HeLL breaks loose But there is a reason to Smile!

Switch from HLL to Colgate

Analyst
Toral Munshi 5540 8651 (toral@indiainfoline.com)

March 2004

Dealing (+91 22) 2685 0505

Sandeepa Arora Biren Patel 5540 9033 5540 8601

ITS ALL ABOUT MONEY, HONEY!

HeLL breaks loose- But there is a reason to smile!

Investment Summary
SECTOR RESEARCH (FMCG)

Recommendation HLL - SELL

Share Holding Pattern Promoters Institutional Investors Other Investors General Public

(Rs 157)
% 51.55 26.94 1.20 20.31

Share Price Chart

HeLL broke loose last week when Proctor & Gamble (P&G) initiated a price war by cutting detergent prices steeply. There is a possibility of a similar war in hair care segment. This will cause a significant dent in HLLs cash flows. A surprise beneficiary of this price war could be Colgate. Colgate is a leading player in oral care segment with meaningful competition from HLL. In this segment, HLL will have not only lesser cash to fight but also a lesser cause as its parent has exited the oral care category in select markets. Incidentally, Colgate itself was at the receiving end when HLL cut prices sharply some time ago. With parent support, Colgate launched new products to consolidate its position, and is set to improve its financial performance also. Colgate, which runs an advertisement campaign with a smiling face will have a reason to make its shareholders smile too. We recommend investors switch from HLL (Rs157) to Colgate (Rs138).

Valuation
At Rs138, Colgate trades at 18x FY04 (Mar) earnings, whereas at Rs157, HLL trades at 20x FY03 (Dec) earnings. We expect HLL to pass through an extended phase of heightened competitive pressures which will restrict topline as well as bottomline growth. Colgate on the other hand is likely to witness improved sales and profit growth over the next few years aided by a) Revival in volume growth b) Further decline in adspend as competitive pressures ease c) Lower tax outgo due to excise and income tax benefits on new manufacturing unit at Himachal Pradesh Over the longer term, decision by parent to make India a sourcing hub as the global restructuring of manufacturing locations gathers pace, could act as a big trigger for growth and a further re-rating of the stock. We expect HLL to under perform the market and recommend a switch from HLL to Colgate for a long-term exposure to the FMCG sector.
Hindustan Lever Ltd (Rs 157)
(Rs mn) Sales % yoy 12/01 1,06,676 12/02 99,549 (6.7) 12/03 1,01,118 1.6 12/04E 1,00,107 (1.0) 12/05E 1,00,607 0.5 EBIDTA 20,958 23,404 24,364 22,920 23,014 % yoy 11.7 4.1 (5.9) 0.4 OPM % 16.1 19.6 19.7 18.6 18.8 APAT 16,413 17,557 17,717 16,462 17,493 % yoy 7.0 0.9 (7.1) 6.3 EPS 7.5 8.0 8.0 7.5 7.9 P/E 21 20 20 21 20

Colgate - BUY
Share Holding Pattern Promoters Institutional Investors Other Investors General Public

(Rs 138)
% 51.00 12.54 2.02 34.44

Share Price Chart

Colgate India Pvt Ltd (Rs 138)

(Rs mn) 03/01 03/02 03/03 03/04P 03/05P 03/06P Sales 11,991 11,609 10,569 10,622 11,047 11,709 % yoy (3.2) (9.0) 0.5 4.0 6.0 EBIDTA 1,229 1,374 1,662 1,767 1,991 2,304 % yoy 11.8 20.9 6.3 12.7 15.7 OPM % 8.5 9.6 12.9 13.5 15.6 17.1 APAT 625 698 887 1,056 1,316 1,677 % yoy 11.7 27.0 19.1 24.7 27.4 EPS 4.6 5.1 6.5 7.8 9.7 12.3 P/E 30 27 21 18 14 11

March 09, 2004

HeLL breaks loose- But there is a reason to smile!

The Detergent Wars

HLL won the war, but shareholders lost

SECTOR RESEARCH (FMCG)

Flash back to the 80s

The First Detergent War was fought in the 80s when a small manufacturer in Gujarat aggressively marketed a detergent powder called Nirmanationally at onefifth the price of existing detergent brands. The launch changed the profile of the Indian detergent industry.

