Hindustan Unilever. SELL Quick Insight. Is this the beginning of another price war? AMBIT INSIGHTS

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1 Hindustan Unilever Is this the beginning of another price war? P&G India s new management has cut shampoo prices by 25-30% in August 2015 thus far to regain its market share loss. Our channel checks suggest that Hindustan Unilever (HUL) has also taken similar price cuts on its shampoo portfolio. While according to our estimates, the price cuts on the shampoos portfolio (accounting for ~8%/13% of HUL s sales/ebit mix) over one year are likely to lead to an FY16 EPS cut of only 3-4% for HUL, we believe this could be the beginning of a price war in other categories as well. Given the market share loss for P&G in FY15 and given the headroom for further price cuts (due to lower input costs), we believe P&G India s new management could initiate measured price cuts on detergents in the short term to arrest market share loss. During the previous price wars between P&G and HUL in 2004 and 2010, HUL s profitability and PAT growth were severely impacted. Given the overhang of a price war with P&G, we reiterate our SELL stance on HUL with a TP of Rs740 (15% downside). Restructuring of the India business led to market share loss across categories In April 2014, P&G restructured its global business, which resulted in the India business being moved out of the Asia cluster and into a new cluster comprising India, Middle East and Africa (IMEA). Thus, the India business has become the biggest fish in a small pond from being a small fish in a big pond. As part of the Asia cluster India could focus on driving topline growth at the expense of profitability. However, India s inclusion into IMEA, along with P&G s focus of shifting to profitable growth, added pressure on the India business to deliver profits in order to improve the overall profitability of the IMEA cluster. The India business management s Key Performance Indicators (KPIs) were changed to align with the higher profitability objective as well. Several measures have been taken to improve profitability: Cut in A&P spends: As part of various cost-saving measures, P&G India cut down its A&P spends. P&G Home Products saw its A&P spends decline from ~15% of sales in Mar 13 to ~10% in Mar 14. Oral B has been one of the biggest victims of this spending cut. Following its launch in 2HCY13, Oral B had to contend with a smaller A&P budget in CY14 whilst Colgate continued to spend aggressively on A&P. This under-investment in the brand led to a failed launch for Oral B. Delay in passing on benefits of lower input costs: Whilst FMCG companies started passing on the benefits from lower input costs starting 3QFY15, P&G was slow to react. In detergents, HUL started aggressive promotions from Dec 14 whilst P&G waited until Apr 15 to initiate pricing action on Tide. Exhibit 1: P&G Home Products reported higher operating profit at the expense of lower A&P spends SELL Quick Insight Analysis Meeting Note News Impact Stock Information Bloomberg Code: HUVR IN CMP (Rs): 873 TP (Rs): 740 Mcap (Rs bn/us$ bn): 1,889/29.1 3M ADV (Rs mn/us$ mn): 1,238/19.0 Stock Performance (%) 1M 3M 12M YTD Absolute (6) Rel. to Sensex (3) Source: Bloomberg, Ambit Capital research Ambit Estimates (Rs bn) FY16 FY17 FY18 Revenues EBITDA EPS (Rs) Source: Bloomberg, Ambit Capital research Operating Profit (Rs. Mn) A&P as % of Sales (RHS) % % % % Analysts Mar 09 Mar 10 Mar 11 Mar 12 Mar 13 Mar % 10.0% 5.0% 0.0% Rakshit Ranjan, CFA rakshitranjan@ambitcapital.com Tel: Ritesh Vaidya, CFA riteshvaidya@ambitcapital.com Tel:

