Hindustan Lever has turned over a new leaf - its revenues grew in double-digits for the first time in over three years in the previous quarter ended June 30, 2005. What's more, even profits grew on a year-on-year basis, after four quarters of decline.

HLL's [Get Quote] rapid return to profitable growth, however, seems well captured in its stock price, which has risen 60 per cent in the past year, and by 30 per cent in just the past three months. With valuations as high as 29 times estimated earnings for CY05 and 24 times estimated earnings for CY06, it does look like the positives are well priced in, which in turn could mean that returns from the stock in the future would not be exciting.

On the other hand, since HLL is back on a growth path, analysts have again to compare its valuations with peer group companies. HLL had always enjoyed a premium over other FMCG stocks. Last year, this relationship lost importance since HLL's profit plummeted, while peer group companies were reporting handsome growth rates.

As a result, while the HLL stock took a back seat in the past two years' rally, stocks like Godrej [Get Quote] Consumer, Marico and Dabur [Get Quote], which earlier used to trade at single-digit price-earnings ratios, have risen sharply and now enjoy one-year forward valuations of over 20 times earnings.

HLL, on the other hand, has almost always traded in a P/E band that's upward of 20 times earnings, which means that the valuation gap has narrowed considerably. Some analysts are of the view, therefore, that HLL's current valuation is not unreasonable, also considering that the company is back to growing ways.

The turnaround

After four consecutive quarters of declining profit, the FMCG major reported an increase in both operating and net profit in the June quarter. But what was more important about the June quarter results was that the company's domestic FMCG sales rose by 11.8 per cent, the highest in the past 24 quarters.

By the look of it, HLL seems to have come out stronger from the price war with P&G in the detergent and shampoo segments. Though profits have taken a beating, the price cuts in these segments have triggered volume growth.

It was no coincidence, after all, that the total FMCG market saw a revival in volume growth from the June quarter of 2004 after two years of decline. This was the period which first captured the impact of the price cuts in the detergent segment.

But isn't profit growth more important from an investor's point of view? Certainly, but as Hindustan Lever's ex-chairman MS Banga has often said, volume growth is followed by value growth, and a rise in profits thereafter.

"As night follows day, as value growth comes, profit growth follows. That's the way of the game," Banga had said at this year's AGM.

To be sure, sales value growth in the domestic HPC (home and personal-care) business jumped to around 10 per cent in the March quarter and over 12 per cent last quarter. In comparison, HPC sales had risen just 2.2 per cent in calendar year 2004 (CY04), though volume growth had picked up almost as soon as the price cuts were implemented last year.

It's commendable that the company has managed operating profit growth just one quarter after it recorded sales growth in value terms. Operating profit grew 8.4 per cent in the June quarter, at a slightly lower rate compared to the 10.3 per cent increase in net sales.

Set back in time

Though HLL has reverted to profit growth, it needs to be noted that the growth has come on a rather low base. The same time last year, profit had plummeted by over 40 per cent, as operating margin had slumped by 640 basis points as a percentage of sales. In light of that, the operating profit growth of 8.4 per cent is no big deal.

It's important to note that the hit HLL's profit took in CY04 owing to the price cuts has set it back in time by almost five years. Net profit before exceptionals fell to Rs 1,199 crore (Rs 11.99 billion) last year, from a peak of Rs 1,804 crore (Rs 18.04 billion) in CY03. The last time the company's net profit was lower than CY04 levels was in CY1999, when net profit stood at Rs 1,070 crore (Rs 10.70 billion).

Also, it will take the company at least another two years - i.e., till CY07 - to get back to CY04 level of net profit of over Rs 1,800 crore (Rs 18 billion) (this is based on analysts' expectations of a 20 per cent growth in earnings in the next two years). This aspect doesn't seem to be reflected in Hindustan Lever's current share price.

It's interesting to note that HLL's share price was Rs 174 before P&G's price cuts were announced, at a time when analysts had no clue about the extent of damage the price cuts could do to the company's earnings. It turns out that analysts were expecting a net profit of over Rs 2,250 crore (Rs 22.5 billion) in CY06 at that time. Now, consensus estimates are that CY06 net profit would be less than Rs 1,600 crore (Rs 16 billion), about 30 per cent lower.

