Stock Review: Asian Paints

 

Industry dynamics

As a rule of thumb, the paint industry in India grows at about 1.5 to two times the GDP growth rate. So if the Indian economy clocks a growth rate of 7-8 per cent (conservative estimate) in FY12, the paint industry's revenues should grow at around 11-16 per cent. About 65 per cent market share is with the organised sector, and 35 per cent with the unorganised sector. The paint industry caters to two major segments: decorative and industrial. Decorative paints account for 75 per cent of revenue whereas industrial paints account for 25. The top four players in the industry are Asian Paints, Kansai Nerolac, Berger Paints and Akzo Nobel.

Demand in the decorative segment is driven by growth in housing and by re-painting needs. With housing shortage in India estimated at between 25 to 70 million, the growth potential is immense. As more people join the middle class, disposable incomes rise, and aesthetic tastes improve, demand is expected to shift progressively towards higher-end paints, boosting paint companies' margins.

Penetration in semi-urban and rural markets remains low. The major growth opportunities in future will come from these markets. Here, demand is influenced by the monsoons, which determine agricultural output, and hence the demand for paints. Sales of this industry are particularly high in the post-monsoon festive season.

Industrial demand is driven primarily by industries such as automobiles, consumer durables, the infrastructure segment, and industry. Margins in the decorative segment are higher than in the industrial segment. In future, growth will also come from the organised sector gaining market share at the expense of the unorganised sector.

 

Sources of economic moat

Asian Paints derives its economic moat primarily from branding and from its distribution network.

Strong brands. Sustained and clever advertising over the years has led to the highest recall for Asian Paints' brands, which in turn has translated into strong volume growth. The company spends around 4 per cent of its sales (amounting to around Rs288 crore) annually on advertising, which is way ahead of its competitors' ad spends. The company dominates different market segments because it has been proactive in launching and establishing its brands across segments. In both enamel and emulsion paints, it offers economy to premium range products. So even when customers upgrade, they are able to move from one Asian Paints brand to another. In fact, such upgradation has helped the company improve its margins in recent times.
Strong dealer network. Within the Indian paint industry, Asian Paints has the biggest network of dealers (especially in semi-urban and rural areas) with access to over 15,000 outlets. The company plans to add 1,500 to 2,000 dealers every year.

In an industry that was traditionally dominated by multinationals, Asian Paints' dominance is largely the result of distribution excellence. When it entered the field, paint distribution was dominated by wholesale distributors who distributed the products of multinational players and would not allow a toehold to new entrants. Asian Paints chose to bypass this network and went directly to retailers. It also decided to create a much larger distribution infrastructure than the competition (which was confined to the bigger towns), even though this would be a challenging proposition. Not only did this strategy win it market leadership, it has also helped the company sustain it till date.

 

What could cause moat to be breached

 

Competition in recent times has been benign and analysts expect Asian Paints to maintain its lead in the near to medium term. One recent development that could pose a threat is Akzo Nobel's entry into India (it took over ICI). It has brought a number of products from its global portfolio to India and introduced them under the Dulux brand name. It has also brought in the latest technology and is trying to enhance its distribution network.

 

Growth drivers

Decorative business. The massive mismatch between demand and supply for housing and rising levels of discretionary spending are some of the factors expected to drive the company's revenue growth in the decorative segment. High growth in housing over the last five years will also augment demand due to re-painting needs.

Industrial paints business. Asian Paints' joint venture with PPG Industries of the US has enabled it to cater to a large number of automotive clients in India (especially those that were already PPG's clients in the US). Technology support from PPG has also enhanced the company's strengths in the industrial segment.

International business. The company is already the largest player in 10 of the international markets in which it operates. The acquisition of Berger International of Singapore (in 2002) gave Asian Paints access to a number of fast-growing brands and geographies. The company is already the leader in Egypt and the Caribbean region. It is among the top three players in Bahrain and Dubai, and is consolidating its position in Nepal and Bangladesh.
Capacity addition. The company has been investing heavily on capacity addition in order to take advantage of the opportunities before it. In FY11 it spent Rs 150 crore on capex. In FY12 it will initiate work on a plant near Khandala, Maharashtra that will have a capacity of 4 lakh million tonnes. This capacity will get commissioned by the fourth quarter of FY12. This financial year its total capex on the domestic business is expected to amount to Rs 900 crore.

 

Risks and concerns

Pressure from high raw material prices. During FY11 Asian Paints' raw material costs increased 18 per cent. Prices of major raw materials are expected to remain firm in FY12 as well. What remains to be seen is how much they will escalate from current levels during the year.

In FY11, the company raised the prices of its final products by about 12 per cent. If raw material prices continue to rise, forcing the company to raise prices further, it could lead to moderation in volume growth. And if it doesn't raise prices, its margins could get compressed.

Since crude derivatives account for a large percentage of raw material costs, crude's high price has raised the company's input costs. The price of titanium dioxide, another key raw material, has risen due to supply constraints internationally, and this is expected to ease only by 2013 once new capacity gets added.

Slowdown in volume growth. In FY10 and FY11 the company witnessed volume growth of more than 20 per cent. Analysts at Equirus Securities expect growth to slow down to around 15 per cent in FY12 owing to various factors. One, high inflation could dent consumers' spending power. Two, as said earlier, higher raw material costs could lead to further price hikes, which could in turn affect volume growth. And three, the high base of the recent past could also lead to some moderation.

Slow growth from international markets. The turmoil in the Middle East will affect the company's revenue growth (this region contributes the maximum to international revenues). The Caribbean market (the second-highest contributor) has also shown slow growth in recent quarters.

Operating margins in the international markets are lower than in the domestic market. If raw material prices rise further in FY12, margins in the international markets could get compressed further.

 

 

Valuation

The stock is currently trading at a 12-month trailing PE of 36.69, which is higher than its five-year median PE of 29.22. Over the last five years the company's earnings per share (EPS) has grown at a CAGR of 32.93 per cent. Currently the company is trading at a price-earnings to growth (PEG) ratio of 1.14, which is rather high (a level below one is considered appropriate). Keep a close watch on the stock's valuation and buy on correction.