HUL’s second quarter 2015 earnings (up 8.2% over last year) grew much below our average five year forecast of 12.5%. In our opinion, the three critical factors that determine profitability at the firm are revenue growth, segment profitability and advertising spends.
Firstly, revenues were up just 10.8% (4% in volume terms) over last year, as the company performed below our 13.6% five-year average growth forecast. However, HUL continues to grow faster than industry given its expansive distribution reach and portfolio of strong brands, both of which support our narrow economic moat rating on the firm.
Secondly, segment profits for soaps and detergents as well as personal care were moderately higher than our estimates, and we adjust our full-year 2015 EBIT margins to 13.8% and 26.0% from 13.5% and 24.5%, respectively.
Lastly, the company spent 12.2% of sales on advertising for the first six months, versus our 13.0% estimate. Adjusting for this lower spend we have cut our advertising spend forecast down to 12.5% of sales for 2015, which improves our EBIT margin outlook for the firm by 50 basis points to 15.8%. With these changes to 2015 forecast and keeping our five-year forecast broadly unchanged, our fair value is now Rs 626 per share.
As inflation eases and Indian consumers can spare more cash for discretionary expenses, consumer firms like HUL, holding the largest market share across key categories, are bound to benefit. To position itself to capture this uptrend in spending, the consumer giant has reorganized its sales force into a fifth regional branch, comprising five central states accounting for 40% of India’s population and close to 20% of HUL’s sales. Management shared that capita consumption rates of HUL products in this region is 50%-60% that of the rest of the country, thereby representing a huge opportunity. This is a positive move, as it will allow HUL to localize its advertising and brand messaging to better target these Hindi-speaking households.
Investment Thesis
With significant distribution scale, a portfolio of iconic brands and leading market share in many categories, we give India’s largest consumer products firm a narrow economic moat rating. Hindustan Unilever’s (HUL) products reach about 7 million outlets across India, the largest distribution network among peers. 19 of its brands generate annual turnover of over Rs 5 billion, or $80 million, each; while a good 95% of products hold the two leading spots in their respective categories in terms of market share. To ensure that its dominance remains intact, the company is constantly investing in product innovation and supporting brands via the media. As the company innovates to bring new-to-India products to market and gains further scale benefits we anticipate operating margins will expand over the coming decade, keeping returns above its cost of capital.
HUL’s ability to innovate ahead of competition is truly remarkable. We’ve been particularly impressed by the company’s ability to expand margins despite mounting competition in soap and detergents, which contributes 47% to sales. This has been possible by launching new products such as fabric softeners, liquid detergents ahead of competitors. At the same time, its rural strategy of converting local villagers to salesmen has allowed them to access the interior regions of India, and sell them one rupee sachets of its products, keeping volumes buoyant.
In our view personal products, contributing 28% to sales is a big opportunity for HUL to drastically improve its margins. The under-penetration characteristics of this category will allow HUL to leverage the breadth of its brands across price points, to lead adoption across affluent as well as poor households in India. Its recent launches of TRESemme and Tony & Guy brands, is a step in that direction to explore how far up the price band can be expanded in this pseudo-luxury category.
Overall, we see tremendous opportunity in the Indian market, with per capita consumptions that pale in comparison to other emerging Southeast Asian markets. We believe HUL is in a sweet spot to benefit from the imminent, inevitable explosion in consumption.
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