Whose money is it anyway?

If you’re a stock market investor, it’s time you began to pay attention to a neglected item of expense — royalties. Royalty payments by Indian companies to their foreign promoters have been making news in recent times. Earlier this month, Maruti Suzuki announced its decision to pay royalty to its promoter, Suzuki Motor Corporation, in Indian rupees instead of Japanese yen. Last year, the Hindustan Unilever (HUL) stock was beaten down after a new agreement with parent Unilever for an upward revision in payments towards technology and trademark licences. In the last two years, proxy advisory firms such as IiAS (Institutional Investor Advisory Services) have been actively asking minority shareholders to speak up against royalties and related payments of their companies.

As an investor, if you haven’t taken note of your company’s royalty payment policies till date, here are five reasons why you should:

The first reason why royalty matters is that it is not calculated as a percentage of profits, but as a percentage of sales. This practice delinks royalty payments from the performance of companies.

For one, it implies that the promoters will be paid royalty even if the company is faced with a fall in profits, or worse, makes losses. Asahi India Glass, a manufacturer of architectural and automotive glasses, is a good example.

Even as the company has been making losses in the last three fiscal years — 2011-12, 2012-13 and 2013-14 — it has paid ₹20.45 crore, ₹10.4 crore and ₹7.36 crore, respectively, as royalty in these periods.

Secondly, companies enter into agreements that increase the royalty in phases over several years into the future. In HUL’s case, under the new agreement, 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. 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.

Thirdly, it is not just foreign promoters who charge a royalty from their Indian arms for brand names, technological inputs or technical help.

The Wadia group, promoters of Britannia and Bombay Dyeing, also charges a royalty of 0.1- 0.25 per cent of sales from group companies for ‘use of brand equity of the Wadias’ and shared legal, financial and IT services. Whether Britannia, being a strong brand by itself, would require the Wadia name to sell biscuits and should compulsorily pay for it, does open a debate.

But why are royalties so much in the news now? Haven’t they been around for years? Well, removal of the statutory cap on royalty payments by the Government in December 2009 has contributed to a rise in the incidence of royalty payments by Indian companies. Until then, royalty payable under a technical collaboration could not exceed 8 per cent of export sales and 5 per cent of domestic sales. Similarly, royalty payable for use of trademark and brand name of the foreign collaborator could not exceed 2 per cent of exports and 1 per cent of domestic sales.

But the removal of these caps has helped some companies peg up their royalty outgo to much higher levels.

Take Maruti Suzuki, for instance. From 2008-09 to 2013-14, the auto industry has gone from a boom to a slowdown. But the company’s royalty has moved up steadily to almost 6 per cent of net sales now, from around 3 per cent in 2008-09.

From 2008-09 to 2013-14, even as sales grew by a compounded annual growth rate (CAGR) of only about 10 per cent and profits by a CAGR of a mere 2.7 per cent, royalty payments have galloped at a CAGR of 25 per cent for Maruti Suzuki. Clearly, had the royalty payments been lower, Maruti shareholders would have enjoyed far better earnings.

As a percentage of net profits after charging royalty, Maruti’s royalty outgo crossed 100 per cent both in 2011-12 and 2012-13 and now stands at 89 per cent.

ABB India’s outgo for royalty, technology and trademarks has also moved up steadily from below 2 per cent of sales in the year ended December, 2009 to 3.5 per cent by December, 2013. The outgo on this account has also been higher than the profits that the company made in the last few years. In 2013, royalty and related payments to ABB amounted to ₹267 crore while net profits, after charging royalty, were only ₹179 crore.

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

Whirlpool of India has been making profits for the last five years 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 2013-14, 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 knowhow fees to the extent of 1.2 per cent of sales and 19-28 per cent of profits during 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 declared a dividend of 240 per cent on its ₹5 worth equity shares for 2013-14.

But this works to only ₹362.5 crore for all shareholders put together, compared with ₹2,486 crore paid as royalty to promoters. ABB’s royalty outgo for the year ended December 2013, is four times its dividend of ₹3 per share (face value ₹2.)

Since companies pay royalty/technical knowhow/licence fee, etc., predominantly in foreign currency to MNC parents, another spill-over effect of royalty payments for investors comes from currency movements. 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.

To tackle this, Maruti has announced that it will pay royalty in rupees for future models. If it does start paying in rupees in the near term, the timing of the announcement doesn’t help investors. At a time when the yen is depreciating, it denies investors the benefit of any forex gains that would add to the bottom line. But rupee payments, however, will ensure that Suzuki doesn’t lose out.

Investors may not mind paying royalties to the promoters for real benefits such as technological inputs or access to well-known brands. But the problem is that most royalty agreements tend to be shrouded in secrecy and investors tend to get a raw deal from inadequate disclosures. Many companies club payments for different purposes such as use of technology, brand-name, trademark, professional/consultancy service charges under a one-line item — royalty — in the ‘other expenses’ section of the Profit and Loss Account.

Whether the entire amount is towards recurring expenses or whether it also includes one-time payments or amortisation is also not disclosed.

Hero MotoCorp shows transparency in this aspect. As part of the transition after the split-up with Honda in December, 2010, Hero MotoCorp has been paying two types of royalties. One is a lumpsum payment worth about ₹2,450 crore which was being amortised over 14 quarters and the other is towards licensing for new products. With June 2014 being the last quarter for expensing off the lumpsum payment, investors can look forward to savings of about ₹200 crore on this count from the September, 2014 quarter onwards. However, the monetary benefit of the use of the technology, brand-name, trademark and services is not quantified in almost all cases.

Whether the use of the parent company’s new technology helped cost savings, and to what extent, or whether the use of the brand name helped get a higher price point and resulted in better margins, is left to guesswork.

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