Accumulate Gradually

Castrol India Ltd (CIL), a subsidiary of UK-based oil giant BP, is India’s second largest lubricant seller. To CIL goes the credit of transforming a commodity — lubricant — into a branded product. With imaginative advertising and research, it has been able to convince its customers that it has a differentiated product to offer. It currently commands around 20-22 per cent market share in the domestic lubricant market.
By virtue of owning 71.3 per cent of Castrol’s outstanding shares, BP has controlling interest in the company.

Industry outlook
The lubricant industry in India is divided into three major markets: automotive, industrial, and marine and energy applications. The four biggest players — Indian Oil Corporation Ltd (IOCL), CIL, Bharat Petroleum Corporation Ltd (BPCL), and Hindustan Petroleum Corporation Ltd (HPCL) — control 70 per cent market share.
Of the three verticals, the automotive segment is the most competitive. Multiple distribution channels and the large variety of automobiles make it a complicated segment to cater to. Branding plays a big role in this segment, which is why CIL is able to command a high margin for its superior products. In 2010, robust automobile sales allowed the lubricant industry to clock 4-5 per cent revenue growth. According to the company’s management, CIL holds approximately 20 per cent market share by volume in the automotive segment. It is expected that auto sales will drive growth in this segment.
In the industrial sector, India is expected to complete projects worth Rs 15 lakh crore over the next two years. The power sector will be the largest contributor to capacity addition. This capacity enhancement will increase the demand for lubricants. Unlike the automotive segment, more than branding, superior products and cost efficiencies play a prominent role here.
The marine and energy sector is under the weather currently due to a slowdown in cargo movement and due to the prevalence of excess capacity. Lower freight rates have put additional pressure on the players in this segment. Furthermore, the entry of new lubricant companies into this segment has squeezed players’ margins. The changing dynamics of this segment are forcing many existing players, including CIL, to change their strategies.

Strengths
Parentage. Being a subsidiary of one of the largest oil companies does have its perks. BP’s backing means that CIL’s management can always leverage the former’s financial and product superiority for competing in the market.
This is the reason CIL has been able to take on PSU giants like IOCL and BPCL despite not having a comparable distribution network in the form of petrol pumps, as the PSU oil marketing companies have.
Technology and brand. Over the years CIL has worked hard to create a strong brand image in the minds of retail consumers. To its credit, it has been able to back up this image with superior products that have delivered on customers’ expectations. CIL has an R&D centre in Mumbai for developing customised products that can cater to different types of automobiles and industries. It has a broad portfolio of about 100 automotive lubricants and 300 industrial ones. Further, it can potentially access the 5,000 lubricant varieties present in BP’s portfolio. As emission norms get more stringent, CIL will be able to introduce in the Indian market high-end lubricants developed by BP.
Distribution. CIL has adopted the retail model for making inroads into the Indian automotive lubricant market. Most petrol pumps are PSU-owned, and the latter have their own lubricant brands. This made it difficult for CIL to use petrol pumps for distributing its own lubricants. Hence it employed distributors to directly sell its product to 70,000-plus outlets. Moreover, it has setup Castrol BikePoints, Castrol Pitstops and Castrol Car Centres, which offer one-stop solutions to customers for servicing. It has also set up Castrol Authorised Service Associate (CASA) to reach out to small individual mechanics in order to push CIL’s products through them. Tie-ups with original equipment manufacturers of automobiles and customisation of lubricants for different cars has also helped CIL in reaching out to new car buyers.
CIL also works closely with industrial workers to demonstrate to them advantages such as cost-savings and lower wear and tear that arise from using its products.
Cash. CIL has no debt obligations. Its cash reserves of Rs 619 crore make for an awesome war chest. This figure amounts to 1.26 times the profit earned by the company in CY10. Its huge cash reserves give CIL the flexibility to acquire new technology or spend more on advertising and marketing in order to push its products.

Weaknesses
Rising input costs. Input prices are the company’s single biggest operating expense. For the last five years it has averaged around 68.5 per cent of total expenses. High crude oil prices do not bode well for lubricant companies, as base oil, an essential ingredient in making lubricants, is derived from crude oil. Therefore, as the price of crude oil goes up, the operating expenses of lubricant companies also rise.
Moreover, high commodity prices in 2010 also translated into higher costs of other chemicals required for manufacturing lubricants. As a result, in CY10 raw material expenses rose to 70 per cent of total expenses, still lower than the peak of 73.4 per cent reached in CY08, but higher than the level in CY09.
Competition. Competition in the Indian lubricant industry is fierce. On the one hand, CIL is pitted against IOCL, which controls a significant percentage of petrol pumps in India. On the other hand, it has to contend with international players like Royal Dutch Shell, the global market leader in lubricants. Besides the big players, the company also has to ward off the challenge from smaller players who offer cheaper products in order to attract price-conscious customers.
The PSU oil companies have a tendency to chase volume growth by lowering their prices, which forces other players also to cut prices. IOCL, with its lubricant brand Servo, is a significant player in the market. And as said earlier, it also operates most of the petrol pumps in the country. Together these factors make it a potent force in the market.

Financials
CIL has a strong history to back up its claim of being a fundamentally sound company. Over the last five years, its topline has grown at a compounded annual growth rate (CAGR) of 13.84 per cent annually while its earnings per share (EPS) has grown at a faster rate of 27.26 per cent annually. Between CY06-10, the company managed its expenses so well that its operating profit margin expanded from 12.55 per cent to 26.51 per cent. This occurred despite raw material costs increasing rather than declining over the same time span.
CIL’s management has proved itself adept at managing capital, hence the company has been able to earn superior rates of return. Adjusting for the bonus issues, CIL has earned an average return on equity of 52.39 per cent over the past five years and 40.09 per cent over the past 10 years. Sustaining such a high level of performance over a 10-year time span, and that too without leverage, is a remarkable feat.

Valuation
Currently the stock is trading at a price-to-earnings (P/E) ratio of 23.45 (with a trailing 12-month EPS of Rs 20.61). Compared to its five-year median P/E, CIL’s stock is currently trading at a premium of 22.27 per cent. However, this may not be the right measure for looking at the stock’s valuation. Over the same time period, the stock’s price has not seen a precipitous decline. Even during the crash of 2008 the stock declined by just 4.35 per cent.
A better measure for looking at CIL’s valuation would be price-earnings to growth (PEG) ratio, since it takes into account both the company’s P/E and its earnings growth. CIL currently has a PEG ratio of 0.85. A PEG ratio of less than one implies that even at current price levels the stock has an attractive valuation.
Investors should take advantage of the current weakness in the broader market to accumulate this stock over a period of time.