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Can HLL surf the rising tide?

Arun Rajendran | March 15, 2004

If the FMCG marketplace can be compared to a choppy sea, till recently no one had any doubt about who rode the waves: Hindustan Lever.

Well, the seas have got choppier still, and no one can be sure how well HLL can weather the storm now. Already forced to fight price wars with regional brands in several product segments, Gulliver of Lilliput is now facing Goliath.

A week ago, Procter & Gamble unleashed a tsunami of epic proportions by applying its China strategy and cutting the prices of its leading detergent brands Ariel and Tide.

This has forced HLL to batten down the hatches and follow suit by reducing the prices of Surf Excel and Surf Excel Blue. And that may not be the end of the story: With P&G now planning to launch its global toothpaste brand Crest, the FMCG market is going to see even more turbulence.

So where does this leave Levers? If you were to ask the punters, the answer is down in the dumps. The HLL scrip has been foundering on the rocks and has been mauled by bears ever since the P&G price cut.

In fact, the magnitude of the fall can be gauged by the fact that the scrip lost over 11 per cent in just six trading sessions. That's not all.

On  March 8, HLL's P/E ratio fell below that of the BSE Sensex after staying resilient even during the crisis period of April-May 2003, when the stock price hit a major low. The Sensex P/E has held its ground at 19.26. However, plummeting HLL prices resulted in its P/E slipping below that of the index to 19.20.

The outcome of the price wars is anybody's guess, for as yet there are no answers to many questions. Will sales volumes grow to make up for t he drop in prices? How will market shares get redistributed? And, most importantly, is it time to dump HLL or hold on?

P&G's move actually did not take analysts by surprise. Some say that it was just a matter of time before this happened.

Says Nikhil Vora, FMCG analyst at brokerage and research firm SSKI, "P&G's new-found India love comes on the back of a successful relaunch of its detergents offerings, coupled with shampoos. It is now being backed by its strongest global brand, Crest." Vora says that there is certainly strong merit in P&G's India strategy.

"The market share of P&G in all categories - be it oral care, detergents or shampoos - is below 10 per cent. However, by playing the price card, it has virtually forced an existing dominant player like Hindustan Lever to come down the price ladder and redefined the pricing equation in the market. This effectively weakens the contribution margins for market leaders." 

Perhaps, a pointer to the approaching storm was hidden in the December quarter results of HLL, which disappointed analysts on both topline and bottomline. For the full year, net profit was up merely 2.9 per cent to Rs 494.72 crore (Rs 4.947 billion).

However, post-extraodinaries, net profit growth was flat. Total income decreased to Rs 2,684.53 crore (Rs 26.845 billion) in 2003 from Rs 2,735.22  crore (Rs 27.352 billion) in the same period last year.

This was a total anti-climax for analysts who were expecting much better things from the company given that it had recorded its sharpest topline growth in seven quarters with a 4.2 per cent growth year-on-year (y-o-y) in the September 2003 quarter, led by the beverages and personal care businesses.

The effect of the price war on HLL's bottomline and product portfolio will take some time to figure out, but what is certain is that there is certainly going to be some upheaval. HLL's portfolio presently looks skewed with a lot of its brands now competing in the same price range.

For instance, Rin Shakti and Surf Excel Blue are now at the same price point of Rs 42 per kg. Surf Excel Blue had recently been re-launched, possibly to convert Rin Shakti users to Surf Excel Blue.

Also, the difference between Surf Excel and Rin Supreme has narrowed down considerably. This will inevitably lead to some cannibalisation. Analysts say it's only logical for HLL to resort to more price cuts to correct this anomaly, thereby leaving no doubt that margins will take a hit in the short run.

The price cut by P&G has resulted in a repositioning of Tide in the popular segment. Consumers could well see a huge value-for-money proposition in Tide and downtrade to Tide from Rin Supreme.

Where does this leave the premium section? Nowhere, say analysts. With the price cut, P&G has virtually killed the premium segment and reduced the detergent segment to the mid-price and popular segments.

Not surprisingly, HLL is not on anybody's wish-list right now - and that is putting it kindly. Analysts say competitive pressure is at an all-time high and HLL's stranglehold in various segments is going to pass through the most testing of times.

"Ten years ago, HLL had a virtual monopoly in all the market segments, but look at the situation today. The dominance does not even extend above two or three categories," says Rajiv Sampath, head of research at brokerage and research firm Parag Parikh Financial Advisory Services.

"The scrip has been underperforming the Sensex for the last two years. Its December results were not encouraging at all and one should not expect anything rosy in the next two quarters at least," adds Sampath.

Margin woes

HLL has been bearing the brunt of low margins, and had been bereft of margin gains in its soaps and detergents portfolio, for the last five quarters.

