Rising royalty on their Indian operations will remain an overhang for the stocks of foreign consumer companies

The Indian consumer sector is a long-term growth opportunity led by growing incomes and increasing propensity to spend. It is dominated by foreign consumer companies which have been excellent long-term value creators. But now several foreign consumer companies are imposing royalties on their Indian operations.

Hindustan Unilever and Nestle India have already revised royalty rates, while Colgate and GSK Consumer are sitting on the fence. While it is difficult to predict the timing of any potential change in royalty rates, it will remain an overhang for the stocks. This is according to Nomura Equity Research in its report on the Indian consumer sector.

The idea behind the royalty hikes is that the Indian subsidiary needs to pay more to get access to the parent company’s technology and R&D capabilities and the right to leverage on the global portfolio in India. The increase in both the cases is a gradual change, which cushions the burden on minority shareholders. While it is difficult to conclusively say if the increase in royalty rates is justified, it does take out the near-term uncertainty over these companies. However, in the long-term, it does raise the question on how the move will impact the interests of minority shareholders, says Nomura.

The net impact on earnings is not much, according to Nomura’s analysts. While there will be some impact on earnings both for Hindustan Unilever as well as for Nestle India of the increases in royalty rates, the quantum will not be large. For Nestle India, the increase will kick in only on 1 January 2014, and for Hindustan Unilever, the increase in royalty rate will be 50bps (basis points) each year for the next two years starting 1 April 2014. The companies will also have the option of passing on these increases to consumers at an appropriate time. Royalty rates are high in the consumer sector relative to other sectors.  Even if we look outside the consumer sector, there are a large number of listed subsidiaries of MNCs (multinational companies) which pay royalties to the parent. Some of the more prominent names and the royalty rates for them are below.  Excluding Maruti, the royalty rates paid by both Nestle India and Hindustan Unilever are higher than those paid by companies in other sectors. 

Valuations of consumer companies continue to remain at high levels relative to their long-term average. Within MNC companies, Hindustan Unilever, Nestle India, GSK Consumer and Colgate Palmolive trade at an average 26.1x FY15F (Nomura’s estimate), about 23% premium versus domestic consumer companies. While the companies have historically traded at a premium to domestic companies, the premium has shrunk over the past five years. If over the longer term royalty rates continue to rise, MNC firms are likely to become less attractive to minority shareholders. However, there is no risk in the medium term, as MNC companies continue to have a more complete portfolio of brands and have a significant head start versus domestic companies in the segments in which they operate in.

Nomura continues to prefer ITC among large cap consumer stocks, where visibility of earnings growth is much higher. It expects ITC to pass on the recent rise in excise duty and VAT (value added tax) in certain states by way of price hikes. Its long-term target of growing the cigarette business EBIT (earnings before interest and tax) by 15%-16% remains intact and is supported by valuations of 23.4x versus Hindustan Unilever at 25.7x and Nestle at 25.1x. In mid caps, Nomura prefers Emami which should deliver an 18% earnings growth over the next couple of years, and the stock currently trades at 20x FY15F earnings, a significant discount to the sector.