THE SMART INVESTOR: Strong growth trajectory for Hindustan Unilever

Volumes and margins to improve on higher demand, price hikes, premiumisation and operating leverage.

Hindustan Unilever has underperformed its peer index, the BSE FMCG, in recent weeks correcting about 11 per cent as compared to the 6 per cent fall for the index. In addition to the worries on pricey valuations of the sector, the Street was worried about the ability of the company to maintain margins, given higher crude oil prices, a weak rupee and more importantly HUL’s ability to maintain volumes in view of recent price hikes.

However, the management’s optimistic commentary last week helped assuage some of the Street’s concerns, helping the stock bounce back a bit. Even after the correction, the stock is still trading at 48 times its FY20 earnings estimates — much higher than the five-year average price to earnings ratio of about 40 times.

Volume growth to sustain

After 12 per cent year- on-year volume growth in the June 2018 quarter, on a lower base, the management expects volumes in subsequent quarters to grow at an average rate (6-7 per cent) achieved over the last two years. Analysts expect stable market demand seen in Q1FY19 to continue into the current quarter with rural growth outpacing that of urban (rural is growing 1.5 times of urban in volume terms and 1.3 times in value).

The stabilisation of overall trade channels too supports the expected volume growth. Analysts expect HUL to clock 7-8 per cent volume growth in Q2, outpacing the 4 per cent volume rise in the September 2017 quarter, which is positive. Further impetus to the positive volume outlook may come from pre-election spending and increase in minimum support price for the Kharif season.

Further, the 2-3 per cent average price hikes undertaken in Q2 should enable HUL to post a double-digit top line growth, yearon-year, in ensuing quarters. The impact of these price hikes would partially get reflected in Q2 and fully in December quarter onwards. Within segments, the company took a higher 3-4 per cent price hike in the home care segment and is taking price hikes for personal care portfolio (at premium end) too. These two segments together accounted for over 78-80 per cent of HUL’s revenues and 84-86 per cent of its operating profit in FY18.

Margin gains

Though currency headwinds are offset by softening palm oil prices (11 per cent down quarteron-quarter and 16 per cent yearon-year, so far), according to the management, crude oil prices still remain a pain point for HUL. The price hikes, along with operating leverage (employee costs and other costs excluding marketing spends), should also HUL protect its operating margins in an inflationary environment. HUL believes the inflation level is not alarming and can be managed through pricing action and cost savings. Analysts say strong demand environment is favourable to pass on the impact of the moderate increase in material costs.

Margin support also stems from an expected faster growth of high-profitable premium products with the goods and services tax (GST) implementation and improved performance of modern trade. Nitin Gupta, of SBICAP Securities, expects HUL’s operating profit margin in Q2 to expand by 130 basis points to 21.8 per cent y-o-y.

On the recent issues related to GST anti-profiteering, HUL is confident and says it has followed due process. It has passed on the entire GST benefit to its consumers either by reduction in prices or by increase in grammage. Although, any update in this regard is a key monitorable.

Valuation

Some analysts, who are positive on the earnings potential of HUL, see valuations limiting the upsides for the stock. Some, however, consider the recent correction as a good buying opportunity for the long-term. While analysts at CLSA expect an 18 per cent upside in the stock, Motilal Oswal Securities believes that the stock has the potential to gain 23 per cent. The latter in a recent note said that the price correction of over 10 per cent offers a more attractive entry point with the valuation of the stock deserving the premium with significantly improving business fundamentals.