20 Oct 2015 20:09 IST

Why you should make note of royalty payments

Often, companies that pay dividends alongside royalty are more benevolent towards promoters

‘Maruti Suzuki’ or ‘Nestle’ may be household names in India today, but their parent companies are foreign. Similarly, many other players across industries such as automobiles, engineering, consumer durables and fast-moving consumer goods (FMCG) have foreign companies as promoter-shareholders.

For instance, foreign promoter Unilever holds 67.21 per cent stake in Hindustan Unilever, maker of your favourite Kissan Jam, Knorr Soup, Dove Shampoo or Surf Excel. Similarly, the Switzerland-based promoters of electrical equipment maker ABB India, hold 75 per cent in the Indian arm. The Indian arms typically pay royalty to these foreign promoters for use of the brand name, trademark, and technological know-how.

If you pull out the annual reports of such companies from their websites, royalty payments in most cases will appear as an item of expense in the Profit and Loss account. Often, it may not even be shown as a separate item of expense, but just as part of ‘other expenses’.

In such cases, royalty payment details can be seen in the break-up of ‘other expenses’ given in the notes to the financial statements. Sometimes, companies also pay a lump-sum royalty for certain know-how and amortise it over a few years. Whatever be it, while it may seem as just another payment that a company may make, here are three reasons to sit up and take note of royalty outgo.

Linked to sales, not profits

The first reason why royalty matters is that it is predominantly calculated as a percentage of sales, and not as a percentage of profits. This practice de-links royalty payments from the performance of companies. For one, it implies that the promoters will be paid royalty even if the company faces a fall in profits or, worse, makes losses.

Second, companies can enter into agreements that increase the royalty in phases over several years into the future. Hindustan Unilever is a good example. The company faced a lot of flak about two years ago, when it entered into a new royalty agreement with its promoter.

According to this, the royalty cost was expected to move up from 1.4 per cent of the turnover at the time of announcement to 3.15 per cent of the turnover by March 2018. It stands at 2.3 per cent of sales for the latest year ended March 2015. In such cases, future benefits to the bottom-line from the use of technology, brand name or trademark cannot be quantified at the time of inking the agreement. But promoters get an assured ‘return’ on these inputs via royalty payments.

Forex risk

Since companies pay royalty, technical know-how and licence fees predominantly in foreign currency to their MNC parents, currency movements affect royalty payments. These payments are not made everyday but on a periodic basis. Hence, hedging costs are incurred.

Besides, during unfavourable movements, provisions for marked-to-market losses and exchange loss at the time of payment affect profitability of the company.

Precedence over dividends

Royalty, being a compulsory item of expense, can also take precedence over dividends, which are essentially a discretionary distribution of profits. So, companies can retain royalty payments but can opt to reduce or skip dividends, leaving minority shareholders empty-handed.

Whirlpool of India, a maker of kitchen appliances, refrigerators and washing machines, has been making profits since its turnaround in 2008-09. In the early days of the turnaround, the company did not give out annual dividends for equity shareholders due to accumulated dividend obligations on preference shares and the cash needed to redeem preference shares.

But, even by 2014-15, the company was yet to declare dividends for equity shareholders; the annual reports cite the need for future capital expenditure as the reason for non-payment of dividends. On the other hand, the company has paid royalty and know-how fees to the extent of 1.2-1.3 per cent of sales during these all these years. Similarly, 3M India is also among companies that pay royalty each year, but no annual dividends.

Even in the case of companies that have been paying dividends alongside royalty, there is a tendency to be more benevolent towards promoters. Maruti Suzuki declared a dividend of 500 per cent on its ₹5 worth equity shares for 2014-15. But this works to only about ₹755 crore for all shareholders put together, compared with ₹2,657.5 crore paid as royalty to promoters.

Hence, if you have invested in stocks of any company that pays royalty to its promoters, it is essential to scrutinise the fine-print to see if the company is short-charging you.

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