume growth of only 2-4% per annum. The company is likely to lose market share in oral care (5% of total revenues) due to Colgate’s strong competitive advantages and rising competitive intensity from Dabur. Its skin care segment (10% of total revenues) is likely to see a drag on growth rates from high penetration in the mass market (FAL) and intense competition from players like L’Oreal in the premium market. Consequently, we expect HUL’s overall volume growth rates to remain subdued (5-6% CAGR over FY14-18) even once the broader premiumisation trends and discretionary consumption sentiment revives to the previous levels.
Valuations–trading at an unjustified premium; reiterate Sell: We expect 13% revenue CAGR for HUL over FY15-18e, given the high penetration levels and rising competitive intensity across categories. Considering the marginal Ebitda margin expansion, we expect EPS CAGR of no more than 15% over FY15-18e (20% EPS CAGR reported over FY11-14). HUL’s wide portfolio positioning, high operational efficiencies and large scale are likely to help the company sustain its leadership position in most of its key products categories over the medium to longer term.
However, current valuations of 42.7x FY16 EPS do not adequately factor in the likely near-term weakness in EPS CAGR. We have marginally revised our FY16/17 EPS estimates factoring in the delayed recovery and weaker price growth for FY16.
We reiterate our Sell stance on the stock with a target price of R710 (revised down from R725/share), an implied P/E multiple of 34x for FY16e.
Prolonged market weakness and lower-than-expected Ebitda margin expansion are likely to be negative catalysts in the future.
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