The Hindu Business Line : Paint stocks take on a richer hue

IT may not boast the visibility of information technology services or the interest associated with a high-growth sector such as retailing, but the paint industry has proved it is certainly not trailing behind in delivering returns to shareholders. Paint companies have not quite set investor imagination on fire in the current bull market frenzy, though they have been busy posting index-busting returns over the past year.

There is certain solidity about the performance of key players such as Asian Paints, Goodlass Nerolac and Berger Paints that appears to suggest that the good times may last awhile. That these players are bullish on the sector's prospects is evident from their capacity expansion plans: Asian Paints has commissioned a new facility at Sriperumbudur, near Chennai, and is contemplating two more units at Taloja (Maharashtra) and Baddi (Himachal Pradesh).

Goodlass, too, has kick-started operations from its new facility in Haryana. Berger, in association with Nippon Bee Chemicals, intends to set up a new plant at Gurgaon, in addition to the unit it put up in Jammu recently.

A look at some of the factors that have brightened up the sector in recent times:

Higher growth is likely in the decorative paints segment driven by the construction boom.

Boom in housing: With the decorative segment accounting for about 75 per cent of the Indian paint market (estimated at close to Rs 8,000 crore), the performance of the sector hinges on the demand from this category. And if one were to use disbursement of housing finance companies as an index for housing demand and, by extension, that for decorative paints, paint companieshave every reason to cheer.

Though the step-up in housing loan disbursals will benefit the players only after some time, the growing demand for housing will positively impact companies that derive a significant portion of their revenues from the decorative segments, such as Asian Paints and Berger.

Accelerating demand — the cars story: Close to 50 per cent of the demand for industrial paints comes from the automotive sector. A sharp spike in the fortunes of this segment, especially in 2003 and 2004, led to a re-rating of Goodlass Nerolac, a dominant player in this category.

While the auto industry may struggle to replicate the scorching pace of growth of the last two years, the powering ahead of such majors as Maruti and Hyundai this fiscal indicates that there is some steam left in the passenger car segment. With companies adding new models and new entrants coming in, paint-makers can look forward to increasing opportunities.

Industry-linked growth: The other half of the demand from the industrial segment is driven by demand for protective coatings, powder coatings and special applications. With a swathe of companies across Corporate India announcing significant manufacturing expansion plans, the demand for industrial paints is soaring. Likewise, a fairly healthy demand growth in consumer durables has given the paint industry a fillip.

Benign interest rate regime: A key driver of the surge in demand for housing as well as for passenger cars is the benign interest rate environment. Confined as they have been to the 7-9 per cent band (depending on whether the loan is floating or fixed), interest rates have played a pivotal role in ensuring that a dream home or that sought-after car remains affordable. While there may be some upward adjustment in interest rates in the near term, it may not be of an order that will dramatically affect the demand for housing or two/four-wheelers.

The fading out of seasonality: About 65 per cent of the demand for decorative paints stems from repainting. Till the recent past, this activity usually preceded the festival season culminating in Deepavali. Now, with rising aspirational levels, coupled with a shift in the perception of paints as having a protective value rather than a mere decorative, the use of paints may well be through the year. This will smoothen out the ups and downs and lend a greater stability to the earnings stream of companies.

Reduction in peak duties: The industry has been a beneficiary of the progressive lowering of import duties. From 30 per cent in early 2003, the peak import duty has halved. A key input for the paint industry is titanium dioxide, much of which is imported. The import duty cut has also enabled the industry counterbalance, to an extent, the rise in the prices of such inputs whose prices are linked to that of crude oil.

Another consequence of this duty reduction is that it has enabled frontline players compete aggressively with the unorganised sector.

Favourable demand environment: A combination of all these factors has set the stage for a secular growth in demand trends.

Unlike in the past, when a feeble demand environment and the spectre of rising input costs had the sector in a bind, the current milieu permits the players to pass on cost increases to the end-user, without the fear of a demand backlash.

Market leader Asian Paints put through two price hikes the last calendar and one this year. Should input costs show an escalating trend, do not expect paint majors to shy away from another price hike.

Admittedly, such hikes are comparatively easier to push through in the decoratives segment, as opposed to the industrial category.

Incidentally, players such as Asian Paints and Goodlass are also stepping up the focus on branding, the idea being that creating strong brands will render their demand impervious to price increases.

Potential pitfalls

With a clutch of such positives, the future does appear rosy for the paint industry. But a few concerns do remain, which may well take the sheen off the industry's growth picture.

Input costs: With raw material costs accounting for close to 60 per cent of revenues, their importance to maintaining operating margins cannot be emphasised enough.

Though crude oil prices are showing signs of stabilising, having risen sharply in the aftermath of Hurricane Katrina, the impact on the industry was cushioned by the lower import duty rate and, importantly, an appreciating rupee that makes imports less expensive.

However, with the rupee now showing signs of moving in the opposite direction vis-à-vis the dollar, input cost pressures could be back again, impacting earnings of key players.

Another development that bears a watch would be the supply situation of crucial inputs, especially as a few key producers in the US have temporarily shut down facilities after the recent hurricanes.

A tightening of supplies could lead to a further hardening of input costs. Against this backdrop, an escalation in crude prices can only precipitate the problems for paint manufacturers.

Fuel prices: Rising crude prices may spell good times for ONGC and its shareholders, but not for those dependent on gasoline for transportation needs.

If petrol and diesel prices are constantly readjusted to align with rising crude prices, passenger car sales may slip by a gear or two, as prospective customers may defer or avoid purchase decisions.

Goodlass, a key player addressing this segment, would be affected by such a slowdown.

Bright spots

FROM an industry standpoint, though the demand side of the equation inspires confidence, the supply situation would appear to be more delicately poised.

We believe that the decoratives space would show strength compared to the industrial segment, as growth in the latter may be capped by a combination of a high base effect of the earlier year and the limited pricing power. Within the sector, Asian Paints continues to be our preferred play, driven as it is by a combination of well-known brands, strength in distribution and superior operational metrics vis-à-vis its peers.

Berger is our next choice, as its valuation, at about 15 times its expected per-share earnings for the current fiscal, makes it attractive compared to its peer set.

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