Creating Values: Hindustan Lever Limited

Economic value added (EVA) has become a buzzword in the corporate world. EVA measures how much a company has earned over and above its cost of capital, which includes both debt and equity. EVA represents value added to company investors, produced by generating operating profit in excess of the cost of capital employed. This, EVA proponents argue, gives a better all round picture compared to just the net profit declared in financial results. In other words, a positive EVA shows that the company has created wealth even though its sales and net profit growth rates may have slowed. Hindustan Lever (HLL) has been in the forefront providing additional information on EVA in its annual reports (see Exhibit 1).

The Company

HLL is the largest multinational in India. Unilever, the parent company of HLL, holds 51 per cent stake. HLL has a good dividend record and has been a long time stock market favorite. In 1956, HLL made its first public offering of 10 per cent of its equity. It now has about 300,000 shareholders across the country. On Indian stock markets, it has always been in top three in terms of capitalization.

HLL manufactures soaps and detergents, personal products, beverages such as tea and coffee, oils and vanaspati, animal feed stuffs, and dairy products. The company has more than 50 manufacturing units and operates from 70 locations. It has such a financial clout that it operates on a very thin margin of working capita , which often turns negative. This means that while it demands credit of anywhere between 60 and 90 days from its suppliers, it does not extend any credit and insists on immediate payment by its stockists and dealers. It has

arguably the strongest and most widespread distribution network in the country. It has

reach over one million retailers serviced by 4500 redistribution stockists. It is also one of the biggest exporters.

During the 1990s HLL adopted a strategy of growth by acquisition. It acquired TOMCO (1993), Brooke Bond (1996), Ponds India (1998), Lakme (1998), and a public sector company, Modern Bakeries (2001). It is in the process of rationalizing its brand portfolio by focusing on chosen 30 power brands out of its portfolio of 110 brands. These have been selected on the basis of absolute size, brand strength, competitive positioning, and future growth potential. Along with this it plans to add value added services to the brands like opening beauty salons, and tea and coffee vending machines, setting up cyber stores, and web malls for upmarket urban consumers.

The chairman's letter included in the annual report for 2002 states that "A recent study done by B.T.-Stern Stewart has ranked HLL as the No.1 in Market Value Added and in EVA". While presenting the results for 2002, an HLL spokesman said, "Hindustan Lever's EVA has increased beca se of two factors: increase in profits and a tight control on capital employed, added to an extent by the falling risk-free interest rates." In absolute terms EVA has gone up from Rs. 548 crore in 1998 to Rs. 1236 crore in 2002. While EVA has seen a good run, there is concern among analysts on the net profit front. Net profit has shown a reduction in the growth rate from 44 per cent in 1998 to 18 per cent in 2001, with the figure finally dropping to 11 per cent in 2002.

Estimating EVA and MVA

Recent research has focused on the performance of earnings-based valuation relative to discounted cash flow and discounted dividend methods. The findings indicate tha , over relatively short forecast horizons, ten years or less, valuation estimates using the a normal earnings approach generate more precise estimates of value than either discounted dividend or discounted cash flow models.

If the balance sheet is perfect, using book values can help arrive at market valuation. Market value would be equal to net book value if the return on capital employed is equal to the cost of capital and, thus, generating no additional economic values. In such a situation, market- to-book value would be one. However, if return on capital employed is earning more than risk-adjusted cost of capital, the firm would generate surplus and in the process add economic values. In that case, market value would be equal to present book value plus the present value of future surplus earnings that is EVA, and addition to market value (MVA) would be equal to present value of all future EVA. In other words, maximizing the present value of EVA also amounts to maximizing the market value of the firm. Thus, the market value created could be compared with cumulative economic value added. In theory, the following relationship would hold:

MVA = Present value of all future EVA

MVA = MVt - (MV0 + any funds raised through new issue during the period)

In other words, MVA is any change in market value minus new capital issued over the observation period. Thus,

Market Value = (MV0 + new issued capital) plus present value of all future EVA

Exhibits 1 and 2 present EVA as calculated by HLL and selected financial data for including market capitalization for the yea s 1993-2002. MVA can be calculated as the difference

between the current market value of the company and the market capitalization at the

beginning of the observation period.

One would notice that in recent years, HLL's market performance does not seem to support the above theory. In two of the last three years, market capitalization has fallen in spite of a rise in EVA. The first was during 2000 when the company's market capitalization fell by 8.3 per cent. After an 8 4 per cent gain in 2001, market capitalization fared very badly during 2002 with the figure crashing by a massive 18.7 per cent. This actually amounts to a loss of Rs. 9,223 crore over a one-year period. Market analysts attribute this to the fact that the market in India still judges the worth and performance of a company by net profit, rather than by concepts like EVA which are known but not easily understood.

Assignment Question:

1. How do you measure financial performance? How has financially HLL performed? What does the stock price performance tell you?

2. Show how the economic value added measure is calculated by HLL. How does it differ from the residual operating income measure?

