Stock Review: Pidilite Industries

 

Pidilite Industries is a leading manufacturer of speciality chemicals in India. It produces adhesives, sealants, construction and paint chemicals, automotive chemicals, art materials, industrial adhesives, industrial and textile resins, and organic pigments and preparations. The company's major brands include Fevicol, Fevikwik, and Dr. Fixit. It currently exports to more than 80 countries and has 14 overseas subsidiaries. Moreover, it has significant manufacturing and sales operations in USA, Brazil, Thailand, Singapore, Bangladesh, Egypt and Dubai.

 

Sources of moat

Focus on brand creation. The company focuses on creating brands even in low-involvement categories where end-customer engagement is low or nil. All over the world there is very little branding in products such as adhesives and sealants. But Pidilite has increased brand awareness through advertising and also by educating users like carpenters, plumbers, and civil contractors. It promotes Fevicol among carpenters, and M-Seal and Dr. Fixit among plumbers. It educates construction workers about the benefits of using its Roff tile-fixing solutions. It also conducts training classes for carpenters and water-proofing workers at its in-house Dr. Fixit Institute.

Strong sub-segmentation strategy. The company has developed a large suite of products to cater to different sub-segments. For instance, it has different adhesives for product categories such as furniture, paper, marine products and crockery. Each adhesive has different characteristics and targets different categories of customers. Strong distribution network. Pidilite has developed a strong and diversified distribution network for its wide-ranging product suite. It sells its products through stationery, hardware, kirana, medical and furniture stores. It also sells some of its products directly to end consumers. Operating through such varied distribution channels has helped it augment its sales.

Targeting niches. The company has avoided launching products in highly competitive or well-penetrated segments. Instead it has targeted niche sub-segments like adhesives and sealants where competition is limited. In these sub-segments, it has developed strong market-leading brands such as Fevicol, Dr. Fixit, and M-Seal. Its products enjoy as high as 80 per cent market share in these niche segments. In adhesives, a mature product category, Fevicol commands more than 50 per cent market share in all regions.

No major competitor in sub-segments. In these niche sub-segments the company's competition is comprised of mostly local players who lack the managerial acumen and financial strength to build major brands. These players also lack the resources to invest in research and development. Hence, they have conceded market leadership to Pidilite.

3M (previously Minnesota Mining & Manufacturing Company), Henkel and AkzoNobel are the major global producers of adhesives. However, they cater to institutions and do not have branded products for retail.

Innovative products for niches. The company has developed products for new sub-segments that were non-existent earlier. It has created brands such as M-Seal to stop leakages in pipes (whereas earlier pipes were replaced when they began to leak). Also, it has created adhesives to fix broken tiles, whereas earlier such tiles were discarded altogether. Its products for mending crockery and utensils have also created new sub-segments.

Strong pricing power. The company has strong pricing power in all the sub-segments that it operates in. Hence it is able to pass on higher raw material costs to end customers. At the national level, Pidilite is the price-setter in roughly 65-70 per cent of its revenue pie.

 

What could cause moat to be breached

As mentioned above, the company is the market leader in adhesives and sealants. Its strong brands, pricing power and the absence of any major competitor in these segments make it unlikely that its moat will be breached in the near future.

However, construction speciality chemicals are generally not do-it yourself products and require end-to-end integrated services. The key to leadership in this category is to acquire new technologies that address the needs of Indian consumers (water-proofing, damp-proofing, etc.). Only by doing so continuously will Pidilite be able to maintain its economic moat.

 

Growth drivers

Changing revenue mix. The company's revenue mix is shifting in favour of consumer products, whose share had increased to 79 per cent of sales in FY10 compared to 70 per cent in FY01. With the revenue mix changing towards higher-margin sub-segments, the company's overall margins are expected to expand in future.

Growing demand. The demand for fast moving consumer goods is growing rapidly in semi-urban and rural centres on account of rising income levels. The company is well-placed to tap this opportunity owing to its elaborate countrywide distribution network.

 

Concerns

Uncertainty around Elastomer project. In June 2007, the company acquired the plant and machinery, patents and technology of a synthetic Elastomer (polycholoroprene rubber) facility. It was earlier expected to commence commercial production in March 2010, and its production capacity was estimated at 25,000 TPA. Due to slowdown in global industrial demand, the company went slow on the project. It had earlier indicated that once it chose to commence work in full swing, time to commissioning would be around 18 months. It had also indicated that the project would entail a further capex of Rs 250 crore (Rs 260 crore has already been spent).

Now the date for commissioning of the Elastomer project has been pushed forward to FY12 with an incremental capex of Rs 150 crore (a reduction of Rs 100 crore) plus working-capital deployments.

With Rs 260 crore invested, no visibility yet on commissioning, and further investment requirement of Rs 150 crore billion, this project poses a risk to the company's future earnings.

Ongoing business risks. The industrial pigments business is cyclical in nature and could pass through periods of unprofitability if inventories or capacities run high. In adhesives, margins are likely to erode over time as it is now a mature market. In art products, competition is strong. In construction chemicals, managing the quality of services and solutions as it scales up rapidly will be a challenge.

Raw-material price risk. The company has done backward integration for its key raw material VAM (vinyl acetate monomer) and now has a hedging mechanism in place for the raw materials that it imports. But in case of sharp fluctuations in foreign-exchange rates, similar to that in FY09, some impact on profitability cannot be ruled out.

 

Financials

The company has notched up strong return numbers. Over the last five years it has registered a compounded annual growth rate (CAGR) of 23.62 per cent in total income and 29.07 per cent in profit after tax. Moreover, the five-year average of its profitability ratios such as return on capital employed and return on net worth is 25.34 per cent and 27.83 per cent respectively.
The company also has a low debt-equity ratio, currently at 0.31 times (FY11). In FY11, its free cash flow stood at Rs 339 crore.

Its operating profit margin decreased by 0.2 percentage points in FY11 compared to FY10 while net profit margin down by 0.7 percentage points over the same period.

 

Valuation

The stock is trading at a price to earnings (P/E) ratio of 27.11(as on September 2, 2011). This is higher than its five-year median P/E of 21.96. The company has registered a five-year CAGR in earnings per share (EPS) of 29.25 per cent which translates into a price-earnings to growth (PEG) ratio of 0.92 times.

Investors may invest in this stock on declines with at least a three-year investment horizon.