HUL: Margin estimates need to be toned down

Will pass on large part of margin gains from weak crude as it cuts prices and invests in advertising

Weak volume growth, muted margin gains and higher employee costs pulled down Hindustan Unilever (HUL)'s earnings for the quarter ended December 2014. The company's net profit was driven by non-operational, one-time exceptional gains on sale of property. This gain, of Rs 397 crore (up 17 times year-on-year), led to a net profit of Rs 1,252 crore, up 17.9 per cent year-on-year and 16.7 per cent higher then the consensus Bloomberg estimate of Rs 1,073 crore.

The real indicator of HUL's performance during the quarter is profit after tax without considering the exceptional gain, which stood at Rs 955 crore, flat on an annual basis. This isn't surprising, given the company posted subdued volume growth of three per cent against expectations of five-six per cent. Consequently, HUL's net sales increased only 7.7 per cent to Rs 7,579 crore, missing the consensus Bloomberg estimate by four per cent.

During the quarter, HUL cut the prices of its soaps and detergents and cleared high-priced inventory, replacing it with lower-priced products. Adjusting for this move, volume growth could have been higher, about four per cent, say analysts. Continued pressure on discretionary expenditure and a weak show by the oral care segment were other pressure points on volumes. Discontinuation of tax/fiscal benefits affected revenue by 120 basis points. The management believes through the next two quarters, volume growth will recover gradually. Even as growth in rural areas saw some improvement, the management is watching this trend closely to ascertain its sustainability. HUL plans to take steps to revive the sales of Close Up and Pepsodent this year.

The benefits of lower input costs due to weak crude oil prices were barely visible during the quarter. HUL's input costs (as percentage of net sales) fell 64 basis points to 37.7 per cent. Even as total expenses declined 15 basis points to 86 per cent of net sales, an increase of 89 basis points in employee costs (due to one-offs) at 5.8 per cent restricted the rise in earnings before interest, tax, depreciation and amortisation margin (17.6 per cent) to 14 basis points.

Recently many brokerage houses upgraded the stock, anticipating higher margin gains from weak crude oil prices. The HUL management plans to pass on a large part of the gains to end users. The company will look to protect market share in the soaps and detergents segment by cutting prices and keeping segment margins competitive. Given lower input prices increase competition from both organised and unorganised players, this strategy should lead to higher volumes. The current quarter should also see volume gains on account of the spill-over of demand for skin care products due to a delayed winter.

As the HUL stock is correlated with volume growth, it fell five per cent on Monday to close at Rs 892.8. Given the stock's recent run-up, a high price-earnings valuation of 65.3 trailing 12 months earnings (10-year average trailing price-earnings is 34) and the management's plans to keep margins competitive, there could be some correction.