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P&G: 'Royal'ty hit

May 2, 2005

Performance Summary
Procter & Gamble Hygiene and Healthcare (PGHH) reported a 26% growth in the March quarter revenues (its third quarter for the current fiscal), but a disappointing 20% bottomline fall. Though the revenue performance is encouraging, the expenditure growth outpaced revenues. However, if we exclude the royalty payments made to the parent for 1HFY05, profit growth was about 18% for the quarter.

(Rs m) 3QFY04 3QFY05 Change 9mFY04 9mFY05 Change
Net Sales 1,373 1,724 25.6% 4,337 5,133 18.4%
Expenditure 1,093 1,511 38.2% 3,219 4,053 25.9%
Operating Profit (EBDIT) 279 214 -23.6% 1,118 1,079 -3.4%
Operating Profit margin (%) 20.3% 12.4%   25.8% 21.0%  
Other Income 21 24 13.6% 90 127 40.9%
Interest 4 1 -87.2% 4 1 -87.5%
Depreciation 39 24 -39.4% 89 76 -14.4%
Profit before Tax 258 214 -17.1% 1,115 1,130 1.4%
Tax 77 76 -0.7% 320 370 15.6%
Exceptional Items - 9 - - 102 -
Profit after Tax/(Loss) 181 147 -19.1% 795 863 8.5%
Net profit margin (%) 13.2% 8.5%   18.3% 16.8%  
No. of Shares (m) 32.5 32.5   32.5 32.5  
Diluted Earnings per share (Rs)* 22.3 18.1   32.7 35.4  
P/E Ratio (x)         17.3  
*(annualised)            

What is the company's business?
P&G is a 65% subsidiary of the FMCG major, P&G USA. In India, the company is a focused two-product company, dominating both segments backed by strong brands, namely ‘Vicks' in the anti-cold segment and ‘Whisper' in feminine care segment. The parent has two other 100% subsidiaries in India, which have a dominant shampoo and detergent portfolio. P&G undertakes contract manufacturing for its parent's detergent portfolio (Ariel, Tide) in India.

What has driven performance in 3QFY05?
Core blues: The company's key businesses are anti-cold and feminine care. In the March quarter, the company's Whisper folio of feminine care grew by a good 13% YoY. The performance was led by continued demand for its 'Ultra' and 'Maxi ' range. In contrast, the company's anti-cold folio (Vicks) grew by a lower 7%. The growth in the ‘Vicks” folio mainly came from Vicks Action 500+, Vicks Inhaler and Vicks Cough Drops. But one must remember that the anti-cold category is season driven. Overall, the company's core business of hygiene and healthcare grew by 10% during the quarter. But comparatively, the business performance was lower as compared to the previous quarter (2QFY05), where it had recorded a growth of 19% in revenues. But some of the slack could be resultant of the VAT related concerns.

Support from contract manufacturing: The key growth driver for the company's topline continued to be the detergent contract manufacturing business. This division saw a significant 38% growth in revenues during 3QFY05. The parent's strategy to garner a bigger chunk of the Indian detergent market by slashing product prices to almost half, has done wonders for this division. Contract manufacturing accounted for 45% of the company's revenues in the quarter. P&G too has benefited in terms of higher volume of contract manufacturing.

Segment snapshot
(Rs m) 3QFY04 3QFY05 Change 9mFY04 9mFY05 Change
Health & Hygiene Products 809 945 16.9% 2,907 3,082 6.0%
PBIT margin (%) 27.6% 18.4%   33.4% 30.6%  
Contract Manufacturing 564 779 38.1% 1,430 2,051 43.4%
PBIT margin (%) 6.8% 4.7%   6.7% 4.7%  
Total revenues 1,373 1,724 25.6% 4,337 5,132 18.4%
PBIT margin (%) 19.0% 12.2%   24.6% 20.3%  

Royalty blues hit margins: Not only the performance of the core business was relatively staid on the revenue side, profitability was also hit (see above table). PBIT margins of this business went down by more than 9% during the quarter. Also, though contract manufacturing aided greatly to the topline, margins for the same dipped by 2.1%, adversely affecting the overall bottomline growth. However, for contract manufacturing, margins between 4.5% to 5% are what's realistic in the future.

Overall operating margins declined owing to the payment of royalty expenses to the parent. The quarter was exceptionally hit, owing to royalty payments that also included payments for the first half of the company's fiscal (about Rs 67 m). If we exclude this payment that pertaining to the past quarters, profit growth is actually encouraging at 18% YoY.

Cost break-up
As a % of net sales 3QFY04 3QFY05 9mFY04 9mFY05
Consumption of raw and packaging materials 43.5% 47.6% 35.4% 45.3%
Purchase of trading material 6.3% 0.1% 7.6% 0.9%
Staff costs 5.8% 5.7% 6.5% 5.5%
Advertising expenses 9.7% 9.8% 8.0% 8.2%
Royalty expenses 0.0% 6.4% 0.0% 2.5%
Others 14.5% 18.0% 16.7% 16.6%
Total expenditure 79.7% 87.6% 74.2% 79.0%

The company's bottomline performance would have been even worse but for an extraordinary fillip, in terms of sale of property (Rs 9 m) in the quarter.

What to expect?
At the current price of Rs 614, the stock trades at a P/E of 17 times annualised 9mFY05 earnings and market cap. to sales of 2.9x. Investors need to consider that over 80% of P&G's total PBIT comes from its core business. Though contract manufacturing will continue to spearhead topline momentum, focus should be on the company's core operations of health and hygiene. The company has introduced a new variant of Whisper at a lower price point in southern India. This may increase penetration of the product, thereby aiding volume growth. At the same time margins are under pressure, which is a cause for concern.

We had recommended P&G Hygiene in November 2003 as a BUY with a target price of Rs 630. The stock has breached that earlier. In the coming years, as the unlisted P&G subsidiaries make their presence felt in the detergent space, P&G Hygiene too will benefit from the quantum of contract manufacturing. Also, the poor per capita consumption for its feminine care folio indicates latent growth potential. On the flip side, there are many international brands (imports) available now atleast in the key metros that sometimes work out to be cheaper for consumers. In that sense, the space is getting competitive. The parent too has started charging a royalty of around 4.2% on its core business revenues, which will eat into margins.

The stock is trading at a P/E of 18.6 times our FY08 earnings estimates, and in our view is not a good buy at the current levels. In short, though P&G may benefit from an uptick in consumption, its relatively two-product focus and the parent's other 100% subsidiaries put it at a bottom heap of our valuation matrix. In our view, there are better growth stories available in the FMCG space.

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