 "Falling crude oil prices: margin booster for paint companies")
Falling crude oil prices has brought cheer to paint companies' prospects and as a result stocks of Asian Paints, Berger Paints (Berger) and Kansai Nerolac have outperformed the S&P BSE Sensex since July 2014. All three stocks made new all-time closing highs on 1st December, 2014 when Brent crude oil prices fell to $68.82 per barrel.
Notably, titanium dioxide and other crude derivatives such as PAN and PENTA together form about 40-50% of total input costs for these companies. As per analysts estimates, every 10% fall in these inputs prices adds 7-10% to paint companies' earnings. In the September 2014 quarter as well, Berger and Kansai Nerolac witnessed EBITDA margin expansion of 62 basis points and 146 basis points respectively on a year-on-year basis.
Asian Paints though posted a 190 basis points contraction in EBITDA margin as it stepped up advertising and staff costs inched up. Analysts expect Asian Paints to register a 10 basis points and 30 basis points expansion in EBITDA margin in FY15 and FY16, respectively while Berger is estimated to record 90 basis points and 65 basis points expansion in this metric in FY15 and FY16, respectively. For Kansai Nerolac, the street expects EBITDA margin gains of 230 basis points in FY15 due to a lower base in FY14 and by 10 basis points in FY16.
"Softening of global crude prices and titanium dioxide can provide a significant margin boost to Berger. Furthermore, Berger's plan to reduce inventory days (by five days per year) and expand margins boosts our confidence in the company", says Harsh Mehta of HDFC Securities.
Lower input costs alongwith improving demand scenario will drive these gains. Kansai Nerolac is also play on improving demand for industrial paints as it derives a relatively higher proportion of sales (45%) from this segment versus the other two (15-20% for Asian Paints and Berger). Decorative paints segment continues to witness strong traction and drive growth for the paint companies as industrial paints' demand is recovering gradually.
"We expect Asian Paints' revenues and net profit to grow at a CAGR of 18.6% during FY14-17 and operating margins to inch up 60 basis points by FY17 driven by high operating leverage due to sustained volume growth in decorative paints and a recovery in industrial paints demand", says Sanjay Manyal of ICICI Securities.
At Monday's levels, Asian Paints stock trades at 42.7 times FY16 estimated earnings (historical average of about 30 times) while Berger and Kansai Nerolac trade at 39.8 times and 28.6 times, respectively. Historical average one-year forward PE ratio of Berger stands at about 20 times while that of Kansai Nerolac is 25 times. All paint companies have been re-rated in recent times due to improving growth prospects and profitability.
Thus, while most analysts are positive on these companies' business growth, current valuations leave little room for meaningful upsides. Analysts believe shift towards premium products, higher frequency of repainting cycle and higher purchasing power of the end user will drive growth for the paints companies. Strong distribution network and brand equity of the players is also a key positive, while an economic recovery will only boost demand for both, industrial as well as decorative paints. The key downside risk though remains intensifying competition which could put pressure on pricing and restrict margin expansion of these companies as they vie for higher market share.