2 Due to the reduced A&P spends, P&G lost market share across most of its product categories over the last 12 months. P&G which commanded ~27% market share in shampoos in FY15 vs 29% in FY14 lost market share mostly in Pantene due to the following issues: Product gap: Pantene s key competitor Dove did several product innovations over the last months, improving the efficacy of the product. Tresemme also posed a significant threat to Pantene due to competitive pricing and product innovation. However, during the same period, Pantene s lack of product innovation resulted in a gap between consumer want and the final product. Dilution of brand equity: Due to the overall reduction in A&P spends, P&G under invested in Pantene whilst HUL continued to aggressively invest in Dove and Tresemme. Head & Shoulders due to its strong anti-dandruff shampoo brand equity and less competitive pressure faced lower market share pressure than Pantene. A much-needed price correction in shampoos from P&G Over the last three months, P&G India has seen several management changes. Its MD for 13 years, Shantanu Khosla was replaced by Al Rajwani in Jul 15. In Jun 15, P&G India also replaced its Head of Sales and the Head of Marketing was moved to a different geography. The new management took its first pricing action, with a 25-30% price cut on shampoos in Aug 15. Following the price cut, P&G has moved from a ~15% premium positioning to a ~15% discount to HUL (as shown in the exhibit below). Exhibit 2: P&G has taken 25-30% price cuts on its portfolio of shampoos Variant Old MRP New MRP Price cut (%) Pantene PRO-V, 80ml % Pantene PRO-V, 180ml % Pantene PRO-V, 340ml % Pantene PRO-V, 675ml % Head & Shoulder Anti-Dandruff, 80ml % Head & Shoulder Anti-Dandruff, 180ml % Exhibit 3: Following the price cuts, P&G retails at a ~15% discount to HUL s shampoos per 100ml (Rs.) Premium/(Discount) Brands Old price New price Old New Pantene PRO-V, 180ml vs. Dove Daily Shine, 180ml 86 0% -29% Sunsilk 73 17% -17% Clinic Plus 70 24% -12% Head & Shoulder Anti-Dandruff, 180ml vs. Clear Ice Cool Menthol Anti-Dandruff Shampoo, 170ml % -13% As these price cuts are unlike the price discounts taken on Soaps and Detergents, these are stickier in nature. On our market visit to some of the retailers, we saw that HUL has also taken a similar pricing action by pasting price discount stickers on its shampoo SKUs. According to our estimates, a price cut of 25-30% on the Shampoos portfolio (~8%/13% of HUL s sales and EBIT mix) over one year will lead to an FY16 EPS cut of only 3-4% for HUL.

3 New management could resort to measured pricing action We believe that P&G s global focus on profitable growth will be maintained by the new management of the India business over the long term. However, given the benefits accruing from lower input costs, we believe that P&G could take measured pricing action in the near term to arrest its falling market share across categories. As shown in the exhibit below, HUL s EBIT margin is at one of its highest levels in more than 5 years, indicative of the possible room for competitors to attack HUL. Exhibit 4: HUL s 1QFY16 EBIT margin is one of the highest in the last several quarters 19.0% 18.0% 17.0% 16.0% 15.0% 14.0% 13.0% 12.0% 1QFY11 2QFY11 3QFY11 4QFY11 1QFY12 2QFY12 3QFY12 4QFY12 1QFY13 2QFY13 3QFY13 4QFY13 1QFY14 2QFY14 3QFY14 4QFY14 1QFY15 2QFY15 3QFY15 4QFY15 1QFY16 Case study: What happened to HUL s profitability during previous price wars with P&G? Considering the possibility of the price war moving to other categories such as Detergents, we look at the previous two instances (2004 and 2010) of price wars to assess the impact that these price wars have on HUL s profitability. Case Study 1: The HUL and P&G detergent price war in 2004 P&G s actions: In 2004, as P&G moved from a premium positioning to a price-led strategy, the company cut prices of Ariel and introduced Tide detergent as a competitor to Rin Shakti. P&G cut prices of Ariel and Tide by ~50% to retail lower/on-par with HUL s pricing for Surf and Wheel. HUL s response: HUL warded off P&G s threat to its market share by: (a) Taking similar price cuts on Surf and Rin and then stepping up its A&P spends; (b) Investing into product innovation and upgradation - Surf was relaunched as Surf Excel Blue but at a lower price; Rin Shakti was relaunched as Rin Advanced; and (c) Increasing overall A&P spends to support these new launches. Although HUL was able to defend its market share, margins for the Soaps and Detergents (S&D) category took a hit, dropping from 24.8% in CY03 to 17.3% in CY04 whilst PAT dropped 32% YoY in CY04. It took HUL almost 4 years to recover its PAT to the CY03 levels.

4 Exhibit 5: HUL s PAT and EBIT margin declined sharply following the price war with P&G PAT (Rs. Mn), RHS S&D EBIT margin (%) Overall EBIT margin (%) 27.0% 25.0% 23.0% 21.0% 19.0% 17.0% 15.0% 13.0% CY01 CY02 CY03 CY04 CY05 CY06 CY07 19,000 17,000 15,000 13,000 11,000 ; Note: The dotted circle highlights the year when the price war happened, S&D = Soaps & Detergents Case Study 2: The HUL and P&G detergent price war in 2010 P&G launches Tide Naturals: In Dec 09, P&G launched a new variant called Tide Naturals which was priced 30% cheaper than Tide. In Mar 10, the company started offering 25% more grammage on this product. HUL s response: HUL responded by cutting the prices of Surf and Rin by 10-30%. The company also stepped up its advertising spends and launched an advertising campaign, directly comparing the efficacy of Rin and Tide Naturals. This aggressive pricing action from both HUL and P&G resulted in both the companies gaining share from smaller unorganised players. However, the EBIT margin of HUL s Soaps and Detergents reduced from 14.3% in FY10 to 9.3% in FY11 whilst its PAT remained almost flat over FY Exhibit 6: HUL s EBIT margin declined sharply whilst its PAT was flat following the price war with P&G PAT (Rs. Mn), RHS S&D EBIT margin (%) Overall EBIT margin (%) 18.0% 16.0% 14.0% 12.0% 10.0% 8.0% CY07 FY09 FY10 FY11 FY12 FY13 33,000 29,000 25,000 21,000 17,000 ; Note: The dotted circle highlights the year when the price war happened, S&D = Soaps & Detergents As has been observed in the above two case studies, a Detergent price war with P&G severely impacts the profitability of HUL, with PAT declining/remaining flat for at least two years.