The current stock price, however, is at similar levels of Rs 170 per share, which simply means that forward P/E valuations have gone up significantly though things have gone worse on the profit front.

Great expectations

Evidently, the markets expect growth to be high even beyond CY07. But the farther one goes in terms of earnings projection, the riskier things get since visibility is that much lower. For now, it's clear that the reversal in volume growth that started last year will continue in the near to medium term.

While the price cuts had led to an almost immediate pick up in demand in urban India, volume growth returned to the rural segment only this year in the March quarter. With both segments growing, sales growth is expected to accelerate in the near term. Yet, volume growth is not expected to return to double-digit levels seen till the late 1990s.

According to retail sales data, HLL's volumes grew 3.3 per cent in June while the whole sector grew volumes by 5 per cent (the reason sales growth in value terms was much higher in double-digits last quarter was that the company had taken some price increases in the HPC segment in order to offset raw material cost pressures).

Volumes in the detergent and shampoo segments, both of which saw sharp price corrections last year, grew in double-digits. To re-iterate, overall volume growth was led by segments, which saw price cuts. Though pressure from the down-trading phenomenon has eased, it certainly hasn't disappeared.

Increased cost of health, education and utilities - coupled with the higher competition for a share of the consumer's wallet in the form of durables, houses, automobiles and services - means that consumers would continue to look for cheaper alternatives.

With ample such alternatives available from regional players and organised retailers, HLL's business had suffered. Last year's price cuts have helped it gain back share in some categories. At the same time, in categories such as personal-wash where similar price cuts have not happened, sales volumes have declined lately.

Nikhil Vora, vice-president (research) at SSKI Securities, adds, "The downside for HLL is restricted in the HPC business; however, the up-tick in the business will be gradual as penetration levels in the soaps and detergents business are quite high and the upside potential is limited.

Besides, foods business remains a cause for concern and HLL has not yet identified drivers for strong and sustainable growth. It will also have to live with the fact that margins will be constrained."

Besides, on the profitability front, HLL is expected to continue to benefit in the near term because of fiscal benefits from its new plants in Himachal Pradesh and Uttaranchal. Besides, savings on interest would continue for the rest of this year, thanks to the redemption of its bonus debentures. These savings accounted for 60 per cent of the increase in net profit last quarter.

Clearly, the incremental benefits from these measures would not continue from the next year. For earnings growth to be at high double-digit levels beyond CY07, not only would the trend in volume growth have to continue, but there would also have to be price increases or significant cost savings.

Stock returns

The key question for investors is whether the Hindustan Lever stock would deliver positive returns relative to the market going forward.

From a plain vanilla PEG (price earnings/growth ratio) standpoint, the stock looks overvalued.

Its trailing P/E is 31, while expected growth going forward is 20 per cent, which gives it a PEG ratio of 1.55 times (anything over 1 is normally seen as sign of overvaluation). While all FMCG stocks trade at P/E valuations that are lower than that of HLL, quite a few are also expected to grow earnings at rates higher than HLL's 20 per cent growth expectation.

Another way to look at it is that even if HLL's stock delivers average returns of just 7 per cent for the next two years (anything less than that would obviously not warrant an investment in the stock), it would get a high trailing P/E of 25 times two years from now.

That's based on the assumption that HLL's trailing 12-month EPS would increase to Rs 7.8 from current levels of Rs 5.4, using analysts' expectation of a 20 per cent annual growth.

If the stock gives better returns, which is what investors at current levels are expecting, the P/E would be even higher. Earnings projections beyond CY07 need to be bullish for the stock to justify a trailing P/E of over 25 times two years from now. But that's gazing too far ahead in the future, which raises the risk element in the investment.

But do valuations matter at a time when investors, especially foreign ones, are chasing stocks as if there's no tomorrow? Currently, they don't. What's also working in HLL's favour is the fact that it's the market leader in a sector that's on the buy list of most brokerages.