3. In recent years, HLL has had considerable growth in EVA, but growth in market

capitalization has not been so good. What could be the reasons? Is EVA any good for financial analysts in valuing companies?

4. Calculate HLL's market price-to-book ratio. Do you think that the growth in EVA justifies the multiple?

I want,

a) Introduction

b) Facts

c) Analysis

d) Solution (Provide answer of these four questions)

e) Recommendation

f) Conclusion

Exhibit 1 Hindustan Lever Limited (Extracts from Hindustan Lever Report, 2002 p. F33) EVA in practice at Hindustan Lever Ltd. In Hindustan Lever, the goal of sustainable long-term value creation for our shareholders is well understood by all the business groups. Measures to evaluate business performance and to set targets take into account this concept of value creation. EVA Trends: 1993-2003 ( Unaudited) (Rs. Crores) 2002 2001 2000 1999 1998 1 1997 1996 1995 1994 1993 Cost of Capital Employed (COCE) 1. Average Debt 45 50 93 162 165 160 156 110 135 2. Average Equity 3351 2766 2296 1908 1487 1127 815 588 482 350 3. Average Capital 3306 2816 2389 2070 1652 1287 971 898 559 414 Employed 4. Cost of Debt, post-tax 6.45 7.72 8.46 8.61 9.10 8.82 7 88 7.56 7.36 6.76 % 5. Cost of Equity 14.4 187 10.7 10.7 10.7 19.7 197 10.7 10.7 18.7 6. Weighed Average 14.3 16.54 19.27 18.83 18.64 18.34 17.8 17.79 17.57 16.17 Cost of Capital 7. COCE: (3)'(6) 486 480 320 308 238 173 124 98 80 Economic Value Added (EVA] B. Profit after tax, before 1716 1541 1310 1070 837 580 413 239 190 127 exceptional items 0. Add: Interest, after 5 B 19 21 32 11 15 13 taxes 10.Net Operating Profits 1722 1546 1318 1084 856 801 445 250 205 140 After Taxes (NOPAT) 11.COCE, as per (7) (486) (466) (4 0) (380) (380) (236) (173) (124) (28)( above 12.EVA: (10)-(11) 1236 1080 858 824 548 385 272 126 107 80 (Please note: 1 crore=10 million that is one crore converted in millions would be equal to 10)Exhibit 2 HLL's Selected Financial Data for the years 1993- 2002 Rs Crores 2002 2001 2000 1999 1998 1997 1996 1995 1994 199 Profit and Loss Account Sales 10952 11781 11302 10918 10215 8343 7120 3775 324 2436 Other income 385 382 345 319 245 184 118 67 56 30 Interest (8) (8) (13) (22) (29) (34) (57) (20) (30) (27) Profit before tax 2197 1943 1865 1388 1130 850 605 372 303 223 Profit after tax3 1716 1541 1310 1070 837 580 413 239 190 127 EPS of Re. 14 7.98 7.46 5.95 4.86 3.67 2.81 2108 1.84 1.30 0.91 DPS of Re. 14 5.50 5.00 3.50 2.90 2.20 1.70 1.25 1.00 0.80 0.56 Balance Sheet Fixed Assets 1322 1320 1203 1087 1054 794 722 395 320 254 Investments 2365 1636 1770 1006 698 5 2 329 123 191 51 Net Current Assets -240 -75 -373 187 226 122 378 458 342 196 Net Deferred tax 270 248 0 0 0 Total 3717 3127 2800 2280 1978 1448 1429 76 501 Share Capital: 220 220 220 220 220 109 199 146 147 140 Reserve & Surplus 3439 2823 2268 1883 1494 1062 870 870 560 246 Loan Funds 58 BA 112 177 284 187 280 180 146 115 Total 3717 3127 2600 2280 1078 1448 1429 862 501 HLL Share Price 181 75 223.65 206.35 6 186.35 138.35 80.7 62.4 50 57.5 Market 40008 49231 45409 40513 36525 27555 16073 9100 8604 8049 Capitalization (Rs. Crore) Return on Capital 59.40 62.40 64.55 61.84 58.65 61.06 52.91 49.14 48.52 40.91 Employed % Retum on Net 48.00 53.93 52.65 50.87 48.89 46.00 41.62 37.48 35.29 33.0 Worth % Source: Hindustan leve Report 2002 and CMIE database.DPS of Re. 14 5.50 5.00 3.50 2.90 2.20 1.70 1.25 1.00 0.80 0.56 Balance Sheet Fixed Assets 1322 1320 1203 1087 1054 794 722 395 320 254 Investments 2385 1636 1770 1006 698 5 2 329 123 191 51 Net Current Assets -240 -75 -373 187 226 122 378 458 342 196 Net Deferred tax 270 246 Total 