HLL: Reality check

Recently, both Hindustan Lever (HLL) and P&G have raised price of their detergent sachets, which could signal a cooling off of the intense marketing war between the two. This has resulted in a lot of renewed optimism in HLL on the stock market. We examine the issue. For the uninitiated, P&G nearly halved prices of its detergents (Ariel, Tide) and shampoos (Head & Shoulders, Pantene) earlier this year to improve its market share in these segments. This put pressure on the market leader, HLL, to follow suit in a bid to save its turf. While the company was reasonably successful in holding onto its market share, its operating margins nose dived from 17.6% in the first half of 2003 to 13.8% in first half of current year. Net profits shrunk by 35% YoY during this period. Read more on HLL 1HCY04 results.

This was because the soaps & detergents segment contributes a bulk of HLL's revenues (over 44% during 1HCY04). PBIT margins of this segment shrunk by nearly 6% in 1HCY04 to 17.2%. Owing to this poor performance, HLL sunk to record lows on the bourses. The stock has since recovered almost 25%. As such, the news of the price war abating is good news for investors.

But there are a few things investors should keep in mind. For one, a bulk of HLL's financial year is already over and the effects of price revisions, if any, will be seen only from 2005 onwards. 2004 is likely to end on a poor note for HLL. Another thing to note is that globally, FMCG companies operate on high volumes and lower margins. HLL's parent, Unilever, had operating margins of 15.7% in 2003, while HLL itself earned around 19.5% in 2003.

To be fair, HLL has consistently managed to improve efficiencies by restructuring and consequently, improved operating margins over the years. But the fact is that in a growing economy like India, such high operating margins encourage competition to come in (including imports). Also, it may be difficult to raise prices to earlier levels, as consumer acceptance may not be so easily forthcoming. Another inherent issue is the company's inability to launch successful new products over the past few years. The lack of new growth drivers is the key cause of concern.

In our view, though HLL may 'tide' over the short-term price blues, the fact of the matter is that margins are unlikely to reach the past highs. Having said that, we would be comfortable with a 3% to 4% growth in topline over the next three years. As a market leader, the company will continue to see a spate of new competition going forward. Unless the demand outlook improves or the company finds new growth engines, cost-cutting measures alone will not be of much help.

The stock trades at Rs 123, a P/E multiple of 21 times our expected 2004 earnings and market cap to sales of 2.7x. Though growth is not visible currently, we believe the FMCG sector as a whole, is slated for growth going forward. With the consuming class expected to touch 46% by FY07, HLL will be a key beneficiary of an upturn in demand outlook over the long term.

View the HLL Research Report.