Friction At Castrol

Castrol has been a star performer on the stock market. Recently its parent Burmah Castrol, UK accorded its 51 per cent subsidiary Castrol India a separate regional status making India the sixth region in Castrol's global structure. Castrol India is the second largest and second most profitable subsidiary after the US. It is one of the leaders in lubricants and enjoys brand value. A Rs 100 invested in 1990 is worth Rs 10,000 today -- an annualised return of 78 per cent a year. Its substantial value creation has fostered a highly favourable sentiment.

But there are some problems now. The stock has fallen from a high of Rs 750 in January to the current Rs 540. The reason is not too difficult to fathom. The industry structure has undergone a radical change with intense competition and low growth rate which have put the Castrol scrip on alert. This is despite the fact that 1997 sales have grown 11 per cent and net profit rose 67 per cent. Any chances of a major appreciation would be more speculative than fundamental, says an ICICI Securities analyst.

The lubricants industry is divided into two segments; automotive and industrial lubes. The automotive segment accounts for 60 per cent of the sector and competition from multinationals and oil PSUs is heavily tilted in this segment. The consumer base is almost entirely retail and the advantage lies in building strong distribution network and brand image. The lubricant cost is only a fraction of the total operating cost. Thus the retail consumer is unlikely to be price sensitive and is expected to pay a reasonable premium for superior quality. The industrial lube market demands customised products for variety of user specific applications. The segment is much more price sensitive than automotive lube market. The industry was under strict regulation till 1992 and the oil PSUs dominated 90 per cent of the market and it is only in the last few years that few private players like Castrol, Gulf Oil and Tidewater have gained market share.

Liberalisation brings success

Castrol went public in 1983 with an issue of 9 million shares at a price of Rs 19 per share. Castrol was the only multinational manufacturer during the period from early 1970's to 1990's when the lubricant sector was heavily regulated. Consequently, it was well positioned to take advantage of the liberalisation process. With the removal of restrictions on advertising and base oil sourcing, Castrol became the first mover and responded quickly to expand its market share from less than 6 per cent to around 18.8 per cent and saw its sales rise at a CAGR of 28.5 per cent compared with 7-8 per cent growth of the overall market while its volume growth was 33 per cent during the same period.

In 1997, Castrol increased its market share by 1.5 per cent. The increase in net level is attributed to a fall in international price of base oil (accounts for 40 per cent of total costs) which fell 15 per cent and increased production at its unit at Silvassa which enjoys a tax holiday. For the first half of June 1998, its turnover stood at Rs 527.98 crore up 10 per cent while net profit rose 14 per cent to Rs 86.90 mainly because of a lower tax provision of Rs 21 crore (previous half Rs 27 crore). Its interest burden reduced by one third to Rs 1.2 crore. Castrol seems to have peaked as far as growth is concerned. ICICI Securities expects Castrol's growth in market share to slow down to one per cent a year for the next three years.

Competition comes in

Despite Castrol posting consistent performance in the past, the coming years would see severe competition from oil PSUs and a number of MNCs which have turned aggressive. The Indian lubricants market which consumes around 10.3 lakh kilolitres is worth Rs 5,000 crore and the fifth largest lubricant consuming country in the world. The industry is expected to witness a volume growth of 3 per cent in the next three years. This makes India an attractive market for global players which are encountering stagnating or even declining volumes in most developed countries. In the last three years alliances were entered between IOC and Mobil, HPCL and Exxon and BPCL and Shell in order to access the brands and technology of these global oil majors.

Coupled with increased competition the decontrol of petroleum products (base oil since March 1998) has also enabled Indian oil PSUs to tap the bazaar route. The bazaar route was pioneered by Castrol for selling products through auto mechanics, garages and spare part shops to bypass the control that PSUs exerted over petrol pumps. However with decontrol, oil PSUs too are now allowed to use the bazaar route (which was previously done through joint ventures). DV Ramkrishna, analyst, Birla Marlin Securities, says, "Castrol is in a fix as oil PSU can tap Castrol's distributional set up while Castrol cannot penetrate petrol stations." The argument seems logical but Castrol with a distribution setup of 18,000 retail outlets which is comparable to the 15,000 petrol stations in the country seems comfortable.

Besides Castrol enjoys 15-20 per cent premium over other brands and even other MNCs. But one major hitch for Castrol is that cheaper MNC brands would be available through bazaar route by virtue of which mechanics may switch to cheaper brands. This is already happening as is evident from the flat first half performance, says an analyst. Currently the bazaar route accounts for nearly 35 per cent of lubes sales. The share of petrol pumps is expected to decline from the present 65 per cent to 25-30 per cent as in international markets.

Will have to redefine its competence

In terms of price, Castrol commands a premium of 15 to nearly 50 per cent in some products. Though price wars are not a phenomenon in the lubricants industry, indirect wars have already started after the entry of MNCs by better incentives and discounts to stockists. Analysts argue, "Castrol's strategy of placing its products at a premium is aimed at giving higher margins to dealers. The margin for selling a single product of Castrol is equivalent to almost selling double the quantity of other brands." Ramkrishna adds, "Castrol could shift most of its production to the tax free Silvassa plant and gain tax benefits (till 2000) while in turn pass discounts and incentives to dealers."

While the above will help Castrol in the short term, but will not benefit in the medium term. Adds Ramkrishna, "Profits from lubes business contributed nearly 25 per cent of profits for oil PSUs. Secondly with decontrol of base oil, PSUs stand to gain due to integration. As such the lubes business would turn out to be a profit centre for them adding a thrust ."

With deregulation, the oil PSUs would be able to retain around Rs 2,000-3,000 per tonne being the difference between retention price for base oil and the import parity price which was hitherto reimbursed to the oil pool account. This would give the oil majors pricing flexibility in their lubricant operations and lead to a lowering of gross margins for the lubricant industry. Thus with decontrol, the industry structure is changed and competition itself is quite different.

To sum up, Castrol will not be able to post major growth in the coming years while its cost control will be a crucial parameter for profitability. Price increase will only be in tandem with inflation, ad spend will have to be beefed up further and margins will remain under pressure. The current slowdown has halved the industry growth rate to 3-4 per cent against 5.2 and 7.7 per cent in 1995-96 and 1996-97 respectively. The aggressive tussle for market shares has intensified competition. Though Castrol looks at comfortable levels at current prices, it is advisable to wait till third quarter results or full year performance before arriving at any conclusion.