Vicious circle

A price cut of HLL's premium brands may have a cascading effect

Procter & Gamble's decision to cut prices of its detergents has stirred a hornet's nest, from Hindustan Lever's point of view. For starters, the price reductions have been considerable (25 per cent on an average).

According to reports from trade circles, HLL has matched the price cut in P&G's 'Ariel' in the case of 'Surf Excel', but has left prices of 'Surf Blue' slightly higher than that of 'Tide'.

This will have two consequences for HLL: not only will margins be hit badly, there is also the possibility of a loss in market share from the current levels of over 40 per cent.

This is a matter of serious concern as detergents account for around 20 per cent of the company's total turnover. It's no wonder the HLL stock has fallen around 9 per cent since P&G announced its price cuts.

The stock is now 21 per cent lower since it announced its results in mid-February.

But HLL's woes don't stop there. The "new" price of 'Surf Blue' is now almost on a par with another detergent from the HLL stable, 'Rin Supreme'.

This leaves the company with two options: to discontinue the brand or merge it with 'Surf Blue' or reduce prices of 'Rin Supreme' as well. If it decides to reduce prices, it will have to do so for a host of other detergent brands.

This is because HLL is positioned in every other price point with brands such as 'Rin Shakti' and 'Wheel' lower down in the value chain.

This will be disastrous as far as margins go. Furthermore, lower prices for premium products such as 'Surf' and 'Surf Excel' could cause consumers to upgrade from segments such as 'Rin Supreme'. Thus, even the level of cannibalisation between brands will increase.

But the rationalisation in prices was inevitable - in 2003, HLL's soaps and detergents division enjoyed an EBIT margin of 25 per cent, leaving plenty of room for a downward correction.

Especially so in categories such as detergents where downtrading has been rampant . Needless to say, a similar trend can be expected in some other categories as well.

In summary, the price war in the detergents business has triggered an end to high margins enjoyed by HLL. With sales growth also difficult to come by, the market may consider another round of price reductions for the HLL stock as it still enjoys a discounting of 18 times estimated 2004 earnings.

The ONGC offering

ONGC's current offering is at 9.71 times FY06 consensus earnings (assuming the lower end of the price band) and at a 10 per cent discount to the current market price of Rs 756 . Among its peers, Exxon currently trades at a multiple of 13.26, CNOOC is at 15, while BP is at 21.31.

The short-term attraction is, of course, the fact that the company would see its earnings rise due to an uptrend in crude prices. But a key determinant to profit growth will be the PSU's capability to quickly find new reserves of crude oil and natural gas.

The company's ability to aggressively grow its proven domestic crude oil reserves has been lacklustre - these reserves have fallen 3 per cent to 3306 million barrels as on April 1, 2003. Domestic reserves of natural gas have shown a similar trend.

On the production front, rapid growth is not anticipated""-crude oil production which was at 206.81 million barrels is expected to grow to 230 million barrels on an annualised basis this year.

Further, output growth is capped as the company is dependent on two major drilling sites - and the oil fields located there have started to mature. This trend was reflected with net sales dropping 3.5 per cent to Rs 7,227.74 crore for the quarter ended December 31, 2003.

To remedy the problem, ONGC plans to invest $3 billion over the next 3-4 years to fund activities relating to finding new reserves.

Also, its acquisition of Cairns' 90 per cent interest in the KG-DWN-90/2 block in the Krishna - Godavari basin should help the company boost its production capacities in the next few quarters. However, the real growth opportunities for the company lie elsewhere.

ONGC's international crude oil reserves have jumped 94 per cent to 673 million barrels at the beginning of FY04 - and this is set to rise aggressively as they are expanding rapidly in Sudan, Myanmar, Iran, Libya and Syria.

Also, international crude production is set to jump with the Sakhalin-1 project in Russia, expected to commence production shortly. The earnings from these overseas projects should flow to the company in the next 2-3 quarters.

With contributions from Mobis Philipose and Amriteshwar Mathur