Stock Review: Castrol India

Castrol's scrip has been underperforming broader markets since mid September last year as a result of rising input costs, which have put pressure on its margins. Although in the December 2010 quarter, margins were higher on a year-on-year basis, these were much lower on a sequential basis. This indicates that Castrol hasn't been able to fully absorb the cost pressures. Not surprisingly then that after the December quarter results, its stock continues to underperform broader markets – it has fallen by a little less than three per cent, as against a 0.4 per cent loss on the Sensex. Analysts estimate that firm input prices would result in a drop in profit margins in 2011 calendar year. And, with volume growth also seen moderating, they expect these factors to weigh on the stock's performance, unless crude oil prices ease substantially.

Margins at peak

A look at the annual numbers of Castrol reflects robust performance. While sales grew at 19 per cent, net profits grew even faster, at 24.8 per cent, aided by strong operating margins of 27.8 per cent — the best-ever in the company's history. Castrol was able to shrink costs (employee cost down 8 per cent and other expenses by 3 per cent) coupled with a shift in its product mix towards high profitability products like synthetic oil-based lubricants, which aided this margin expansion. However, rising crude oil prices pushed up raw material costs (as a per cent of sales) to 50.6 per cent, compared to 48.5 per cent in 2009 calendar year, offsetting part of these gains. Also, advertisement expenses grew by only 9 per cent over 2009 to Rs 162 crore, led by its sponsorship of the FIFA and ICC world cups. Volume growth of 7per cent was driven by higher traction witnessed in both the segments, namely automotive and industrial.

However, the trend in quarterly numbers reflects a somewhat different picture. While margins were up on a year-on-year basis, data from Capitaline show that PBIDT margins have been on a decline in the last few quarters — down from 31.4 per cent in June quarter to 23.8 per cent in December quarter. Higher raw material costs (mainly base oil, acrude oil derivative) are among key reasons for the margin pressure. For a $25-per-tonne rise in base oil prices, Castrol's EPS is expected to be impacted by 3per cent, say analysts.

Outlook

Castrol took price increases of 7-8 per cent in mid-December, leading to a 13 per cent rise in realisations to Rs 129.8 per litre for the December quarter — volume growth was largely muted. While the company hopes that it will be able to mitigate the cost pressure through various initiatives, including price rise, analysts expect Castrol's realisations to rise 6 per cent and 1 per cent for 2011 and 2012, respectively, and margins to slip by 100-110 basis points in 2011. Modest volume growth (2-3 per cent) and lower margins are among key analysts' concerns and should weigh on the stock in the near term.

At Rs 403.10, the stock is trading at almost 18 times its 2011 earnings, which is at the higher end of its historical P/E band of 14-18 times.