Should Royalties of MNC Stocks Worry You?

Royalty payments by subsidiaries to parent MNCs have often stoked debate, particularly since these payments spiked after 2010. That is when the foreign investment rules were relaxed and the caps on royalty payments were lifted.

Up until 2009, royalty payments were regulated by the government. They were capped at 8% of exports and 5% of domestic sales in the case of technology transfer collaborations. Additionally, they were fixed at 2% of exports and 1% of domestic sales for the use of trademark or brand names.

Opinions on royalty payments vary. Some companies argue that such payments aid in expanding their business, while others believe they erode earnings available to shareholders, primarily benefiting the parent company.

The recent hike in Hindustan Unilever's royalty payments has brought this never-ending dispute into the limelight.

The fast-moving consumer goods (FMCG) giant said its board approved a proposal to hike the royalty and central services fees payout to parent Unilever Plc from about 2.65% in the financial year 2022 to 3.45% in phases over three years.

In the financial year 2023, apart from the dividend outlay, HUL funnelled 2.6% of its total revenues to its parent, Unilever. In absolute terms, that amount to Rs 15.8bn.

You have to spend money to make money

Royalty fees are contractual payments made by a subsidiary to its parent company. They typically involve the use of intellectual property rights, such as trademarks, patents, copyrights, or technical know-how. Generally, it's a percentage of the gross or net revenue of the subsidiary, paid annually.

For the parent company, this represents a steady source of revenue. But for the subsidiary and its minority shareholders, it is a considerable amount of cash outflow for the use of intangible assets of the established parent.

For example, Nestle India pays 4.5% of its total revenue to Nestle S.A. every year. This gives Nestle India access to over 2,000 brands owned by Nestle S.A. The company says apart from the brands, the science and technology they borrow from the parent help them expand the business.

Not a small price to pay for greatness

Although the royalty payment is only 4.5% of Nestle India's revenue, the absolute amount is substantial, especially in comparison to the company's net profits. The Rs 7.5 bn payment represents a whopping 31% of Nestle India's net profit for the fiscal year 2022.

Nestle India does provide a respectable dividend to its shareholders, with a 5-year average dividend yield of 1.2%. In the financial year, the total dividend outlay amounted to Rs. 21 billion or Rs. 220 per share.

However, if the royalty payments were low, investors could have potentially received 25% higher dividends, approximately Rs 275 per share.

In the case of Hindustan Unilever, a whopping 15.5% of net profits were deposited in the parent's bank accounts as royalty. This resulted in a direct loss of Rs 15,780 m in the form of dividends in 2022 alone.

Hindustan Unilever Royalty Payments (2018-22)

	2018-19	2019-20	2020-21	2021-22	2022-23
Royalty Payments (Rs)	10,730	10,860	12,040	13,520	15,780
% of Total Revenue	2.70%	2.70%	2.60%	2.60%	2.60%
% of Net Profit	17.70%	16.10%	15.10%	15.20%	15.60%

Source: Equitymaster

There is no provision to restrict or lower the royalty payments in case of a downturn in business. Take ABB ltd for example, where royalty payments reached as high as 70% of the net profits in certain years.

ABB Ltd Royalty Payments (2018-22)

	2018-19	2019-20	2020-21	2021-22	2022-23
Royalty Payments (Rs)	1,745	2,145	1,726	1,987	2,581.70
% of Total Revenue	2.61%	2.93%	2.97%	2.87%	3.01%
% of Net Profit	68.70%	71.00%	74.90%	37.30%	25.20%

Source: Equitymaster

So, this money could have been disbursed to all shareholders (including the parent company) equally, in the form of dividends or ploughed back into the business for future growth.

But a large part of it is first directed right into the parent company's bank accounts, which seems unfair to the minority shareholder.

What's worse is that this number is subject to unpredictable hikes over the years. The idea behind the hikes is that the subsidiary needs to pay more to get access to the parent company's technology and R&D.

Moreover, it is difficult to predict the timing of any potential change in royalty rates, which casts a shadow of uncertainty over the stocks.

While subsidiary companies do maintain that the parent companies bring a lot to the table, the real question is, do the benefits of these royalties outweigh the costs?

Do the ends justify the royalties?

It's worth examining the extent of the greatness that these royalty payments bring. Unfortunately, many multinational corporations (MNCs) simply focus on reselling or assembling products in India rather than engaging in product innovation.

For instance, Colgate does have research and development facilities globally. However, its operations in India primarily focus on manufacturing and marketing, with a stronger emphasis on distribution and sales rather than significant product innovation specific to the Indian market.

This begs the question, are royalty payments and the hikes worthwhile considering the limited scope of innovation and technology transfer?

It is difficult to conclusively say whether the rise in royalty rates is justified. Moreover, these hefty payments raise concerns over the potential impact on the interests of minority shareholders.

Increased royalties make Indian companies less competitive, creating an unfair playing field. This harms their earnings and reduces the likelihood of providing healthier dividends to minority shareholders.

But rising royalty rates are not the only issue when it comes to investing in MNCs. The overbearing presence of the MNC (the parent company) on its subsidiary can be detrimental to investors.

The shadow of an overbearing parent can stifle growth

Take Siemens India for instance. Recently, the company announced that it is selling its low voltage motors and geared motors businesses to Siemens Large Drives India, a subsidiary of Siemens AG for Rs 22 bn.

The rationale was that Germany globally decided to carve out low voltage motors and geared motors business into a legally separate company.

Investors nationwide have voiced concerns not just about the fairness of the valuation but also about the company's exit from a lucrative sector. However, they don't have much say in the matter.

Shareholders are the owners of a company and have the right to disagree with the management if they feel it's not acting in the best interest of the company.

However, usually, minority shareholders often opt to sell their shares rather than challenge the management's decisions.

This is prevalent in the case of MNCs where decisions on M&A transactions or divesting from subsidiaries with very little consideration to the interest of minority shareholders.

The impact of this was evident in the case of Siemens, as the stock plummeted by more than 15% within two days of the news.

So, what should investors do?

Investors: Fight or Flight?

The government is actively working to address this issue. The Finance Bill 2023, passed in March 2023, introduces measures that require Indian units of MNCs based in the US and UK to pay double tax (from 10% to 20%) on royalty payments to their parent companies.

As per this amendment, the government can impose a 20% tax on companies based in countries or jurisdictions where India does not have a tax treaty.

The Swadeshi Jagran Manch (SJM), an affiliate of the Rashtriya Swayamsevak Sangh (RSS), has urged the government to implement a cap on royalty payments. Advocating to reintroduce a cap on royalty payments, similar to the practice in India before 2009, they argue that the increasing royalty payments by MNCs have adverse effects on the overall health of the economy.

This includes the rising foreign exchange outflows and the further depreciation of the Indian rupee.

While this still seems farfetched, investors must remain cautious and consider the risks associated with investing in MNC subsidiaries. Ultimately, a better bet is to carefully evaluate the costs of royalty payments and their impact on long-term shareholder value.

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