At a time India's economy is slowing and growth expectations are low, shareholders have become touchy about anything that lowers the earnings per share. One such area is royalty payments to parent companies based abroad.ROYALTY LIES IN NAME
Royalty is a fee that a company pays for using technology, patent, copyright, brand name or anything 'owned' by another company or entity. It can run into huge amounts and hit bottom lines in a big way. For instance, the top 20 royalty-paying companies in India remitted Rs 3,601 crore as royalty in 2011-12 as against Rs 1,196 crore in 2007-08, according to a report by the Institutional Investors Advisory Services (IIAS). While the royalty payment by these companies more than doubled during the period, sales grew just over 70 per cent, said the IIAS report.
When a company uses something owned by another, it is bound to pay for that, but it is the valuation that is often debated, especially when the two companies are related. Concerns also arise when royalty is demanded for something that is difficult to value, such as a brand name, and when it is increased without any value addition.
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"Royalty is justifiable when resources outside the company have gone into creating the brand name, which gives pricing power and increases entry barriers for other possible competitors. It is also justifiable when technology and process improvement have been developed outside the company," says Chetan Parikh, director of Jeetay Investments, a portfolio management firm.
"I think if a company is paying for a new product or technology, royalty is justified. But charging for the entire business is not justified," say Sandip Sabharwal, chief executive, portfolio management services, Prabhudas Lilladher.
Recently, shares of Hindustan Unilever were battered on concerns it might have to pay a higher royalty to parent Unilever, which holds over 52 per cent in the Indian unit. The concerns arose after Unilever's Indonesian unit decided to increase royalty payments in a staggered manner. While it has not announced an increase in royalty yet, its shares have been under pressure. For instance, on December 12, the day the news about the Indonesian unit was out, they fell 3 per cent to Rs 529.
"There is a one-step correction in stock price when the news of royalty increase comes out. It might depress the return of existing shareholders but is forgotten after one year," says Sandeep J Shah, CEO, Sampriti Capital.
Royalty is also paid for use of brand and family names. This gets shareholders the most agitated as it is difficult to put value to a name. "It is not justifiable as a form of 'economic rent' that the promoter group uses as a separate income stream along with dividends. There cannot be a formula to determine royalty," says Parikh of Jeetay Investments.INVESTMENT TIPS:Be realistic when setting financial goals
In 1996, Tata Sons became the first big Indian company to start charging royalty from subsidiaries for using the brand name. Wadia group Chairman Nusli Wadia said in August last year that the group would charge royalty for sharing its name with the group businesses.
Minority shareholders may lose out if there is no proper framework for royalties that the companies charge. Shah of Sampriti says if there is not much brand recognition and the management charges for using the brand name, it means creating a brand at the cost of minority shareholders.SHAREHOLDER RETURNS
An increase in royalty payment leads to cash outflow. This will leave less cash for expansion and growth, forcing the company to take more debt.
An increase in royalty is not necessarily a reason to sell the company's stock but it's the nature and quantum of the payment which determines whether the company deserves a place in your portfolio.
"As an issue, royalty may not be significant for investment. But if a company imposes an unjustifiable royalty, it's a matter of concern," says Parikh.
"Royalty is a small component of the profit and loss account and a small expenditure. However, what one should look at is to what extent will it affect profitability, whether parents' commitment will increase after the payment and whether it will keep increasing the fee in the future," says Shah of Sampriti Capital.