Lubricant firms: Better days ahead

Analysts back Gulf Oil over Castrol, given the former's better valuations

Stocks of lubricant companies Castrol and Gulf Oil Lubricants (Gulf Oil), among others, have outperformed broader markets in the past month, and this trend could gain momentum going forward. The sector’s prospects are closely linked to the domestic automobile sector, which forms about 85 per cent of these companies’ revenues.

The auto sector will be a key beneficiary of the Seventh Pay Commission’s recommendations as well as a gradual recovery in the economy. While this will aid revenues of lubricant companies, falling crude oil prices will also rub-off favourably on their gross margins as derivatives such as base oil and additives form a major chunk of their input costs. Global oil prices are now hovering around seven-year lows. The actual Ebitda (earnings before interest, taxes, depreciation and amortisation) margin gains, though, will be a function of the companies’ strategy on passing lower input costs to dealers/customers through price cuts as well as the quantum of ad spends and reinvestment into business.

The bad news is that the intensity of competition is rising. Smaller players (by volume market share) such as Gulf Oil have increased price discounts (on maximum retail price) they offer to dealers in the wake of intensified competition. Hindustan Petroleum Corporation Limited (HPCL), too, recently bundled all its lubricant brands under the HP Lubes umbrella, indicating enhanced focus in the business. But, analysts do not seem worried by this move.

Mehernosh K Panthaki, analyst at HDFC Securities, says, “I think competition will not increase significantly after the HP rebranding, given that its main focus is on petrol pumps, which are witnessing falling demand. Though HP is expanding in the bazaar segment now, private players such as Castrol, Tide Water and Gulf Oil have a stronger presence in this segment and, hence, may not lose market share.” Bazaar segment includes authorised Original Equipment Manufacturer dealers, mechanic workshops and spare part stores.

How this will impact incumbents is anybody’s guess, but the bigger positive is the expected rise in demand which should benefit pure-plays in the listed lubricants space.

“While Castrol maintained its market share in key personal mobility categories, commercial vehicles (CV) segment continues to see a drag and is expected to show an uptick with the likely economic pick-up toward the end of calendar year 2015”, says Harshad Borawake of MOSL.

In a results release, Castrol’s management also sounded positive on the future.

“Looking ahead, although the drop in crude oil price has translated into lower base oil cost, we are likely to experience volatility in the cost of goods due to a volatile rupee exchange rate. In the longer run, we continue to remain optimistic about the lubricant market and our business growth. The company is in a strong position to benefit from growth prospects, enduring relationships with key stakeholders and continued commitment of its staff,” the company said.

Thanks to its leadership position in the market, Castrol is giving lesser price discounts to channel partners. On an average, the gap in selling price between Castrol and other players is around 18 to 20 per cent after factoring in discounts given to dealers, estimate analysts. But, this could have implications say some analysts.

“Over the past five years, Castrol’s pricing power has eroded. In this case, smaller players like Gulf Oil and Tide Water may eat away some of Castrol's market share in the personal mobility segment. In the CV space, Gulf Oil is now stronger than Castrol, because its price discounts in this segment are at 10-12 per cent on average,” says Panthaki.

Gulf Oil, on the other hand, is aggressively branding and marketing its products. On an average, the price discounts in first half of financial year 2016 was 2.5 to three per cent for the company. Castrol’s stronger distribution network of 105,000 dealers is higher than Gulf Oil's 58,000, and, hence, could provide some cushion going forward. There’s also the possibility of Castrol reacting with more discounts or price cuts.

Overall, analysts are positive on both Castrol and Gulf Oil, but the upside potential for the latter is pegged higher at 21.5 per cent versus 9.2 per cent for Castrol from current levels, according to analysts polled by Bloomberg since November 2015. This is partly due to the rich valuations of Castrol, which trades at 30.2 times CY16 estimated earnings, as against 22 times for Gulf Oil. The rich valuations, however, are justified given its larger size and superior margin and return profile.