Royalty cloud on earning horizon

Maruti Suzuki’s move to increase the royalty payment to its parent has put investment managers on the alert. Reason: They expect other companies to also do so. Studies say as a result, 32 companies in the BSE 500 index may see their profit margins shrink.

In April, the government allowed companies to remit royalty payments on technology equal to five per cent of domestic sales and eight per cent of exports. Subsequently, Maruti Suzuki increased its royalty payment from three per cent to roughly 5.1 per cent. In December 2009, Hindustan Unilever increased its royalty outflow from 0.6 per cent to around one per cent of net sales.

According to a study by Religare Institutional Research, royalty payments are made by 75 BSE 500 companies and comprised 19 per cent of overall selling, general and administration (SG&A) costs in financial year 2009. These accounted for 130 basis points of earnings before interest, tax, depreciation and amortisation (Ebitda) margins.

The notification affects 32 companies in BSE 500 that have technical collaborations with foreign (non-portfolio) equity holders, and thus excludes domestic companies, which have no restriction on royalty payments. Wholly-owned foreign subsidiaries have no restrictions either.

According to Tirthankar Patnaik of Religare, “With little information on the actual value of the technical expertise, or by way of equity of certain brands, a potential rise in payments could raise questions of fair distribution of earnings to common stockholders.”

Royalties for these 32 companies had a share of 11 per cent in SG&A expenses, accounting for 100 basis points at the Ebitda margin level.

Royalties for these 32 companies had a share of 11 per cent in SG&A expenses, accounting for 100 basis points at the Ebitda margin level. “A quick sensitivity analysis shows that a rise in payments to a blended five per cent of sales will hurt margins by a further 390 bps, and margins will fall to 11.8 per cent,” says the report. Royalties amounted to more than 40 per cent of total dividends declared in 2008-09.

However, according to Motilal Oswal, chairman of Motilal Oswal Securities, “There will not be any general impact. The current incident is an isolated one and one should look at it on a case to case basis.

Automobile, pharmaceutical and fast moving consumer food sectors see the highest royalty payments. On Monday, auto sector stocks were hammered, with Maruti Suzuki taking the lead with a 12 per cent drop in the share price. Hero Honda, which also has a substantial royalty outflow — with royalty and technical fees comprising 30 per cent of SG&A costs — was also battered.

“We are surprised by the extent of the increase in royalty payments at Maruti Suzuki,” said Kapil Singh of Nomura Financial Advisory and Securities.

“While there could be cost and margin implications, one should also note that better royalty payments would translate into parent companies bringing better technology and newer brands. This will have a positive impact on overall growth,” said a fund manager with a domestic fund house.