3717 3127 2800 2280 1978 1448 1429 976 862 501 Share CapitalS 220 220 220 220 220 199 146 147 140 Reserve & Surplus 3439 2823 2268 1883 1494 1062 970 670 560 246 Loan Funds 58 84 112 177 264 187 280 180 146 115 Total 3717 3127 2600 2280 1978 1448 1429 976 862 501 HLL Share Price 181 75 223.65 206.35 225 186.35 138.35 80.7 62.4 50 57.5 Market 40008 40231 45409 40513 36525 27555 18073 9100 8604 8049 Capitalization (Rs. Crore) Return on Capital 59.40 62.40 64.55 61.84 58.65 61.06 52.91 49.14 48.52 40.91 Employed % Retum on Net 48.00 53.93 52.65 50.87 48.89 46.00 41.62 37.48 35.29 33.0 Worth % Source: Hindustan leve Report 2002 and CMIE database. Other income mainly consists of income earned from investments including dividend and interest. "Includes Exception I items; in 2001 Rs. 100.36 net of tax were earned on transfer of Trademark and sale of Quest Flavors and Fragrance business. 'Statutory corp rate tax rates in India: base rate varied between 35 to 45 per cent, with added surcharge varying from 2 to 8 per cent. For past few years, the corporate tax (including surcharge) were: 2002 2001 2000 1099 1998 | 1907 1996 1995 35% 35.7% |39.55% 35% 35% 43% 46% |46% -Adjusted for Bonus There has been no new issue during the period (1092-2001). Any increase in paid up capital is due to bonus amount capitalized from reserves and surplus. Based on year-end closing prices quoted in the BSE, adjusted for bonus.Exhibit 3 HLL's Equity Returns and Prices CAGR (1993-02) 2002 2001 2000 1999 1998 1997 1996 1995 1994 1993 Stock Price Dec. 31 14% 181.75 223.65 206.35 225 168.35 1 8.35 80.7 82.4 59.0 57.5 2 Earnings Per Share 27% 7.98 7.46 5.95 4.88 3.67 2.81 2.08 1.64 1.30 0.91 3 Dividend Per share 29% 5.50 5.00 3.50 2.90 2.20 1.70 1.25 1.00 0.80 0.56 4 Capital Appreciation -18.3% 10.8% -6.79% 37.0% 2.8% 73.5% 31% 7.5% 4.0% 5 Unit Link Series 3.68 4.30 3.96 4.25 3.10 2.55 1.47 1.12 1.04 1.0 6 Cumulative Compound 15.6% 20.3% 21.7% 27.3 25.4% 26.3% 149% 5.7% 0.04 Average Return 7 Sensex 0.1% 3377 3262 3972 5006 3055 3850 3085 3110 3827 3346 % Change over last year 3.5% -17.9% -20.6% 63.8% -16.5% 18.6% -0.8% -20.8% 17.4 Unit Link Series 1.01 0.97 1 19 1.50 0.91 1.09 0.92 0.93 1-17 1.00 10 CAGR (Moving) 0.1% -0.3% 2.5% 6.9% -1.8% 2.3% -2.7% -3.6% 17% 11 Sensex FMCG Index 820 928 1037 12 % Change over last year -11.6% -10.5% 12 HLL P/E 22.8 30.0 34.7 46.3 45.3 49.2 38.8 38.0 45.4 63.1 13 Sensex P/E 12.6 14.3 18.3 27.5 13.6 17.8 13.6 15.7 28.5 41.1Exhibit 4 HLL's MVA and Cumulative EVA CAGR 2002 2001 2000 1999 1998 1997 1996 1995 1994 1993 (1993-02) 1 Book Value of Equity 28% 3650 3043 2488 2103 1714 1261 1169 816 716 386 2 Book Value of Debt -79% 58 84 112 177 264 187 260 160 146 115 Total Assets 25% 3717 3127 2600 2280 1978 1448 1429 976 862 501 4 MV of Equity 209% 40008 40231 45409 49513 36525 27555 16073 9100 8604 8049 5 MV of Debt -7% 58 84 112 177 264 187 260 160 146 115 6 Total Market Value 19% 40066 40315 45521 406 0 36789 27742 16333 9280 8750 8164 7 MVA (=MV - BV) 19% 36349 46188 42021 47410 34811 26204 14904 8284 7888 7863 8 Change in MVA over last year -9830 3267 -4489 12509 8517 11390 8820 396 225 7863 9 EVA 40% 1236 1080 858 804 548 365 272 126 107 60 10 % increase in EVA over last year 14% 26% 24% 27% 50% 34% 116% 18% 78% 11 Change in MVA/EVA -7.96 3.0 -5.23 18.15 15.54 31.20 24.33 3.14 210 127.72 12 Cumulative EVA 5346 4 10 3030 2172 1478 930 565 293 187 80 13 MVA/ cumulative EVA 8.80 11 24 14.17 21.83 23.55 28.27 26.38 28.27 47.23 127.72 14 MV/BV of Equity 10.9 18.2 18.3 23.6 21.5 22 0 14.0 11.3 12.2 21.2 15 EVA as % of BV 33% 35% 33% 30% 28% 25% 19% 13% 12% 129% Source: Case writer analysis