Godrej Soaps: Invest

Recommendation: Invest

Essentially, a demerger of the consumer products business was a necessity to protect the cash cow. Only, it has taken the management of Godrej Soaps quite a while to realise its inevitability, says Suresh Krishnamurthy.

``I think Godrej Soaps' current valuation is absurdly low. Its price-to-earnings ratio is about 3.7, while for most fast-moving consumer goods companies, the P/E ratios are around 20. The idea is that once we restructure, there will be a much better case for getting a full valuation. We expect to be able to fully implement a strategy of making Godrej Soaps a focussed consumer products company during this financial year.'' -- Mr. Adi Godrej, chairman, Godrej Soaps, in an interview to Reuters on May 15.

TRUE to this statement, the Godrej Soaps chairman has unveiled a restructuring plan involving the demerger of the consumer products business into a separate company. The restructuring, as outlined, suggests there may be a case for better valuation for the company.

The details of the restructuring of the consumer products business are:

The new entity to have a similar shareholding pattern as that of the existing company;

The new entity to be debt-free;

Consumer brands owned by Godrej Soaps and Godrej and Boyce to be transferred to the new entity;

The new entity not to have investments currently held in subsidiaries by Godrej Soaps.

The only grey area in this scheme of things is the valuation to be accorded to the brands owned by Godrej and Boyce and how the consideration is to be paid. Since the company has said that the existing shareholding pattern would not be altered, it is more likely to involve payment of cash to Godrej and Boyce. The structuring of the deal and the level of transparency would have a bearing on the valuation of the stock. Overall, the restructuring, according to the management, appears designed to unlock value for the shareholders.

The rationale

Competition in the fast moving consumer goods has been intensifying the last few years. This has necessitated increased investments in the entire spectrum of operations -- from manufacturing to distribution and in the brands. Thus cash flows from the consumer products business had to be ploughed back and not diverted to other operations.

The consumer products business needed undivided focus and could not be clubbed with other businesses. Recognising the need to see the consumer products business holistically, Godrej Soaps took over from January 1999 the distribution of the consumer products business from the associate company, Godrej Hicare. This had an immediate positive impact on the profitability of the consumer products operations. According to the information disclosed at an analyst meet by the management, the return on capital employed of the consumer products business, which was 12 per cent in 1998-99, improved to 38 per cent in 1999-2000.

However, the measure taken in 1999 would not alone have been enough by itself. The other businesses of Godrej Soaps were doing poorly. For example, according to the management, the chemicals business had a return on capital employed of 4 per cent in 1999-2000. Given this backdrop, it was inevitable that the other businesses would have cannibalised into the cash flows of the consumer products business, affecting the ability of the consumer products business, to compete. Essentially, a demerger of the consumer products business, was a necessity if the cash cow was to be protected. Only, it has taken the management of Godrej Soaps quite a while to realise its inevitability.

Going the right way

However, the positive aspect is the way the management is going about the restructuring -- giving the existing shareholders a stake in the demerged entity, making the demerged entity a debt-free company, transferring the brands to the demerged entity and making it a focussed consumer products company. These, and the consistent track record in terms of corporate governance, can go a long way in improving the valuation of the consumer products company. It is essential that the words are followed up with deeds. The management has set itself a considerably long time-frame, of six months, to finalise the modalities of the demerger and ensure that the details are finalised.

Eyeball on valuation

In the year-ended March 2000, the branded consumer products business recorded a turnover of Rs. 324.44 crores, and contract manufacturing a turnover of Rs. 58.04 crores. According to the management, the consumer products business had an operating profit margin of 16.8 per cent in 1999-2000, which means the operating profits were Rs. 64 crores.

Since the consumer products business is going to be debt-free, the other charges against the operating profits would be depreciation and taxes. Even if the entire depreciation of Rs. 23 crores Godrej Soaps charged in 1999-2000 is charged against these profits and a taxation rate of 40 per cent is assumed, the post-tax profits would be around Rs. 24 crores.

If a price-to-earnings multiple of around 10 times is assumed, the market capitalisation of the consumer products business would be around Rs. 240 crores. The present market capitalisation of Godrej Soaps is itself around Rs. 240 crores. If an investor assumes that the value of all the other businesses put together is nil, the scope for further rise in value for an investment would be pegged to the expected growth rate in the consumer products business.

However, consider the other businesses. The major component is the chemicals business, which reported a turnover of Rs. 290.74 crores, an operating profit margin of 8 per cent and a return on capital employed of 4 per cent in 1999-2000. This is unlikely to enthuse the stock market. This is not all. Godrej Soaps is shedding a major portion of its existing stake in Godrej Sara Lee and expects to garner Rs. 150 crores. This would go to reduce debt and improve the returns from the business.

Also, Godrej Soaps has a portfolio of investments in subsidiaries and associate companies. At least, one of the businesses, Godrej Pillsbury, is doing well, enhancing the prospects for a return from these investments. Godrej Soaps would also receive non-compete fees of around Rs. 6 crores for the period-ended March 2001. The other businesses of Godrej Soaps would also command certain value and there appears to be scope for improved valuation from an investment in Godrej Soaps at the present levels.

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Position of shareholders

But should an investor hold on to the exposures with a medium-term perspective? The reason behind holding on to an investment now is more because the demerger is likely to unlock value than of its being one of the best-run businesses. Therefore, once the demerger improves the valuation, investors should try to reduce their exposure in the stock.

At the outset, the other businesses of Godrej Soaps do not appear to hold the potential to deliver returns commensurate with the risks involved in the business. This implies that as soon as the record date for the demerger is over, investors should sell their holdings in Godrej Soaps. In the case of the demerged entity, which would hold the consumer products business, it may be better to hold on for a few quarters to allow the demerger to get reflected in the financial performance. Any decision on the exposure can be evaluated then.

The risk of an investment in Godrej Soaps in anticipation of improved valuation due to the demerger is fairly high. In this backdrop, less adventurous investors can await further developments before taking exposure. Risk-averse investors can avoid the opportunity altogether.