Royalty payments: Too early to take your eyes off

MNCs’ payments to parent companies are legitimate, but the brand and/or know-how needs to translate into commensurate growth in sales or result in higher margins than peers. Although data for the last two years shows a comforting linkage between royalty paid and financial numbers, there are still companies where it is not so and where shareholders need to engage. This and definitional issues suggest that investors still need to remain focussed on royalty.

Multi-national corporations (MNCs) based in India are charged royalty by their parent companies since these MNCs benefit from the usage of global brand and / or product technology. Of the 31 MNCs[1] covered in this study the royalty paid aggregated to Rs. 82.8 bn in 2019 (see Annexure A): more than double the amount of Rs. 38.6 bn paid in 2012 (CAGR of 11.5%). During this period sales grew by 9.1% and profits by 11.3% on a CAGR basis, indicating that royalty is broadly in sync with the top-line and bottom line.

[1] MNCs (more than 25% foreign shareholding, and where the foreign parent is in control) forming part of the S&P BSE 500 index, having aggregate royalty payments in excess of Rs.60 mn, and having paid royalty in at least three of the last five years.

Royalty payments have been remained in check

MNCs have taken note of increasing investor scrutiny on royalty and become cautious. The gap between growth in pre-royalty pre-tax profits (PR-PBT) to that of royalty reduced over both the 2017 and 2018 periods, with 2019 demonstrating only a marginally higher increase in royalty as compared to PR-PBT.

While investors take comfort that sales growth and margins sit well with aggregate royalty paid….

IiAS believes that MNCs’ payments to parent companies are legitimate, but the brand and/or know-how needs to translate into commensurate growth in sales and result in higher margins.

As these are now broadly in step, royalty payments in the aggregate are not a major area of concern for investors. This does not however give investors the luxury to take their eyes of such royalty payments. Even as growth in royalty in aggregate have toned down although certain pockets still need scrutiny.

….company level data still shows that investors need to continuously engage with companies on these pay-outs

Three areas deserve attention. These are companies where royalty growth has outpaced PBT, companies that have seen growth in royalty payments exceed 20% over the past year and the five highest royalty paying companies.

Companies where royalty growth has outpaced PBT over the last five years are shown in Exhibit 3. Five years is a long-enough period for the numbers to align. That they have not means either the brand does not have sufficient pull or pricing power or that there is not enough of a cost advantage that the parent brings.

Companies need to explain themselves better regarding what they a getting for the royalty that they pay, or rationalize such pay-outs. Investors too need to constantly scrutinize these companies regarding royalty payments to ensure that the quantum of such outflows do not grow exponentially and that payments have a legitimate basis. Exhibit 4 lists companies that have seen growth in royalty payments exceed 20% over the past year.

The one other pocket that deserves investors focus are the ‘big five.’ Just five companies (Exhibit 5) - Maruti Suzuki India Limited (MSIL), Hindustan Unilever Limited (HUL), ABB Limited (ABB), Nestlé India Limited (Nestlé), and Bosch Limited (Bosch) – have accounted for over 70% of the royalty payments over the past five years. Their 2019 share of royalty (at ~77% of the aggregate of the 31 MNCs) is higher than their share of profits: these five companies accounted for 65% of the 31 MNCs’ aggregate pre-royalty pre-tax profits.

Will royalty take precedence over profit distribution?

One other area deserves attention.

Having large cash balances has increased investors’ fear that payments to the parent company will increase (Exhibit 6).

Of the list of 31 MNCs assessed in this report, nine companies appeared in IiAS’ study of companies that can pay more dividends: based on that study, these nine MNCs can pay upto Rs. 68 bn in incremental dividends. Investors need to engage with these companies to pay more as dividends.

Investors remain supportive

As long as there is a clear rationale and adequate disclosures for royalty payments, investors are supportive of them (see Annexure C). The investor vote is a message to companies that investors view royalty as a legitimate expense. Companies need to respect this trust.

Companies must therefore provide more robust disclosures and resolve investor concerns around royalty. In its 2019 AGM, Nestle India Limited initially sought approval for royalty payment in perpetuity. However, after investors and IiAS expressed their reservations, the company changed the initial validity to a five-year period, after which Nestlé will seek shareholder approval again. The resolution was subsequently approved with an overwhelming majority.

How should regulations change?

SEBI’s decision requiring shareholder approval for royalty payments was a much-needed step forward. Earlier, royalty payments were clubbed within the related party transaction regulations and did not require any specific shareholder approval on their own, as they were seen as being in the normal course of business. Notwithstanding, the threshold of 5% of consolidated turnover prescribed, is high – only two companies, ABB India Limited and 3M India Limited breached this threshold in FY19.

There is, in addition, a need to further strengthen the provisions with regards to coverage of royalty.

Cash outflows to parent companies take many forms, other than royalty or brand payments. These are usually termed as ‘Management fees paid’, ’Technology License fees’, ‘Charges for SAP/R3 and connectivity’, ‘Expenditure on information technology, engineering, management and other services.’ Such payments can be large and do not fall within the ambit of royalty.

Currently, shareholder approval for royalty is required if payment to a single entity exceeds the 5% threshold. Companies can get away with paying less than 5% to more than one entity without requiring shareholder approval.

In 2019, ABB India Limited paid around Rs. 4.6 bn as royalty, technology and trade-mark fees to multiple related parties. However, since this payment is split across three entities and only payments to one entity exceeded the erstwhile regulatory threshold of 2%, the company sought shareholder approval for payment to only one entity. Further, it also paid another Rs. 4.3 bn as information technology, engineering, management and other services to promoter entities. Thus, IiAS calculates cumulative payment by ABB to its parent aggregates to ~8.2% of sales, as against the reported number of ~4.2%. SEBI must consider amending the threshold to cover the overall money flowing to the parent company and subsidiaries.

We expect SEBI to have a more encompassing definition of payments to parent companies – one which includes the different forms of outflow to the parent company, including royalty. While it may be argued that these get covered under related party transaction regulations, the quantum of such outflows, while being meaningful (about 8% in FY19 for the 31 MNCs covered in this report), rarely exceed the current 10% threshold prescribed under Regulation 23 of SEBI LODR. Perhaps, this issue will be addressed if the recommendations of the recent ‘Report of the Working Group on Related Party Transactions’ become mandatory: this paper requires prior shareholder approval if related party transactions exceed Rs. 10 bn or lower, of 5% of the consolidated revenue, assets or net worth.

A strong brand or better technology should result in revenue and / or profitability that is higher than competing peers. Accordingly, there is a need to align royalty with both sales and profitability. As a practice, royalty is pegged to sales: IiAS recommends that royalty must be linked to profits as well. Several companies have paid royalty that aggregates over 25% of pre-tax pre-royalty profits, which is high. There have also been instances where royalty has increased despite lower profits. On the other hand, in 2019, Castrol India Limited linked its royalty payment to 3.5% of annual turnover, subject to a cap of 10% of profit before tax: a good practice.

IiAS continues believes that royalty is a legitimate expense and the parent company needs to be compensated for the development of the brand and technical know-how. However, such payments should be pegged at a justified level and should be accompanied with adequate disclosures on the terms of the contract, quantum and more importantly the basis for the royalty payment. Further, there must be a strong link between royalty and profitability. Considering the increased investor debate on royalty payments, we continue to ask these companies to explain the rationale for such payments. We expect this transparency will boost investor confidence. And it will help shareholders in taking a well-informed decision when they cast their vote.

To read full report click Here