HLL won the war, but shareholders lost

HLL launched Project STING (see Annex) as a strategy to win back market share. The battle between HLL and Nirma has been well documented in Darden School of Business, University of Virginia case study : Hindustan Lever Limited Contemplates Indias poor. No doubt HLL won the battle, but as is evident from the chart below, under performance with respect to BSE Sensex meant that share holders lost out. The period of under performance coincided with the period of heavy fighting for market share.
Exhibit 1: Stock underperformance during 1987-1990
20

16

HLL

Sensex rebased

12

0 Oct-87 Oct-88 Oct-89 Dec-87 Dec-88 Dec-89 Oct-90 Aug-87 Aug-88 Aug-89 Aug-90 Dec-90 Jun-87 Feb-88 Jun-88 Feb-89 Jun-89 Feb-90 Jun-90 Apr-87 Apr-88 Apr-89 Apr-90

The Second Detergent War begins

We are about to witness what could be The Second Detergent War in India. It started with Procter & Gamble (P&G) slashing prices of its 20gm Ariel sachets by 30% to Rs2 and Tide sachets by 50% to Re1. Hindustan Lever Ltd (HLL) followed suit by lowering price of its premium Surf Excel sachet from Rs3 to Rs1.50. The move by P&G was aimed at inducing trial of its brands and a gradual shift to the brand as consumers experienced the benefit of a using a premium product. However, sachets account for just 15-20% of the detergent volumes sold in the country.

March 09, 2004

HeLL breaks loose- But there is a reason to smile!

SECTOR RESEARCH (FMCG)

P&G made its second move by announcing a huge 46% cut in the price of Tide and a 27% cut in the price of Ariel large packs. Two days later, HLL reacted by announcing 29% and 26% cut in large pack prices of its premium brand Surf Excel and midpriced Surf Excel Blue (earlier known as Surf) respectively.

How much does HLL get affected?

The Indian detergent market largely comprises of three segments Popular, Midpriced and Premium. What the price cuts have done is effectively brought down the huge price differential between the popular and the premium brands from 7x to 5x. This move is likely to bring about a dramatic change in the consumer profile of each segment. The impact would be felt by brands in all segments as mid-priced users may upgrade to premium brands, while popular brands may face volume pressure as customer upgrade to more affordable mid-priced brands. All leading national players in the industry HLL, Nirma, P&G and Henkel as also the smaller regional brands are likely to witness a huge realignment in their customer base. HLL with its dominating presence in all the categories is likely to be the worst affected, as Detergents is the largest and the second most profitable business of HLL. The stakes are therefore much higher for HLL than for P&G. HLL also faces the additional risk of its premium brands eating into share of its own mid-priced and its mid-priced brands eating into share of own popular brands. On the other hand, P&Gs detergents are marketed by the 100% subsidiary of P&G, USA. The parent would therefore easily be willing to absorb losses for a few years for market share gains. The listed entity only manufactures for the 100% subsidiary and infact would be a key beneficiary of any volume share gains that P&G gets.

Caught between the devil and the deep blue sea

HLL, therefore finds itself on the point of a double-edged sword wherein If it did not cut prices, there would be a big threat of losing market share in its largest business If it cut prices, that would not only put huge pressure on already shrinking margins it also raises a question on the future strategy for its leading power brands Surf and Rin.

March 09, 2004

HeLL breaks loose- But there is a reason to smile!

SECTOR RESEARCH (FMCG)

The challenge of managing brand equities

The price cut have led to three major realignments a) Premium brands Surf Excel and Ariel now cost 25-30% less than before b) P&Gs Tide has moved from the mid priced segment to the popular segment c) Rin Supreme is now more expensive than Surf Excel Blue
Exhibit 2: Revised pricing structure of P&G and HLL brands
Original Price Per Kg P&G Brands Ariel 135 Tide 85 HLL Brands Surf Excel 140 Surf Excel Blue 90 Rin Supreme 80 Rin Shakti 40 Wheel Active 26 Wheel Green 20 Revised Price Per Kg 99 46 100 67 80 40 26 20 Change % -27 -46 -29 -26 0 0 0 0 Category realignment From To Premium Mid priced Premium Mid Prices Mid Prices Popular Sub Popular Sub Popular Premium Popular Premium Mid Priced Mid Priced Popular Sub Popular Sub Popular

The key challenge for HLL would be maintaining the premium brand equity of its Surf brand, a variant of which is now available at a price discount to a Rin variant. Will consumers accept a Rin, which is more expensive thanSurf? Does this pricing not go against decades of brand equity established in consumer minds? Wont the Rin Supreme user upgrade to Tide which is certainly perceived as a more premium brand than Rin? Managing the equities and positioning of long established brands, therefore would be a big challenge for HLL.

The challenge of managing profitability

HLL has had a long history of facing several such marketing wars - be it in the oral care, fairness creams, shampoos or ice-creams. And it has been able to fight these wars without taking a big hit on its profitability in the past. But this time around, it could be different due to a variety of internal and external reasons The company faces low or negative category growth in almost all product segments that it operates in. Strong regional brands have strengthened their stronghold over local markets in the past few years and have already been eating into existing market shares.

March 09, 2004

HeLL breaks loose- But there is a reason to smile!

