08/08/2011 (Financial Express) - Hindustan Unilever’s Q1FY12 recurring PAT (profit after tax) of R 5.8 bn was in line with our estimates. Operating Ebitda (earnings before interest, taxes, depreciation and amortisation) of R6.79 bn (margin of 12.3%, and +50 bps and -20 bps QoQ and YoY, respectively) was slightly ahead of our estimates. Net revenues increased 15% year-on-year to R55 bn.

Gross margins of 44.1% were down 5 percentage points YoY and 160 bps quarter-on-quarter as the company was impacted by costs like CPO (crude palm oil), PFAD (palm fatty acid distillate), etc. This was mitigated by a sharp cutback in A&P (advertising and promotion) spends (-16% YoY, much lower than our estimates) as management noted that a reduction in competitive intensity in segments like soaps & detergents resulted in the scale-back of promotional activity (though competitive intensity remains elevated in personal products and foods).

Volume growth tapered off to 8%, in line with the management’s earlier assessment that FY12 revenue growth will be a more balanced mix of price/volumes. We note that going forward, volume growth could continue to decelerate, given the base effect–and benefits of the enhanced distribution initiatives are also baked in the base.

PP (personal products) revenue growth was a healthy 19% YoY, though this was a low base quarter (recall in Q1FY11 PP revenues rose 11%, impacted by lower hair care). PP remains at 29% of revenues, in line with past trends. Segmental margins at 25% are also steady, though in the next quarter, a challenging base will render a YoY comparison difficult, coupled with the fact that intensity remains high in segments like oral and hair care.

We make minor adjustments to earnings estimates (<1% over FY12-13e—estimated) and roll forward our target price of R330 to Mar13e P/E (price-to-equity) from Sept12e earlier, maintaining our 25x (times) target P/E multiple. Maintain Hold.

Investment strategy: We have a Hold/Low Risk (2L) rating on the company's shares. We think the company has been able to sustain and garner decent volume growth in core categories (soaps, detergents, personal products), ahead of category growth—with a trend of premiumisation continuing at a steady clip. Product innovations and new launches continue at a healthy pace—50% of the brand portfolio has been refreshed—the strongest in recent times. That said, we think the company will remain challenged on multiple fronts – given the heightened competition, strategically ad spends will remain elevated, and investments in new brands/categories will continue to impact margins. With management’s twin focus on volume growth and defence of its market shares, we think margin expansion may remain muted. In the short term, concerns on input costs remain.

Hindustan Unilever’s fairly steady earnings stream renders P/E a good methodology to value the stock. Our target price of R330 is based on 25x Mar13e P/E, at slightly higher than the mid range of the stock’s historical trading band of 18-28x of the past five years. We use a lower-than-peak multiple, as the earnings growth is likely to be relatively lower (at 15% CAGR over FY11-13e). At 25x P/E, the share will trade at a relative P/E of 1.6-1.7x, i.e., around the levels it found support during the last price war with P&G. We don’t believe the share should trade at a premium to its past relative P/E multiples (1.65x average since 2004), given that competitive intensity in most of its key segments has heightened over the past few years. The company has historically enjoyed more than a 100% premium to the Sensex owing to its high capital-efficiency ratios and consistent earnings growth. However, we do not expect the stock to re-trace to its historical high premium (almost 3-3.1x witnessed in the late 90s, given that the company's growth prospects are far more sedate today than they were around 10 years ago).

Risks: We rate Hindustan Unilever shares as Low Risk as the company operates in branded consumer products and has a diversified product portfolio—consistent with our quantitative risk rating system which tracks the 260-day share price volatility of the shares. The most significant risk to our target price is the possibility of a prolonged battle for market share with other MNC peers as well as Indian companies. The company is equally leveraged to the rural and the urban economies and, as such, any dislocation would affect the company's performance. Although the company's brands have strong pricing power, in a challenging external environment price increases are limited. P&G is aggressively seeking to increase its market share in detergents, shampoos and some other categories.

Other downside risks to our target price include higher-than-expected raw-material costs and the company’s inability to deliver on top-line growth. Upside risks to our target price include: (i) benefits on the distribution side (plenty of initiatives undertaken in the past one-twos) could kick in, (ii) favourable shift towards PP should result in a more stable profit profile, especially as 25% of the company's revenues (low-end soaps/detergents) is largely commoditised.