The Hindu Business Line : Pidilite: Buy

AN INVESTMENT can be considered in the Pidilite stock (Rs 87). At this price, the stock commands a price-earnings (P-E) multiple of about 20 times its expected per share earnings for FY-06. The valuation level is demanding, but in the context of the growth prospects, it does not appear unreasonable either. Incidentally, the mark-up in valuation is also a more recent phenomenon. After having traded historically in a P-E band of 13-15 times forward earnings, the expansion in valuation indicates a sharp re-rating of the stock.

The stock had a stellar 2005, when it notched significant gains. Though the stock has quadrupled since the time we initiated coverage three years ago, we believe there is more headroom on the upside. Investors, however, would be better off moderating their return expectations from the current price level.

Some of Pidilite's brands — Fevicol, M-Seal and Dr Fixit — are household names in the consumer market. The consumer products segment accounts for a lion's share of revenue (70 per cent of sales) and the industrial chemicals division chips in with the rest.

Growth in the first half of this fiscal was strong, with revenues and earnings rising by 20 per cent and 35 per cent respectively. We expect the strength to continue; with the economy displaying robustness and the attendant boom in housing, products of Pidilite in the construction chemicals and adhesive business should be indirect beneficiaries. Earnings will also likely get a leg-up from the four units that Pidilite is commissioning in the tax haven of Baddi in Himachal Pradesh.

Operating margins have also shown an improving trend. For the half-year ended September 2005, margins, at 19.3 per cent, were up 50 basis points on year-on-year basis. That this improvement should have taken place even when raw material costs accounted for a higher proportion of sales (on a year-on-year basis) suggests that Pidilite has been able to rein-in other cost heads.

Raw material costs play a crucial role in determining the health of margins, as they account for 40-45 per cent of sales. A key input for Pidilite is vinyl acetate monomer (VAM), a derivative of crude oil. Rising prices of crude oil have a cascading effect on VAM, which, in turn, hurts margins. Though 2005 saw crude oil prices touch historic highs, Pidilite appears to have been relatively unscathed by its effects, if the margin picture is an indicator.

The other aspect that works in Pidilite's favour is that its portfolio is stacked with a formidable array of brands. The principal advantage of such a product basket is that when the company is confronted with a situation of rising input costs, it has the ability to pass on such rises — in the form of price hikes — to the end consumer without an adverse impact on both market share and margins. Should there be an escalation in input costs on the back of firm trends in the prices of crude — a key risk to our call — we believe Pidilite may attempt to mitigate its impact, to a certain extent, by raising prices.

In the industrial chemicals segment, the competition is intense and this is manifest in margins of this business being considerably lower than the consumer products business. With global players eyeing this segment, margins are not likely to show a marked improvement. Further, this division also reports a return on capital employed that is significantly lower than that of the consumer business.

For long, there has also been talk of Pidilite divesting its interests in the industrial chemicals division. Should this happen, we believe it would be a positive for the stock, as it would then free up resources that can be invested more productively in the consumer business.

Consequent to such an exercise, Pidilite may also command a higher multiple, as it would be reckoned as a pure FMCG play.

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