SECTOR RESEARCH (FMCG)

Competition gnawing from all directions in all segments- There is increased Competition not only from existing national players, and stronger regional players, but also from a larger number of multinational companies eyeing the Indian market as imports become more competitive in an era of lower protection. In the past, a speedily growing and highly profitable businesses (such as personal product and toilet soaps) subsidized higher marketing investments in other segments. Today, the core soap and detergent categories are de-growing and margins are under pressure. In personal products the company has just managed to push up growth to double digits levels aided by the power branding strategy. There too margins remain flat. The beverages business continues to be impacted by an adverse commodity cycle. The foods business is not mature enough - and would need further investments for a few more years.

Likely impact on profitability

HLLs soap and detergent turnover in 2003 was Rs43.8bn, of which an estimated Rs20bn is contributed by detergents. It is HLLs most profitable business after personal products. The business contributes 42.6% to HLLs revenues and 48.5% to its EBIT. However Revenues remained flat while EBIT margins in the business have been shrinking and stood at 24.8% in 2003 as against 25.9% in 2002.
Exhibit 3: HLLs Soaps & Detergents business
Revenues (Rs mn) % of revenues EBIT (Rs mn) % of EBIT EBIT Margins (%) 43,794 42.6 10,883 48.5 24.8

We estimate that EBIT decline to range between Rs700mn - Rs1200mn, depending on whether company is able to grow or maintain volumes or loses volume share to P&G. The adverse impact on EPS could range from Re0.6-Re1.00. The company would require a 15-20% surge in overall detergent volumes to maintain revenues and profitability at current levels.

March 09, 2004

HeLL breaks loose- But there is a reason to smile!

SECTOR RESEARCH (FMCG)

Shampoo war looming ahead - could add insult to injury

A much bigger threat could emerge if P&G decides to follow a similar strategy in shampoos. It is very evident from the moves made in the last 2 years that P&G has strategically decided to play the volume game in India. Its success in feminine hygiene has encouraged it to imitate the strategy in detergents. Like detergents, shampoo too is marketed in India through the 100% subsidiary Procter & Gamble Home Products, which gives it significant leeway to take losses without being answerable to shareholders. Currently P&Gs shampoo brands are sold at a 20-30% premium to HLLs top end shampoo brand. But P&G has recently launched a mass market shampoo brand Rejoice at a significantly lower price point (pitched against HLLs Sunsilk and Clinic Plus)
Exhibit 4: Price of 100ml shampoo packs
P&G Brands Head & Shoulder Pantene Rejoice HLL Brands Clinic All Clear Sunsilk Clinic Plus Rs 64.0 61.0 39.0 50.0 41.0 37.5

If P&G does decide to go ahead and cut prices of established shampoo brands like Head & Shoulders and Pantene also, that would mean really really big trouble for HLL. In a scenario like that, other competition like Colgate, Nirma and Cavincare would also make moves to launch their own attacks. And that would mean a big dent on HLLs Personal Products business the only business that is witnessing double digit growth and expanding margins at present.

March 09, 2004

HeLL breaks loose- But there is a reason to smile!

The Return of the Tooth Fairy

SECTOR RESEARCH (FMCG)

The Toothpaste War of the 90s

Colgate Palmolive India Ltd dominated the Indian oral care scenario until the late 70s.Competition came in the form of Balsaras Promise in the early 80s and HLLs Close up in the late 80s. Things really heated up when HLL aiming at increasing its share in the oral care market launched an oral care marketing war in the mid 90s. The success of Pepsodent, which was pitted Colgates largest brand CDC, hit hard with Colgate losing significant market share during the period. 1999 to 2000 was the most exiting period in the oral care history of India as a complacent market leader was taken over by an aggressive competitors moves HLL emerged victorious and strengthened its position as a strong No 2 with 35% market share. Colgate during the period lost market share from over 60% to 47%.

The leader fight backs

An awakened giant retaliated by a slew of new launches such as Colgate Fresh Stripe, Colgate Double Protection, Colgate Total, Colgate Whitening and Colgate Herbal, Cibaca Top, gaining back a part of the market share loss. Colgates sales grew by 8% yoy in FY01 and market share inched up to 49% aided by success of Colgate Herbal and repositioning of Cibaca Top in the economy priced segment. But by then new competition had arrived in the form of SmithKlines Aquafresh and homegrown brands like Anchor. While Acquafresh could not garner significant market share, domestic brands like Anchor and more recently Ajanta have positioned their products on natural and vegetarian platforms and restricted market share gains for both HLL and Colgate. The prolonged war between Colgate and HLL and their high decibel advertising led to spiraling advertising costs, hitting margins hard. While HLL subsidized its high decibel advertising by funding it through other more profitable businesses, Colgates profitability took a big hit. Colgates adspend rose from a mere 9% of sales in FY96 to a peak of 20% of sales in FY02!

