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Institutional EYE

Commentary on Corporate Governance Issues

Royalty payments outpace performance

Royalty payments by multinational companies (MNCs) in India remains an element of concern. In FY16, aggregate royalty payments of 32 MNCs in the BSE 500 aggregated Rs.71bn, up from Rs.63bn in FY15. The trend of increasing royalty payouts without commensurate improvement in revenues and profits continues. In FY16, the royalty paid out aggregated ~21% of the MNCs’ pre-royalty pre-tax profits, reporting a 13.2% 5-year CAGR. In contrast, pre-royalty pre-tax profits have grown at a CAGR of 9.6% and net sales have grown by 8.7%. IiAS believes that companies must provide greater clarity regarding the basis on which royalty is paid-out, given that it has outpaced both sales and profits in the past five years.

Although the growth rate of royalty payouts has marginally abated in FY16 (royalty payments grew by 13% in FY16 against a 17% growth in aggregate pre-royalty pre-tax profits for 32 MNCs ), its five-year CAGR is significantly higher than that of profits and revenues. Over the past five years, royalty payouts have increased at a CAGR of 13.2% vis-à-vis a 9.6% growth in pre-royalty pre-tax profits and 8,7% growth in revenues for the same period.

Chart 1: Growth in royalty payments has outpaced sales and profits growth for the 32 MNCs

Five of these 32 MNCs have accounted for over 70% of the royalty payments over the past four years: Maruti Suzuki India Limited (MSIL), Hindustan Unilever Limited (HUL), ABB Limited (ABB), Nestlé India Limited (Nestlé), and Bosch Limited (Bosch). These five companies paid royalty of Rs. 55.4 bn in FY16 – which is 78% of the total Rs.71bn paid by the 32 MNCs. Their share of royalty (at 78% of aggregate) is higher than their share of profits: these five companies accounted for 61.6% of the aggregate pre-royalty pre-tax profits. This is because ABB paid out 52% of its pre-royalty pre-tax profits as royalty, which was 6.3% of its FY16 net sales.

Chart 2: Aggregate royalty spends for the top 5 royalty paying companies - MSIL, HUL, ABB, Nestlé and Bosch in the past 4 years

Performance Royalty is a legitimate payment, but its value must be evidenced in sales growth or higher pricing power (and therefore higher margins). Revenue growth for MNCs has been higher than that of S&P BSE 200 companies over the past five years and at margins that are comparable as well. However, royalty payouts are high, resulting in average post-royalty margins being lower by over 7% in recent times as compared to pre-royalty pre-tax margins.

Conclusion IiAS believes the parent company needs to be compensated for brand and technical know-how. However, such payments need to be pegged at an appropriate level. While the brands that these MNCs bring carry value – faster revenues at comparable margins to other S&P BSE 200 companies – the question remains on what is the appropriate level of royalty. An over 7% lowering of margins driven by royalty alone is significant, and deprives investors of the EPS upside of investing in a stronger business or brand proposition. Boards need to be thoughtful while approving royalty agreements. They have a commitment to the local entity and its shareholders to be responsible.

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