5 Where do we go from here? HUL, TP of Rs740, 15% downside, Mcap US$29.1bn HUL s Soaps & Detergents (S&D) portfolio (~50% of sales) faces intense competitive pressure from organised and unorganised peers in a soft input cost environment, and hence this part of the portfolio will see price deflation over the next six months. Also, uncertainty around urban demand recovery would likely lead to muted demand for HUL s personal care categories such as skin and hair care (~20% of sales) for the next 2-3 quarters. Following the recent price war between P&G and HUL in shampoos, there is an added overhang of a possible price war between these two companies in Detergents which could severely dent HUL s profitability in the near term. Over the long term, HUL faces high penetration levels in S&D and tea (~60% of sales) and high competitive intensity in oral care (5% of sales) from Colgate and in premium skin care categories from L Oreal. Consequently, we expect HUL s overall volume growth to remain subdued (5-6% CAGR over FY15-18E). Based on the current steep valuations of 44.6x/36.8x FY16/17E EPS and sales/eps CAGR of 13%/18% over FY15-18E, we reiterate SELL with a TP of Rs740 (15% downside, implied FY16E P/E of 37.8x).

6 Balance sheet Year to March (Rs mn) FY14 FY15 FY16E FY17E FY18E Net Worth 32,771 37,248 45,871 58,259 73,902 Total Debt Deferred Tax Liability (1,617) (1,960) (1,960) (1,960) (1,960) Current Liabilities 97,214 99, , , ,617 Total Liabilities 128, , , , ,559 Fixed Assets 27,418 29,365 29,412 29,447 29,465 Investments 30,941 32,779 42,779 54,779 69,779 Current Assets 70,007 72,236 77,887 91, ,815 Total Assets 128, , , , ,059 Income statement Year to March (Rs mn) FY14 FY15 FY16E FY17E FY18E Net Income 280, , , , ,492 % Growth 9% 10% 8% 13% 12% Gross Profit 136, , , , ,230 EBITDA 44,753 52,082 58,719 67,800 79,337 PBIT 48,357 55,399 61,094 74,260 88,358 PBT 47,997 55,231 60,974 74,050 88,148 PAT 35,598 37,299 42,316 51,265 60,989 EPS EPS Growth 11% 5% 13% 21% 19% Cash flow statement Year to March (Rs mn) FY14 FY15 FY16E FY17E FY18E EBIT 48,357 55,399 61,094 74,260 88,358 Depreciation 2,606 2,867 2,953 2,965 2,982 Others (13,110) (18,921) (19,571) (23,906) (28,417) Change in working capital 8,638 2,816 3,992 7,086 7,647 Cash flow from operations 46,491 42,162 48,469 60,404 70,569 Cash flow from investments (12,573) (6,652) (13,500) (15,000) (17,999) Cash flow from financing (28,787) (32,344) (32,900) (37,966) (44,297) Change in cash 5,131 3,166 2,069 7,439 8,271 Free cash flow 41,552 37,348 44,969 57,404 67,569 Ratio analysis / Valuation parameters Year to March (Rs mn) FY14 FY15 FY16E FY17E FY18E Gross margin (%) 48.8% 49.3% 50.9% 51.4% 51.9% EBITDA margin (%) 16.0% 16.9% 17.7% 18.2% 19.0% Net profit margin (%) 12.7% 12.1% 12.8% 13.7% 14.6% Net debt: equity (x) (1.4) (1.4) (1.4) (1.4) (1.4) RoCE (%) 117.9% 105.5% 100.1% 97.0% 90.9% RoE (%) 117.0% 105.2% 99.9% 96.7% 90.7% P/E (x) Price/Sales (x) EV/EBITDA (x)

7 Hindustan Unilever Ltd (HUVR IN, SELL) 1,200 1, Aug-12 Oct-12 Dec-12 Feb-13 Apr-13 Jun-13 Aug-13 Oct-13 Dec-13 Feb-14 Apr-14 Jun-14 Aug-14 Oct-14 Dec-14 Feb-15 Apr-15 Jun-15 Aug-15 HINDUSTAN UNILEVER LTD Source: Bloomberg, Ambit Capital research

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