New pricing strategy yielding results

The two large players in the industry called truce last year, realizing that while they slugged it out fighting with each other, the smaller players were strengthening their positions. The fight over market share and resultant high advertising and promotional activity resulted in increase in product prices for consumers and lack of focus on consumer need. Both the major players lost market share, while local competition took advantage and gained market share by affordable pricing. A slowdown in FMCG growth rates also restricted their ability to spend any further. Mutually consenting to figh local players on the pricing platform, both Colgate and HLL cut product prices last April. The lower realizations were expected to be compensated partly by cutting down on promotions and freebies and partly by the higher volume growth driven by improved product affordability.
March 09, 2004

HeLL breaks loose- But there is a reason to smile!

SECTOR RESEARCH (FMCG)

Improving topline and lower adspend driving profit improvement

The strategy has worked well as is evident from Colgates topline growth improvement seen in the last two quarters. September quarter sales were higher than June quarter by 1.4%, while December quarter sales have jumped 9% over sales in September quarter.
Exhibit 5: Sequential sales growth
9.3

10.0 8.0 6.0 4.0 2.0 0.0 (4.0) (6.0)

(3.4) (3.3) 1.4

(2.0) Mar-03

Jun-03

Sep-03

Dec-03

Meanwhile adspend has been brought down from a high 20% of sales in FY02 to 17.5% of sales in FY03 and 15% of sales in FY04. Operating margins saw a corresponding improvement in FY03, and a marginal improvement in FY04 margins. Colgates net profit has witnessed a 27% yoy growth in FY03 and a 21% yoy growth in the first nine months of FY04.
Exhibit 6: Will Adspend go back to pre 1998 days?
25 Adspend % OPM% 19.9 17.3 15.7 15 11.6 10 9.4 8.9 15.7 13.4 8.4 x1 5 03/95 03/96 03/97 03/98 03/99 03/00 03/01 03/02 03/03 03/04 8.3 8.2 9.2 12.3 18.2 18.2 17.5 15.2 12.7

20

18.0

18.5

March 09, 2004

HeLL breaks loose- But there is a reason to smile!

SECTOR RESEARCH (FMCG)

HLLs worries could make Colgate smile

The detergent price war started by P&G will erode HLLs margins and put pressure on its cash flows. The detergent stakes are too high for HLL and at this point in time it can ill-afford to divert any resources into the oral care biz. Also unlike P&G, HLL may not find funding support from Unilever, who has exited from the oral care category in certain countries such as US and Canada in line with its Path to Growth strategy of focus on fewer brands. As HLL and P&G slug it out for the detergent market, benefits will possibly accrue to Colgate. Colgate, by making a few right moves in the current scenario, could effectively utilize this phase to strengthen its position in the category. The timing could not have been better as a booming economy and strong agricultural growth could trigger a long awaited rural demand revival and spur category growth.

On a strong footing globally

The parent - Colgate Palmolive has reported a record earnings growth during 2003. Worldwide dollar sales rose 6.5% to $9.9bn, an all-time record, global unit volume grew 3.5% and operating profit increased 8%. Net income rose 10% to a record $1,421mn and diluted earnings per share increased 12% to $2.46, also a record. This is Colgates 31st consecutive quarter of increased gross profit, net income and earnings per share. The parent continues to grow volumes and improve market share in key markets of US, UK, Latin America and Asia. The parent expects the strong volume growth and profit improvement to continue in 2004 driven by new product innovations, improved productivity measures and aggressive global cost savings activity.

Outsourcing could be icing on the cake

There is a rising parent interest in Indian operations and India is likely to emerge as an outsourcing hub for the parent. In a recent international presentation made to consumer analysts Colgate-Palmolive Executive Vice President, Mr Ian Cook talked about rationalization of manufacturing facilities as one of the key cost savings initiatives to expand margins. The parent company has drawn up a 5-year plan of cutting down toothpaste and bar soap manufacturing locations to 15 each and toothbrush manufacturing locations to 8 globally. He also spoke of new manufacturing facilities currently being set up in India for toothpaste and China for toothbrush. The Chinese facility would be supplying toothbrush to 55 countries around the globe by end of the current year. Such large-scale production would mean huge economies of scale in procurement and manufacturing. Mr Cook also discussed Colgates global approach to manufacturing, supply chain and procurement enabled by investments made in SAP. Sourcing organizations have been established in China and also in India on an experimental basis for procurement of raw materials, product materials and indirect
March 09, 2004

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HeLL breaks loose- But there is a reason to smile!

SECTOR RESEARCH (FMCG)

materials too. Colgate Palmolive globally procures US$1bn of indirect materials every year and expects 10-15% savings from this initiative. Colgate Indias new toothpaste manufacturing facility in Himachal Pradesh would entail investment of Rs500mn and would provide income-tax and excise benefit to the company. The facilities are being set up for domestic consumption only at the moment. However given that the new plant in India is being set up at a time when the parent is actually looking at cutting down the number of manufacturing locations worldwide, does give an indication that India could likely emerge as one of the 15 sourcing destinations post restructuring And when that happens, it would mean a huge growth opportunity for a company that has been languishing under the weight of low category growth.

