Valuing royalty PDF Print E-mail
Friday, 23 October 2015 03:54
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Shareholders also gained in high-royalty firms


Given that shareholders always want more, it is not surprising that Institutional Investor Advisory Services (IIAS) has put out a catchily-titled note—Royalty flows in Suzuki’s blood—arguing that Suzuki Motor Corporation of Japan is charging its Indian subsidiary Maruti Suzuki India Limited too much royalty. Over the past 15 years, IIAS says, royalty paid per car has grown 6.6 times while average sales realisation per car has risen only 1.6 times. In the last 5 years, IIAS says, Maruti’s profit before tax was Rs 16,770 crore while its royalty payment was Rs 11,870 crore—in FY15 alone, royalty expenses added up to a whopping 36% of Maruti’s profit before tax and royalty. Combine this with the fact that Maruti alone accounts for 40% of Suzuki’s profits, and it does seem like a royal rip-off.

One of the reasons for this given by Maruti’s management is that, with the royalties negotiated in yen, the rupee depreciation has added to the burden. Between FY09 and FY15, for instance, Maruti’s royalty-to-sales have risen from 3.3% to around 5.9%, or an increase of 1.7 times—the fact that the rupee depreciated by 1.2 times during this period is therefore a big factor in the increase in royalties. Which is why, Maruti has now negotiated a new agreement whereby, for new models produced after FY18, royalties will be paid in rupees—that, in a sense, is a tacit acknowledgment of the fact that IIAS has a point. While it is likely Suzuki will hike the royalty rates to take into account the exchange rate risk, the real issue is whether Suzuki, or other MNCs for that matter, is over-charging on royalty. IIAS argues that while Suzuki’s consolidated R&D spending is around 4% of sales—this includes motorcycles—it is charging Maruti royalty at around 6% of sales.

This is where the arguments being made are a bit one-sided. For one, given that motorcycles have lower R&D, it is very possible Suzuki’s passenger car R&D is around 5-6% of sales, a number not too different from the royalty Maruti is paying—indeed, that is also the R&D spending for most auto majors globally. There should, in any case, be no doubt that Maruti would not be the market leader had it not been for the technology Suzuki is supplying it—that is why, Maruti’s PAT margin has risen from 6% in FY09 to 7.6% in FY15, and that is after all royalty payments. Indeed, if Suzuki was ripping off Maruti to the extent being suggested, it is a bit odd that institutional shareholders, both foreign as well as domestic ones, have hiked their stake in Maruti from 23.9% in March 2010 to 30.1% in September 2015, or that Maruti’s share price has more than trebled in this period. Indeed, as our lead story argues today, while royalty payments by top MNC-subsidiary stocks have gone up by 15% (ABB) per annum to 34% (HUL) in the last six years, the stocks have appreciated by anywhere between 20% (ABB) per year to 44% (Glaxo). Which is why, in most cases, these firms are trading much higher earnings multiples than their local counterparts—though not strictly comparable since they are in different segments of the automobile market, Maruti’s trailing PE multiple is 35 as compared to 23 and 9 for M&M and Tata Motors, respectively.


Devangi's story

Despite the hue and cry over royalty payments by Indian subsidiaries of multinational companies, these companies have rewarded shareholders handsomely with not just large capital appreciation but also generous dividends. While stocks such as Hindustan Unilever (HUL) and Maruti Suzuki have outperformed the markets by a wide margin in the last couple of years, the stocks have sustained the performance even over longer periods. In the six years to March 2015, for instance, the quantum of royalty they paid increased by 15% to 34%. But top MNC subsidiary stocks have appreciated by anywhere between 20% and 46% compounded.


The pace of outflows on account of royalty slowed last year — aggregate royalty-linked expenses of the top 15 India-listed subsidiaries of MNCs increased by 11.3% to RS 4,754 crore compared with a growth of 12.8% reported in the previous year. While for most companies the cost paid to the parent firms for sharing technology, know-how, processes and brand or trade names went up anywhere between 7% and 20% in 2014-15, HUL reported the highest growth of 38% in such expenses to RS 751 crore or 2.3% of net sales.

