Paint companies have some of the strongest links to crude prices and two of the biggest players in the industry stand to benefit from low crude
10-Apr-2015 •Mohammed Ekramul Haque
Paint companies have some of the strongest links to crude prices. That is because a whopping 60 per cent of their raw material costs are derived from crude-based products. Most paints companies have periodic contracts ranging between three-six months when sourcing raw materials. Any crude-related benefit, therefore, is likely to show up when existing contracts end in the coming quarters. In addition, since paints companies use derivatives of crude, the trickle-down effect may not equally correspond to the fall in the crude price. This was visible in FY09-10, says Kotak Securities, when derivatives saw a reduction of only around 50 per cent of crude price decline in that period.
Most paint companies should see EBITDA margins expand by 500-600 basis points (Kotak estimates) but that is only so if organised players do not cut prices and go after unorganised smaller players. Another advantage the sector is enjoying is the muted pricing environment of titanium dioxide (25 per cent of raw material costs), which had been down most of the last year and is still down 15 per cent (y-o-y).
Asian Paints, the big daddy of the domestic decorative paints market is one of the few paints companies that have a pricing power. Back in 2009 when crude price fell to $40 per barrel levels, Asian Paints did not cut prices, which led to gross margin expansion of 545 basis points. That is pricing power in action. According to Deutsche Bank Markets Research, Asian Paints could continue to exhibit that strength with earnings growth of 49 per cent in FY16.
The only concern with Asian Paints, as in the paints sector in general, is valuations. The last five years have seen key players getting re-rated, at the forefront of which is Asian Paints with valuations of 59x. That is nearly double of the company’s ten-year average valuation of 31x. Wait till earnings catch up with the valuations before buying.
Kansai Nerolac is set to gain from the two factors that determine its profitability: crude prices as well as automotive demand. Both of these are moving in its favour. Kansai is the country’s largest industrial paint manufacturer with a market share of 35 per cent in industrial paints. Kansai is also a proxy play on the automotive sector of the country. Around 45 per cent of Kansai’s revenues come from the industrial segment, which in turn derives 75 per cent of segment revenues from automotive paints. After a rough last couple of years, the four-wheeler segment has shown sustained improvement in demand. Kansai is the preferred supplier for Maruti Suzuki, also its biggest client in the segment. Maruti reported a volume pick-up of 12 per cent (y-o-y) in the December 2013 quarter, a reflection of the recovery in the sector.
Kansai’s earnings could grow by 22 per cent in FY16 says Kotak Securities. The stock trades at a valuation of 55x its TTM earnings, which, like Asian Paints, does not leave much on the table for new investors. Existing investors though stand to gain. Hold as the company revs up.