Concerns
High reliance on single category Colgates excessive reliance on a single category in India has been the biggest concern. Colgate Indias oral care business accounts for 94% of its turnover and more than 98% of profits , as against a diversified product range of oral, personal, household surface, fabric care and pet nutrition businesses globally
Exhibit 7:Segment turnover and profitability
Turnover Contribution Personal Care 5.3% Others 0.5% Profit Contribution Personal Others Care 0.2% 1.6%

Oral Care 94.2%

Oral Care 98 2%

Personal care biz turned around last year, but reported losses again in H1 FY04 Colgate has expanded non-oral care product portfolio in the current year and launched a wide range of liquid hand washes, shower gels, bar soaps and talcum power under the Palmolive aromatherapy range. While the new launches would enable the company to expand the earnings base, initial brand building efforts could impact margins. The personal care business, which had turned around and made a nominal profit of Rs31mn in FY03, reported a loss of Rs64mn in H1 FY04.

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HeLL breaks loose- But there is a reason to smile!

Annexure
SECTOR RESEARCH (FMCG)
Case A: Hindustan Lever Limited Contemplates Indias poor[1] Project STING At 9:30 a.m. on a Monday morning in June 1987 the top managers of Hindustan Lever Limited (HLL), the Indian subsidiary of the giant multinational Unilever PLC were having an important meeting. Having gathered from all regional offices to the HLL headquarters in Bombay these managers were discussing the launch of Project STING -- the Strategy to Inhibit Nirma Growth. For a company like HLL that had a reputation and performance history that was unbeatable, it was fairly strange that top management would waste their precious time discussing strategies to inhibit the growth of a small time entrepreneur like Nirma. However, over the past decade Nirma had risen from nowhere and had overtaken HLL in the detergent sector. So far HLL had ignored rural India, but Nirmas recent success in this disorganized sector had brought HLL back to the drawing board. Reconsidering their approach and deciding how to regain dominance in Indias detergent market HLLs executives were going to d iscuss three questions that morning. 1.Strategy - Should HLL enter the rural Indian market? 2.Marketing and Distribution - Considering the logistical hurdles of this market how should HLL plan its entry? 3. Design - What kind of product should HLL introduce to combat Nirma? Hindustan Lever Limited Hindustan Lever Limited or HLL was the Indian subsidiary of Unilever PLC, one of the worlds largest multinational corporations. Founded in 1930 and based jointly in the Netherlands and the United Kingdom Unilever sold its products in approximately 150 countries. Predating the creation of Unilever, Levers products first came to India as early as the late 19th century when India was a part of the British Empire. The first Lever product to be introduced in India was Sunlight soap. This foreign product was affordable and available to the British citizens in India and only a small section of the Indian well-off urban population. Thus setting a trend for the profile of clients that HLL would develop. In a truly multinational spirit Unilever was aware that success in India involved having local managers who understood both the Indian way and the Unilever way. After a series of exclusively foreign managers, Mr. Prakash Tandon became the first Indian Director in 1951. By 1955 Unilever had a well-trained local taskforce with about 65% of all managers being Indian. HLL was among the first foreign subsidiaries to offer Indian equity at that point and had 10% of Indian participation. Unilever gradually divested its stake in HLL and by 1982 it held only 52% equity in the company. By the late 1970s HLL had gained the reputation of being a role model for companies that want to succeed in India[2] and was one of the most sought after places to work at in the country. With products ranging from food and beverages to home and personal care products HLL was considered Indias largest household Packaged Mass Consumption Goods (PMCG) Company. Looking specifically at the Indian detergent industry, HLL was the undisputed leader. Traditionally, Indians had used bars or tablets of soap to wash their clothes. Clothes washing had involved scrubbing a wet garment with soap and then beating it with a club (similar to a baseball bat) or against a stone. HLL changed everything by introducing the revolutionary Surf washing powder in 1959. By introducing a washing powder they encouraged people to move from the club to the bucket. Part of their marketing strategy involved demonstrations of how clothes are washed in buckets with a washing powder. Surf was an immediate success and occupied the top spot in the national detergent market. While the concept of a detergent was every Indian housewifes solution to grueling hours of clothes washing, only a fraction of them could afford Surf. Bright blue in color and packaged in a large colorful carton (like the breakfast cereals in the United States) Surf was too expensive for rural India. The rural poor could not afford Surf and so continued to use bars and clubs. Surf was expensive to begin with, and with the early 70s came a rise in the price of crude oil and a massive increase in the cost of raw materials. Surf doubled in price from 1974-75 and so became even more unreachable for the rural people. At this time a host of new medium sized competitors came into being but HLL maintained dominance.[3]

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HeLL breaks loose- But there is a reason to smile!

