Near-term margin concerns an overhang on Kansai Nerolac Paints' stock

Higher advertising costs and demand worries could put pressure on profitability

The stock of the third-largest decorative paint maker in the country, Kansai Nerolac Paints, shed 3.25 per cent in trade on Friday, taking its losses over the past three trading sessions to 7.4 per cent.

This decline follows a lower-than-estimated September quarter (Q2FY23) performance, worries that efforts to enhance decorative segment market share may delay margin recovery, and demand slowdown in the current quarter. Brokerages have cut their earnings estimates by up to 12 per cent over the next two years to reflect these concerns.

The September quarter performance missed Street estimates, largely due to the muted showing in the decorative paints segment. The overall revenue was up 19.3 per cent YoY and aided by a 16 per cent growth in volumes, largely in the industrial segment. The company gets about 45 per cent of its revenues from the industrial segment and has a 50 per cent market share in the automotive paints segment.

Demand from the auto paints segment was strong given the easing semiconductor situation for its customers. On a favourable base, ICICI Direct Research estimates that auto paint volumes would have risen by 33 per cent. What weighed on overall revenue performance was the flattish decorative segment volumes due to the protracted monsoon and weak rural segment demand.

The Street would track near-term demand as the management was cautious about growth in the December quarter. A higher base of last year, early Diwali, extended monsoon in some regions, and rural sentiment could hit decorative paint volumes.

On the cost front, while the company hiked prices by 3 per cent, there was a 7-8 per cent increase in input costs. This, coupled with a product mix change, impacted the gross profit margin that fell 130 basis points on a sequential basis. Downtrading (shift towards paints in economy range) due to price hikes, rebates, and weaker demand because of extended rains impacted profitability in the quarter.

There are, however, mixed views on how the margin trajectory will pan out over the next few quarters. 

Analysts led by Jaykumar Doshi of Kotak Institutional Equities say the company that has lost market and “mind” share in decorative paints in the past couple of years due to cuts in advertising spend and aggression by Asian Paints is looking at increasing marketing spend and focusing on the premium segment. While these initiatives may help the company stem and moderate further share loss, they will come at the cost of margin recovery as gains from easing raw material prices shall be reinvested. Further, given some slowdown since September, operating leverage will be limited, they add.

Other brokerages, however, believe that the worst may be over on the margin front. In addition to premium focus and exit from low-margin segments, increased direct distribution for decorative paints, market development in the business-to-business segment, price hikes, and strong outlook for auto and non-auto segments within the industrial segment should help the company, according to analysts led by Amnish Aggarwal at Prabhudas Lilladher Research.

At the current price, the stock is trading at 30 times its FY24 earnings estimates. Given the uncertainty related to the demand situation, as well as the outcome of the market share/margin trade-off, investors should await clarity on the same before considering the stock.