Hindustan Lever: The spark is missing

Profit growth continues to evade Hindustan Lever

In terms of sales growth, things are getting better by the quarter for Hindustan Lever. Domestic FMCG sales grew 7.1 per cent in the March quarter, 11.9 per cent in the June quarter and 15.9 per cent last quarter. This is the highest year-on-year growth in over two years.

Trouble is, the high growth in sales isn't translating into a proportionate increase in profit. In fact, operating profit growth fell to just 1.7 per cent last quarter, from 8.4 per cent in the June quarter.

To be fair to HLL, last quarter's results included a sales tax liability relating to a prior accounting period, which hit operating margin by 50 basis points. Adjusted for this, operating profit growth would be slightly better at 5.8 per cent.

But the fact remains that profit growth lagged sales growth. The company took a 100 basis points hit on margins last quarter because of higher material costs, especially in the case of chemicals and packaging material, prices of which went up owing to higher oil prices.

Besides, ad spend was increased by 22 per cent, higher than the rate at which sales grew. Again, this caused a 60 basis points hit on operating margin.

Going by the 2.4 per cent increase in HLL's share price, it seems that the markets weren't perturbed by the flat trend in profit. One reason is that the flat trend in profit was largely expected. The other, more important reason is that the markets are happy for now that sales growth has improved.

While urban markets have been growing for some time, rural markets have also caught up, albeit at a slower pace. The fact that rural markets are now growing, compared with a declining trend till late last year, have provided an additional kicker in terms of sales growth.

Also, for now, the markets seem to be going along with HLL's oft-repeated theory that just as revenue growth has followed volume growth, profit growth would come next. But at nearly 28 times CY05 earnings, the markets are banking on high earnings growth going forward. For valuations to make sense, HLL must grow earnings at 28 per cent or more the next year onwards.

Without doubt, that's a tall task. The only thing that works in favour of HLL's valuation is that the premium it commands over the rest of the FMCG sector has halved to about 20 per cent from its historical average. Its unlikely that the premium would come down further, given HLL's size, dominance in various product categories and its superior return on capital.

Dr Reddy's: partnership pays

Dr Reddy's Laboratories' (DRL) September quarter results highlight the efficacy of its partnership-based model to share R&D costs, coupled with its expansion in the emerging markets.

As a result consolidated operating profit margin has expanded 685 basis points to 20.15 per cent in Q2 FY 06. On a sequential basis, too, operating margins have expanded 821 basis points in the September quarter.

The street appears to have factored in the improved operating environment of the company and the stock has outperformed the Sensex over the past one month "" it has lost a mere 3.5 per cent compared to a 8.7 per cent dip in the broader market.

The company's consolidated R&D costs have fallen 37.36 per cent y-o-y to Rs 35.09 crore in Q2 FY 06. Sequentially, too, this cost has dropped 18.41 per cent, thanks to the cost being shared by Perlecan Pharma Private Ltd coupled with its recently concluded agreement with ICICI Venture.

Meanwhile, growth in the active pharmaceutical ingredients (API) segment was helped by a 55 per cent y-o-y growth in the European markets to Rs 33.8 crore in the September quarter, coupled with a 37 per cent y-o-y growth in other emerging markets.

Growth in both these markets was helped by terbinafine (medication for the anti- fungal segment). However, sales in America slipped 6 per cent y-o-y in the last quarter. Nevertheless, the segment profit of the API business expanded 173 per cent y-o-y to Rs 33.88 crore in Q2 FY 06.

It was no different in the generics business "" revenues from the American market fell almost 58.18 per cent y-o-y to Rs 29.9 crore in September.

The drop in revenues was owing to strong pricing pressures for key products such as fluoxetine and tizanidine ( medication for the anti - depressant segment).

To offset the drop, sales in Ukraine and Kazakhstan expanded 39 per cent y-o-y to Rs 20.3 crore in the last quarter. Also, sales in Russia expanded 10 per cent to Rs 64.4 crore in the last quarter, helped by improved sales of Nise (non-steroid anti-inflammatory drug). Strong profit margins in emerging markets helped.

The segment profit of the generics business expanded almost 20 times to Rs 16.79 crore in the last quarter.

As a result, operating profit expanded 63.1 per cent y-o-y to Rs 113.70 crore in the last quarter.

Going forward, a further improvement in operating margins appears likely given its strategy to manage cost and expand outside America.

However, the stock does appear expensive with a discounting of almost 49 times estimated FY06 earnings.