In fact, the 2.2 per cent drop in the overall EBITDA in Q4 FY03 was the worst rate of fall in the last few years. Analysts expect the slippage in EBITDA margins to continue, if not increase, in the next few quarters.

Analysts attribute this to continuing stress in detergents and beverages which account for about 28 per cent of the company's turnover and significantly lower profitability in exports, owing to the rupee's appreciation. Exports , incidentally, account for 12 per cent of its turnover.

The main effect of the price drop is that detergent sales in value terms could drop by 5.1 per cent in CY04. This, in turn, means that EBITDA growth in detergents would be further muted to a 1.4 per cent against analysts' earlier estimates of 7.7 per cent, resulting in a 70 basis points erosion in EBITDA margins to 18.8 per cent.

"Reality bites," says an analyst from a leading brokerage. "The margins clearly need to be realigned to a more realistic scenario and high margins of 25 per cent definitely cannot be sustained anymore," he adds.

To compound the situation, input prices for toilet soaps have risen over 50 per cent since September. In the September quarter, palm oil prices rose 27 per cent.

Also, the average prices of palm oil were 10-12 per cent higher in the quarter ended December 31, 2003, against prices in the quarter ended December 31, 2002. To pass on this steep increase in input prices, HLL raised the price of Lux soap by 50 paise.

However, analysts feel that the measure falls flat, especially if one takes the inflation factor of around 4-5 per cent into account. In fact, including this, the actual price increase is negative, which brings an element of deflation in the scenario.

Competition

As part of its initial strategy, P&G has delivered twin hits to two very profitable segments of HLL - detergents and shampoos.

However, analysts say the introduction of its world-wide bestseller Crest may hurt HLL more, since Colgate and Dabur have also been rather aggressive in pushing their products.

To be sure, some analysts feel that P&G's small presence as yet is rather too weak to make any significant gains in market share even after the price cuts.

P&G was a not even a close competitor to HLL, commanding a measly 5 per cent of the total detergents market while HLL had a commanding 40 per cent.

But they give credit to P&G for forcing HLL to cut prices by over 20 per cent and analysts say the pricing pressure in this segment will inevitably reduce its profitability. Once that is done, P&G would look at building its sales and distribution to build on initial gains.

Another point is that P&G, which markets its detergents through its unlisted company, can afford to take a hit in the bottomline by funding losses from abroad. But HLL, as a publicly listed company, will face selling pressure in the share market.

Distribution

HLL's biggest strength so far has been its unmatched distribution reach. This enabled the company to make the most of an undeveloped and undercapitalised retail market.

Analysts see the advent of organised retailing having the effect of diminishing the power of FMCG companies to insulate their margins. Analysts say organised retailers are set to increase their market share from less than 2 per cent currently to over 10 per cent over the next five years.

"Organised retailing thrives on extracting incremental margins from manufacturers, and FMCG players would not be insulated from this for long, impacting their realisations in the process," says an analyst.

To add to the gloom, the much promised rural boost has not kicked in as yet. In the past, when the company was already struggling for topline growth, it made up for the slack by fairly steady bottomline growth. But looking ahead, even this will be under pressure, given the price wars.

The key development to watch is the increase in rural demand. Analysts say cash flows from the kharif harvest will start flowing in from the quarter starting April.

This could see highly penetrated categories like soaps and detergents, which have consistently registered a declining sales trend, seeing a turnaround in fortunes.

The reason for the optimism is the farming community in the country is likely to garner a higher cash surplus by about Rs 40,000 crore (Rs 400 billion) after the kharif crop harvest compared with last year. The fact that about 50 per cent of HLL's revenues come from the rural areas is a factor that would work to its advantage.

Analysts say the company needs to support sales by heightened market activity for new categories. HLL's poor showing in growing businesses such as bakery products and water and the absence of new growth engines have not gone down well with analysts.

This is compounded by the fact that incremental consumer demand for FMCGs remains low. Analysts expect earnings growth to remain subdued over the next couple of years on account of sedate topline growth and subdued margin gains. They expect an EPS of Rs 8.2 FY05. The telling point is that the stock has lost its allure with analysts.

"Earlier HLL used to be an attractive dividend yield play around the Rs 135 levels. Now that growth has faded off, there are many stocks in the sector like Nestle which are looking more attractive," says Sampath.

However, the stock does have its share of support.  "The stock has been punished more than it deserves," says an analyst with a leading domestic brokerage and research house.

He adds that the stock is presently perceived negatively because of Q4 numbers and the price cuts. But price cuts can improve volumes and the impact on profits may not be more than 10 per cent. HLL has an enviable position in certain segments like skincare which commands loyalty and is not affected much by price changes.

Once rural demand kicks in, things will look much better two or three quarters down the road. That could possibly pave the way for a re-rating, he adds.

But then, most punters will probably wait the period out to check whether the quarterly numbers reflect the rural revival.



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