Wednesday, July 28, 2010

>Analysis of royalty payments in view of Maruti’s margin surprise

Meaningful overhang on margins and valuations for foreign equity companies

Maruti delivered a big negative surprise this weekend as Suzuki raised royalty payments by 150 bps from 3.6% to 5.1%. While the impact on Maruti is already discounted (stock down 10% today), we have looked at the other companies in BSE-500 to ascertain the impact on broader Indian market. We find that that 75 (32 of them to foreign entities) companies in BSE500 pay
royalties largely dominated by automotive, capital goods, pharmaceuticals and FMCG sectors.

With the recent government regulation allowing for higher royalties, we could see the Maruti case being played out in several of these players. While the exact impact is difficult to quantify (as it will be case specific), we note that increasein royalties could hurt margins substantially by 370 bps if implemented across the board. We would closely watch out for more such announcements/changes over the next few months.

Govt. allows companies to pay royalty under automatic route: The Govt. recently allowed companies to remit royalty payments (upto 8% on exports, and 5% on domestic sales) on foreign technology collaboration under the automatic route (With retrospective effect from Dec 2009, notes attached). Companies have since raised royalty payments to foreign collaborators: Maruti raised royalty payments to parent Suzuki Motor Corp by 150bps to 5.1% of sales this quarter.

15% of the BSE500 pays royalties, 32/500 to foreign equity holders: Royalty payments are made by 75 companies in the BSE500 universe, and comprised~19% of the overall SG&A costs in FY09, accounting for ~130bps on EBITDA margins. The new notification affects companies (32/500) that have technical collaborations with foreign (non-portfolio) equity-holders, and thus excludes domestic companies that have no restrictions on royalty payments. Whollyowned
foreign subsidiaries have no restrictions either.

Sector/stock focus: Royalty payments are generally made by companies in the auto and capital goods (technical know-how and collaboration), pharma (marketing rights) and FMCG companies (brand equity). Margin Impact: Royalties for these 32 cos. constituted 11% of their SG&A, accounting for 100bps at the EBITDA margin level (FY09 margin at 16%; FY10 figures available for 8 companies thus far). A quick sensitivity analysis shows that a rise in payments to a blended 5% of sales would hurt margins by a further 390bps, i.e. margins would fall to 11.8%.

Royalty payments vs. dividends: Royalties paid amounted to more than 40% of the total dividends declared in FY09. With little information on the actual value of the technical expertise, or by way of equity of certain brands, a potential rise in payments could raise questions on fair distribution of earnings to common stockholders.

To read the full report: INDIA STRATEGY