Hindustan Unilever’s (HUL) first-quarter consolidated revenue grew 13.3% (volume growth of 6.0%), in line with our full-year forecast of 13.3%. However at 16.2%, operating margins, or earnings before interest and tax, were higher than our 15.2% forecast, as margins for the personal products (27.6%) and food categories (10.9%) were much ahead of our estimates of 24.5% and 4%, respectively.
Several new product launches in both these categories have pushed margins to levels which we don’t believe will last until next year. Furthermore, advertising and employee expenses were also lower than anticipated, as the company reaps the temporary benefit of high media spending outlays in the prior year to support multiple product launches, and makes a one-time adjustment for un-utilized pensions via the employee expense line.
We remain confident that full-year operating profitability numbers will come closer to our recently updated projection, as the year normalizes for any one-time adjustments on the revenue or expense side.
Over the next five years, we believe Hindustan Unilever will expand its operating margins to average at 15.5%, versus the 14.6% experienced over the last five years, as the firm leverages its distribution scale and portfolio of brands to sell more products at higher prices. However, we keep our forecast unchanged: We believe margins of 16.2% are not sustainable. We reiterate our INR 625 fair value estimate and narrow economic moat rating.
At current prices, we think the market may have overreacted to the rosy first quarter results. The stock trades at the border of being fairly valued to overvalued (almost tipping into the 2-star range). Overall, we believe the company has strong growth potential. We continue to remain upbeat on HUL’s future prospects.
Valuation, Growth and Profitability:
We're have recently raised our fair value estimate for HUL by 6.5% to INR 625 per share, from INR 587, which implies a forward price/adjusted earnings ratio of 35 times, an enterprise value/adjusted EBITDA ratio of 25 times, and a free cash flow yield of 3.2%. Our fair value is based on a weighted average of our base, upside and downside scenarios in the same weighting 60%-25%-15%, respectively, to more accurately reflect the future possibilities that await HUL. Our base-case fair value estimate has gone up by a similar 6.5% to INR 605, as we adjust our model for the time value of money since our last update. However, our growth and profit assumptions for the business are unchanged.
We continue to project higher average margins of 15.5% over the next five years, versus 14.6% over the last five years, as the company is able to leverage its scale advantages on the procurement as well as distribution side. Our margin forecast for fiscal 2015 remains at 15.3%, as HUL’s 2014 performance was broadly in line with our estimates for the year.
Our five-year annual revenue growth assumptions also remain unchanged at 13% on average. We believe the company should recover from the low 9% growth it witnessed in 2014, as a general economic revival in India should translate into higher spending power for consumers across all income levels.
Overall, despite the somewhat unpredictable growth momentum we continue to remain optimistic about HUL's prospects in the Indian consumer markets, as it expands its margins with the help of its premium products, and begins to reap the benefits of its widened distribution reach while offering more consumers its large array of products.