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HLL: Where is it heading?

Aug 31, 2005

Investors are in a dilemma of sorts over what to do with their investment in the FMCG major, Hindustan Lever Limited (HLL). Over the years, the HLL stock has seen extremes of investor sentiments, ranging from absolute worship to disgruntlement. Although the FMCG sector is showing signs of revival, HLL continued to show paltry growth, until the latest quarter (2QCY05). In this article, we look at HLL's journey over the past half a decade and try and get some answers from its past.

About the company
HLL is India's largest FMCG company with dominant presence in almost all consumer categories. The company's turnover at Rs 100 bn is over one third of the total branded/organized FMCG market in India. HLL's brand equity remains unrivalled in India. However, in the last couple of years, the company has embarked on a major restructuring exercise focusing on improvement in quality of earnings, pruning brand portfolio and securing a viable future for its non-core businesses through JVs, or spin-offs. The effects of the initiatives had begun to show in the form of better margins. But 2004 saw competition in its key business of soaps and detergents (45% of revenues), taking a huge toll on margins.

Let's look at the company's performance over the last 5 years…
Revenues
In CY00, the company recorded revenues of Rs 106 bn. However, in CY04, the revenues shrunk to Rs 99 bn, a CAGR decline of 0.6%, as compared to a consistent growth from 1995 to 2001 (see table below).

Profits
Profits in the year 2000 stood at Rs 13 bn and were Rs 12 bn in CY04. The company's interest burden increased drastically from Rs 131 m in CY00 to Rs 1,300 m in CY04 due to the issue of debentures to its shareholders.

(Rs m)CY00CY01CY02CY03CY04
Net sales106,038106,67699,549101,38499,270
% growth4.50%0.60%-6.70%1.80%-2.10%
Operating profit14,64117,14019,55919,76714,374
Operating Profit Margin (%)13.8%16.1%19.6%19.5%14.5%
Interest13177926681,300
Profit after tax13,10116,41317,55717,71811,973

Operating margins
The company saw a consistent up trend in operating margins from 1998 to 2003, but due to increasing competition and the price war initiated by P&G in the detergent segment, HLL has seen its operating margins decline to 14.5% in CY04, much nearer to margins that were prevalent in CY00.

Why did all this happen?
During the early 1990's, HLL's pace of growth was aided by a number of key positives. For one, the FMCG sector in India was growing at a decent 10%-15% per annum. In some categories, the growth was even higher than this. However, post 1997, with the GDP growth slowing down, there was a slowdown witnessed in certain key FMCG categories like that of soaps and detergents. On the other hand, new players, both international and domestic, started to increase their presence in the country. This put pressure on HLL to re-think its strategy.

At the beginning of the new century, the company's think tank realised that of the 100 plus brands it had, only 40 contributed to around 90% of turnover and 110% to its bottomline. The rest were actually, proving to be a drag on the company's resources and profitability. In a bid to change this, the company initiated a strategy to prune its brand folio to about 40 and divest non-core businesses. The strategy was able to deliver what was desired, i.e., higher profitability. The operating margins of the company improved from 10.8% in 1998 to 19.5% at the end of 2003.

At the start of 2004, the HLL management indicated that the restructuring is complete and the desired level of profitability has been achieved. Topline growth was the new mantra adopted by the company then. However, P&G's strategy of upping its market share by cutting prices of shampoos and detergents to half, forced HLL to follow suit and margins came back to near 2000 levels in just one year. So all the advantages derived from the efforts of the last 5 years were nullified.

Where to from here?
The FMCG sector is back on track and is on the path to recovery. Growth is being witnessed in urban as well as rural areas. However, despite some recent price hikes, margins are unlikely to touch the 2003 levels of 19.5% in a hurry. Chasing revenue growth still remains the management motto for 2005, even at the cost of margins.

Among the positives, the company has recently been chosen as a hub for meeting Uniliver's oral care requirements in Philippines The company has also initiated a 10-point programme for cost cutting, which is likely to show its results over the next couple of years. The company has more or less given its bakery business (Modern Foods) and confectionery (Max) business a quiet burial. 'Atta' (flour) is also not on the company's growth radar. This in itself will save profitability for the company. Interest costs are likely to go back to pre-2004 levels. The company has also set up a plant in Himachal Pradesh to avail of tax benefits offered by the state.

At Rs 165, the stock trades at 34.2 times its annualised 1HCY05 earnings and market cap to sales of 3.6 times. As far as our full year estimates are concerned, we had projected a much lower 2.4% growth in revenues but an increase in profits. The management has indicated in the past its focus on maintaining market share, even if it comes at the cost of margins. With crude prices showing no signs of easing in the near term, the pressure on profitability could be here to stay.

We have been indicating in the past that HLL is in for tough times in the near term. We foresee the company taking radical steps to improve its performance, but these will be visible only over the next 1 to 2 years. In our view, based on the current situation, investors are better off buying other smaller and growing companies in the FMCG space like Pidilite, Dabur and Essel Propack.

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