SECTOR RESEARCH (FMCG)

The Rise of Nirma In 1969 Karsanbhai Patelts life typified that of millions of other Indians. He worked as a chemist in a factory in Ahmedabad in the western state of Gujrat. Earning a meager salary on which he was desperately struggling to make ends meet. At the same time Karsanbhai recognized that there was a vacuum in the rural Indian market for an affordable detergent. There were low quality soap bars that did not wash very well and were very timeintensive or there were up-market detergent brands that washed very well but were too expensive. Karsanbhai recognized the need for an affordable detergent and concluded that a good product would create its own market. On the basis of this rather simplistic but accurate belief, Karsanbhai started conducting experiments in his kitchen. His efforts finally yielded a pale whitish yellow powder that he named Nirma, after his then one-year-old daughter Niranjana. In no time he began producing small quantities of washing powder and selling them to his neighbors. He packaged his product in small pouches with neither colorful decorations nor designs. Every morning Patel got onto his bicycle and went from door-to-door selling his washing powder. Soon wholesalers and distributors from different neighborhoods, towns, cities and states of India started arriving at Karsanbhais doorstep to buy and redistr ibute Nirma. Karsanbhai took on no responsibility for delivery or distribution; but his product was soon available at every corner of India. Once Nirma arrived on the rural market things changed for Indias poor -- they had an option. By 1977 Nirma was the second largest volume seller in the country. Despite this, no other company took Nirma seriously. The marketing gurus of the world believed that Nirma was a regional product that was seeing temporary success and that its bubble would soon burst. They predicted that at such a low sale price, the margins Karsanbhai was making per unit would not sustain his business for long. Moreover, HLL completely ignored Nirma and believed that it was no threat at all. HLL considered themselves a superior company with a superior brand, and there was a strong belief that the only clients worthwhile pursuing were the Indian middle class and elite. Since Nirma was not in their market segment, HLL did not consider them a threat. The general belief was that rural Indians were poor and the rural sector was too disorganized to bother with. Understanding the Rural Market In India, HLL had disregarded a huge market segment that due to its sheer volume held great promise and potential. By ignoring the lowest rungs of society HLL was in danger of being toppled from the leading position. The question is why had HLL ignored the rural markets? In order to understand the dilemma facing HLL at this time it is important to know how traditional business is conducted, especially as far as multinational corporations are concerned. C.K. Prahalad and Stuart Hart help us to understand this by looking at the market as a pyramid.[4] The Top tier of the market consists of about 75-100 million people who earn more than $20,000 a year (See Exhibit 1). This group consists of the elite/ middle and upper-income people in our societies. Most of these people live in the developed world and a few in the developing world. The second and third tiers consist of the rising middle classes, living mostly in developing countries and earning between $1,500 and $20,000 a year. Prahalad and Hart estimate that between 1,500-1,750 million people live in Tier 2 & 3. Finally, we come to the bottom of the pyramid, Tier 4, which consists of around 4 billion, people who earn less than $1,500 a year. Most of the people in Tier 4 live in the developing world, however there are some who live in urban inner city areas in both the developed and the developing countries. [5] Typically, MNCs have focused on the first tier as it allows for the highest margin of returns. In many cases the second and third tiers of the pyramid have also been focused on, however, the people at the bottom of the pyramid have usually been ignored. While those in Tier 4 have been ignored for a host of reasons it is interesting to notice that by concentrating on the top three tiers MNCs have marketed to only 30% of the worlds population. MNCs have ignored Tier 4 because it has always been assumed that those living in Tier 4 do not have any disposable income and so cannot afford the products produced by the MNCs. Nirmas success in rural India dispelled the myth that rural consumers are poor and do not have the disposable income to buy consumer goods. However, the additional reason that MNCs were wary of Tier 4 markets was because these markets constituted what is called the disorganized sector where a lack of infrastructure and development hinder effective mar keting and distribution of products. Finally, due to high overhead costs most MNCs are not able to price their goods in the manner that local companies

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HeLL breaks loose- But there is a reason to smile!

SECTOR RESEARCH (FMCG)

