Pick up in automotive demand, premium product mix and strong brand presence bode well for the prospects of Castrol India.

Anand Kalyanaraman

An automotive segment in high gear, premium product mix, and a formidable brand bode well for the prospects of Castrol India, a leading player in the lubricants market in the country. Also, the company has been consistently posting solid financials, and has a very high dividend-paying track record.

At its current price of Rs 419, the stock trades at around 22 times its trailing 12-month earnings. Yet, considering the FMCG-like nature of the company's business, there could be scope for further upside (majors in the category currently trade at around 30 times earnings). Also, while the company trades at a premium to private sector lubricant peers Tide Water Oil and Gulf Oil Corporation, this may be justified given its size and lead.

Though the stock has gained strongly over the past couple of years following a re-rating, investors with a high-risk perspective can consider taking advantage of the almost 21 per cent price decline since mid-September. The company's sequential performance in the September quarter (historically weaker) showed a dip, mainly due to input cost pressure. However, one swallow does not a summer make, and, going forward, we expect the company to be able to capitalise on its strong positioning and favourable industry dynamics.

Going strong

Over the years, Castrol India, a BP subsidiary, has strengthened its position, and enjoys more than 20 per cent market share in the automotive lubricants market, from which it derives more than 85 per cent of sales and profits. It has been able to hold its own in a highly competitive market, which is catered to by the PSU oil marketing companies, major multinationals, including Shell and Mobil, local players such as Tide Water Oil and Gulf Oil Corp, and a large unorganised sector. A broad-basing of its distribution network beyond the traditional fuel sale outlets to the ‘bazaar' route and OEM dealerships and workshops has helped Castrol expand its reach significantly.

Customer outreach initiatives such as Pit Stops, Bike Zones and Sanjeevani have helped reinforce the brand. Strong brand presence built over the years, and shifts in its product mix to cater to premium categories, has helped the company deliver robust performance. Despite decrease in volumes sold, the company's profits have grown strongly. Sales grew at an annual rate of around 13 per cent during the 2005-2009 period to Rs 2318 crore, while profits grew around 27 per cent to Rs 381 crore in the same period (the company follows the calendar year).

Castrol has also been active on the product innovation front. It has leveraged technology to offer a range of products, including high-performance synthetic lubricants, giving it an edge over competition. Strong pricing power has enabled the company, for the most part, to pass significant cost increases in base oil, its main raw material.

Historically, Castrol has adopted a strategy of effecting price hikes ahead of the cost curve, helping ring-fence its margins.

This along with a tight leash on costs has enabled the company maintain strong profitability, with operating margins in excess of 25 per cent and net margin around 18 per cent. Strong cash flows, zero debt, return on equity in excess of 75 per cent, and dividend payout ratios consistently above 70 per cent (translating into a yield of between 4 to 5 per cent) also make the company a solid franchise.

Auto charge

Castrol's automotive lube product range caters to commercial vehicles, passenger cars, and two- and three-wheelers. The segment registered robust performance with sales and profits growing 19 and 27 per cent y-o-y to Rs 1,766 crore and Rs 485 crore respectively during the nine months ending September 2010. Castrol is shifting focus from the truck segment (accounting for over half the segment's turnover) to the high-potential passenger car category. This segment is expected to see robust demand on the back of growing demand for personal mobility, attested by the strong performance of the auto sector last calendar.

With a host of recent launches, including that of affordable small cars, the lubricant market is set to benefit from both new and repeat demand. Castrol's tie-ups with leading OEMs should hold it in good stead. The company's increased thrust on rural areas should also help. While in the past, volumes sold have been declining in line with the profitability focus strategy, we expect this trend to reverse given the strong latent demand for the company's premium mix products.

The non-automotive segment (around 13 - 14 per cent of revenues and profits), which supplies industrial lubricants, has also seen good traction in the recent nine-month period, with sales and profits up by 20 per cent and 19 per cent respectively over the previous year to Rs 273 crore and Rs 79 crore. Pick-up in economic and manufacturing growth, which aided this rise, is expected to continue.

Risks

With crude oil price trending upwards, increase in cost of base oil (a key raw material), is a major risk. This could put pressure on margins; yet, with the company's pricing power, we expect margins to remain healthy .

With improving technology, drain intervals (recommended distance after which oil should be changed) for many vehicle types are on the rise. This could moderate replacement demand for lubricants. Competition in the lubes market may intensify, with PSUs getting aggressive on the distribution front. Castrol's positioning and brand, though, should help.

(This article was published in the Business Line print edition dated January 30, 2011)
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