Maruti Suzuki, for instance, raised royalty payments to its parent during the quarter ended June 2010, and its stock value fell partly also because the company failed to meet earnings estimates. However, since then the stock has not just hit multiple new highs, it has more than trebled in value. And institutional investors have upped their take in the carmaker by about 6% from 23.9% to 30.1% between March 2010 and September 2015. The stock continues to trade at a steeper valuation premium to listed competitors like Mahindra and Mahindra and Tata Motors, commanding trailing PE multiple of 35 times as against 23 and 9 for M&M and Tata Motors, respectively.


Since FY09, Maruti’s royalty-to-sales have risen from 3.3% to around 5.9%, or an increase of 1.7 times — but during this period, its top line has nearly doubled. Much of the hike, Maruti’s management has clarified, is due to the sharp fluctuation in the value of yen, the currency in which the royalties are denominated.

During the same period, the yen moved from 46 paise to 56 paise, or a change of 1.2 times. Which is why, in September last year, Maruti announced it would pay royalty in rupees from FY18 onwards for all new models made at the Gujarat plant.

In 2013, ahead of the new Companies Act coming into effect, MNC subsidiaries announced hikes in their royalties, irking proxy advisory firms who claimed it was unfair to minority shareholders since it might impact dividend payouts. HUL, for instance, said it would, over five years between February 2013 and March 2018, raise royalty payments to its parent, the Anglo-Dutch Unilever Group, from 1.4% to 3.15%. The Street promptly dumped the stock, which lost more than 7% of its value in a single session. However, any shareholder who sold the stock believing the higher royalty outflows would hurt dividends would have lost a small fortune. Soon thereafter in April, Unilever announced a buyback to up its stake in HUL to 75%, infusing $5.4 billion, sending the stock soaring 25% in a single session. Against a 34% compounded annual growth rate (CAGR) in royalty payments for the six years since FY09, the HUL stock has gained a compounded 24%.

Royalty and technical fees rose fairly sharply in FY10-11 after the government removed the cap of 5% of domestic sales and 8% on exports in April 2010 with retrospective effect from December 2009. Now, taxes on such payments are set to fall from FY16. So far royalty and technical know-how fees have attracted an income tax of 25% but that will now come down to 10%. However, there are some MNC subsidiaries that may not be materially impacted since the countries that their parent entities are located in have double taxation avoidance agreements with India.

As SP Singh, senior director, Deloitte India, says, the government is generally wary of substantial outflows that can take place through royalty and technical fees even though it wants the finest manufacturing capabilities to come to India. The tax authorities remain watchful MNC subsidiaries don’t resort to royalty payments as a way to avoid dividend distribution tax, given there is a differential in the rates.

For instance, the Union Budget has fixed basic tax rates for royalty at 10% and that for dividend distribution at 17.7%. After the grossing up, effective DDT rate turns out to be more than 20% whereas the highest royalty tax rate for a domestic company with more than Rs 10 crore of revenue will be around 11.5%.

Singh believes it is difficult to assess to what extent the technology or processes covered under the royalty agreement contribute to growth of the Indian business qualitatively or quantitatively. “There are no set guidelines for royalty, which is what leads to disputes,” he said.

Analysts argue that since it hard to fully gauge how much the technology and processes for which royalty is paid boost revenues and profits, the performance of the MNC subsidiary must be assessed relative to the peer group. They point out, for example, that competitors Dabur and Emami have returned 32% and 57% compounded between FY06-FY15.

It’s surprising these analysts don’t seem to consider the fact that these firms are way smaller than HUL with revenues that are one-fourth and one-tenth of HUL and come with attendant risks, such as being relatively illiquid. Emami, for instance, is a relatively illiquid stock with daily average volumes of 22,414 shares compared with 1.31 lakh shares for HUL in the last one year. Also, while the dividend outgo of Dabur and Emami rose by 15% and 29% compounded, respectively, in the last six fiscals, HUL’s dividend payout ratio — dividend distributed to net profit — of more than 80% is way higher than that of 50% and 35% for Dabur and Emami, respectively.




Last Updated ( Friday, 23 October 2015 04:50 )

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