can thus, refraining from entering the rural market due to their inability to be price competitive. The Case of Rural India Looking specifically at India it is easier to understand what working in rural markets entails. In the early 1980s the total population of India was around 750 million of which 70% lived in rural areas.[6] Thus Indias rural population, which was comprised of 525 million people, was equal to almost twice the population of the United States of America. Indias rural market comprised 12% of the worlds population. With an estimated annual growth rate of 1.7%, India was the second most populous country in the world. By the year 2010 its population was expected to reach 1.15 billion.[7] The sheer size of the rural Indian market was the greatest attraction for entering it. Despite the sheer size and potential volume of business in rural areas, HLL stayed away from the rural Indian market for the simple reason that it was physically very difficult to penetrate. The nature of rural markets has always been very complex and rural India presented a number of unusual challenges for HLL. In India the rural client group lived in approximately 570,000 villages spread across the Indian countryside. Approximately 90% of Indias rural population lived in small way-out villages with populations of less than 2000. Most villages neither had electricity nor running water. Access to telephones and the Internet was unheard of. Due to a lack of infrastructure, only 45% of the villages could be reached by road, and few of these were all weather roads. HLLs decision to stay away from the rural markets was not limited to the physical challenges of the land, but also by the so-called social and cultural challenges of the people. In trying to sell their product in rural areas HLL would be dealing with a client group that had never before been focused on by multinationals. Banners and leaflets alone would not be effective since only 43% of rural Indians could read. Moreover, India was a country where 15 recognized languages were spoken along with over a few hundred dialects so any media campaign would have to be effectively translated. HLL would have to tackle the challenge of marketing a product in the absence of conventional marketing and advertising tools. Since only 57% of the rural population was reachable by mass media HLL could not depend only on television or radio to get their message across; they would have to be innovative. Nirma Overtakes Surf: The War of the Bubbles While it may seem that Nirma was of inferior quality, housewives of rural India were not objecting. Karsanbhais product was in high demand. At one-third the price, as long as Nirma washed almost as well as Surf, the consumers did not mind. Going from 0% of the market share in 1976 to 61.6% of market share in 1987 Nirma had pushed HLLfrom the top. At the same time, until 1989, Surf remained between 2.5 to 3.6 times as expensive as Nirma. HLL was astounded by the growth of Nirma. HLL had a very clearly defined idea of what the specific ingredients of a detergent should be and what ratio they should be mixed in. According to HLL, Nirma was a low quality product. HLL commented that Nirma did not contain any whitening ingredient, had insufficient active detergent, had no perfume and was rough on the skin. The rumor was that Nirma contained lower levels of active detergents and more fillers and soda ash. Despite all these factors Nirma had outperformed Surf in the market. Looking at the following figures in Exhibit II the rate of growth of Nirma is astounding. [Now here lets talk about the design of each product: their chemical makeup, etc. By 1984, Nirma occupied the position of No. 1 brand in Asia leaving Surf far behind.[9] Everybody was shocked, most of all HLL. The key question is: how was Karsanbhai able to achieve such tremendous success in an arena that had been dominated by HLL for so many years? Karsanbhais response to this was that he saw an opportunity where others had not bothered to look. He said, I found a massive market segment that was hungry for a good-quality product at an affordable priceso I decided to keep my margins very low, and was happy if I could net between three and five percent profits really came from the huge volumes we generated.[10] Karsanbhai was a genius to have recognized the opportunity provided by this rural market and he was able to successfully give them the product that they wanted at the price that they wanted. A New Business Model - The Nirma Way[11]

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SECTOR RESEARCH (FMCG)

One of the starkest differences between Surf and Nirma was the price. While the contents of the product may differ Karsanhbhai was able to produce such a low cost detergent. There are many areas where he controlled expenditure. Aware that soda ash, the main raw material for his product, was abundant in Gujerat, Karsanbhai set up shop in the vicinity. To keep a lean organization Karsanbahi outsourced all the administrative functions. He contracted tasks like selling, accounting, technical production capabilities and distribution. All this gave him the flexibility to negotiate price during slow periods. Till 1985 the Nirma ingredients were simply mixed by hand thus requiring neither machinery nor capital investment. Due to the scale of his product and the simple non-mechanized production process, Nirma gained a number of tax and excise benefits for not using electricity. Since Nirma was a small-scale local venture, they did not have to pay excise duties that were levied on multinationals. Another area where Nirma saved millions was in labor costs. Being a cottage industry Nirma was not compelled to abide by minimum wage rules. To maintain low costs Karsanbhai used contract workers who were paid Rs. 85 per ton (In 1985 $1 U.S = Indian Rupee 12.368)[12] for mixing raw materials and then bagging them into 1000 bags of 1 kg each. Payment was made according to work done and since labor was not permanent no additional overhead for benefits etc. needed to be paid. It was not until the mid 80s that Nirma started to mechanize their production process, however by then they were an already well-established name. In 1989 Nirmas labor costs for 8000 workers was estimated to be between Rs 15-20 per person day in comparison to HLL who paid their semi-skilled workers approximately Rs 30-40 per person day. (In 1989 $1 U.S = Indian Rupee 16.225)[13] When setting up a distribution system Karsanbhai was extremely aware of the importance of keeping costs down. Once demand for Nirma had outgrown his ability to deliver on bicycle he moved on to vans and then later to trucks. Nirma had neither a field sales force nor owned a distribution network. Karsanbhai negotiated prices with truck and van suppliers on a daily basis. As sales grew Karsanbhai eventually hired stockists (those who stocked additional quantities of the goods) as commission agents. On the one hand it helped him avoid central sales tax and the stockists were responsible for all transportation, octroi,[14] handling and delivery costs. There was also a strict system of protocol and distribution depended on prepayment for stocks so as to minimize risk for Nirma. While advertising did not appear as a cost in his initial budgets, by the late 70s as televisions slowly started to spread into rural India, so did the Nirma ad campaign, with its simple message and catchy jingle. By the early 80s Nirma became synonymous with good quality and lowprice. The stockists were also responsible for promotions and they funded 50% of promotional expenditure for their goods. Nirmas sales reached a rate of growth that was two to three times that of the industry in general. As a result of all the above measures Nirma survived and flourished on what looked like a miniscule margin per unit. The HLL time-line In 1977, with a 12% market share, Nirma was the second largest volume seller of detergent in India. Surf was the leader with 33%. Still, for a long time HLL did not think that Nirma could ever present a potential threat. The general belief between marketing gurus and within HLL was that Nirmas bubble would soon burst. They did not believe that Nirma could survive on the miniscule per unit margins they were making. In addition, being a multinational, HLL had tremendous overhead costs and therefore had never considered itself capable of providing a low cost detergent to compete with Nirmas low priced product. For this reason HLL had traditionally stayed away from the rural and low-income market. Finally, at the time HLL had two detergent producing factories, both of which were having productivity and industrial relations problems. So HLL decided to wait and watch. However, by 1985 Nirma was outselling Surf by 3 to1. While Nirma had a market share of 58% Surfs had dropped to 8.4%. From nowhere, Nirma had risen to become one of the largest selling detergent brands in the world.[15] Nirma had not only increased its share of the pie, but had increased the size of the pie itself. Moving into a so far untapped market, Karsanbhai was responsible for expanding the detergent market 10 times. To HLLs surprise, consumers were

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HeLL breaks loose- But there is a reason to smile!

SECTOR RESEARCH (FMCG)

starting to compare HLLs high quality Surf powder with Nirma. HLL researchers reported that persistent use of Nirma caused blisters on skin and damaged clothes by weakening fabric in the long run. According to HLLs Research and Development team these side effects were due to the high soda ash content in Nirma. Despite these criticisms, Nirma was being perceived as a much cheaper and fairly comparable alternative to Surf. This jolt in consumer confidence and the massive decrease in sales forced HLL to recognize that Nirma was here to stay. Nirma was successfully toppling the giant from the bottom of the pyramid. Finally, in 1986 Nirma started testing a new detergent bar that would be directly marketed as a challenge to Rin, HLL s leading and most profitable detergent bar at the time. At this point HLL recognized that it was not just a question of Surf, Nirma was systematically undermining HLLs dominance in the industry and for the first time HLL got a glimpse of what could be the beginning of the end of their detergent business. It was time for HLL to react. [1] This case was written in July 2002 by Research Associate Pia Sabharwal Ahmad under the supervision of Professor Michael E. Gorman, Professor of Technology, Culture & Communications and Systems Engineering at the School of Engineering and Applied Science, University of Virginia, and Patricia H. Werhane, Ruffin Professor of Business Ethics, Darden School of Business, University of Virginia. This case was written as a basis for class discussion rather than to illustrate effective or ineffective handling of an administrative situation. Copyright 2002 by the University of Virginia Darden School Foundation, Charlottesville, VA. All rights reserved. To order copies, send an e-mail to dardencases@virginia.edu. No part of this publication may be reproduced, stored in a retrieval system, used in a spreadsheet, or transmitted in any form or by any meanselectronic, mechanical, photocopying, recording, or otherwise without the permission of the Darden School Foundation [2] Hindustan Lever: Role model for Multinationals, Financial Times, August 1, 1997 [3] Charlotte Butler, Hindustan Lever Limited: levers For Change, Case registered at London Business School in 2000. Page 40-41. [4] C.K. Prahalad & Stuart Hart, Strategies for the Bottom of the Pyramid, 1999. Seen at http:// www.wri.org/meb/wrisummit/pdfs/hart.pdf [5] C.K. Prahalad and Stuart L. Hart, The Fortune at the Bottom of the Pyramid. Seen at http:// www.changemakers.net/library/temp/fortunepyramid.cfm [6] See Appendix 1 for Map of India. [7]Population statistics taken from the following sites http://www.undp.org.in/report/IDF97/ idftab.htm, http://mohfw.nic.in/popindi.htm, http://www.library.uu.nl/wesp/populstat/Asia/ indiac.htm, http://www.eia.doe.gov/emeu/cabs/india/indiach1.htm, http://www.cs.colostate.edu/ ~malaiya/india.html#Populations%20in%20the%20Sub continent [8] Charlotte Butler, Hindustan Lever Limited: levers For Change, Case registered at London Business School in 2000. Page 47. [9] One Man Show Rivals Multi Nationals, 2000, Responsive Database Services, Inc., Business and Industry, Rodman Publishing Corp., Happi-Household & Personal Products Industry, Vol. 37, No. 2; Page 26. [10] Karsanbhai Patel A Clean Sweep, June 27, 2002. Seen at. http://www.indiaprofile.com/ people/karsanbhaipatel.htm

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