Castrol India: Buy

Investors with a long-term perspective can buy the stock of Castrol India, a key player in the country's lubricant market. The steep fall in the share price in recent months has brought it to levels which seem to factor in most negatives.

Besides, good growth prospects with narrowing of the price premium with competition (which should aid the company's volumes), support our recommendation.

It also helps that Castrol India's dividend yields have been consistently handsome (between 3 and 4.5 per cent) and that it has negligible debt and formidable brand power.

After a rapid rise in the first half of 2011, the Castrol stock has taken a sharp knock over the past six months, falling around 26 per cent. This was mainly due to disappointing results posted by the company, especially in the September quarter.

High cost of base oil — the primary raw material — and loss of volumes due to price hikes taken by Castrol, but not its major competitors, led to the company's September quarter profits declining sharply both on a sequential and year-on-year basis.

At the current price of Rs 433, the stock has come full circle and trades around levels seen a year ago. Its trailing 12-month price-to-earnings ratio is around 22 times, lower than that of many players in the FMCG space, to which Castrol's business is comparable.

That said, the stock may continue to be under pressure in the near term, with rupee depreciation adding to the company's cost pressure and weighing in on its December quarter results.

This makes the buying opportunity suitable only for patient investors with a stomach for risk.

Price premium gap narrowing

Along with crude oil, the price of base oil — a derivative — also shot up in 2011, and was exacerbated by supply-side constraints. From around $1000 a tonne in the beginning of 2011, it increased to around $1,500 a tonne by the September quarter.

While Castrol India had taken price hikes in the early part of the year to mitigate the cost pressure, major competitors such as the public sector oil companies did not.

This led to widening of the price premium on Castrol's products over that of the competition, and resulted in the company losing out heavily on the volumes front.

In the September quarter, the company's volumes were only around 46 million litres, down from 56 million litres in the March 2011 quarter and 54 million litres in the June 2011 quarter.

The company's market share fell 2-3 percentage points to less than 20 per cent. The combination of high raw material cost and reduced volumes saw Castrol's September quarter revenues and profits dip 15 per cent and 33 per cent over the June quarter to Rs 672 crore and Rs 95 crore respectively.

The June quarter itself had shown only muted growth over the March quarter. Profitability also fell sharply, though it still remains healthy with operating margin at around 22 per cent.

However, towards the end of the September quarter, major players such as Indian Oil are reported to have taken good price hikes. This would have narrowed the price premium gap of Castrol's products.

This, along with the company's strong brand presence and marketing efforts on key influencers such as workshops and bazaar outlets, would have aided Castrol recoup some lost ground on volumes and market share.

Also, with crude oil price reducing somewhat, and supply constraints on base oil easing, the price of base oil has moderated. However, the sharp depreciation in the rupee in the December quarter would have added to the company's cost pressure, given that the bulk of its base oil requirement is imported and even the domestic purchase is priced at import-parity.

On the positive side, the recent strengthening of the rupee against the dollar, from 53-54 to 50 levels, if it sustains, would bode well for the company.

Economic uptick to benefit

With inflation in the country showing signs of easing and the focus returning to stimulating growth, a cut in interest rates is expected in the coming months.

This should accelerate growth in commercial and passenger vehicles, and aid Castrol's automotive segment which accounts for more than 80 per cent of its sales and profits. Also, the company's non-automotive segment which sells industrial lubricants would benefit from a revival in industrial and manufacturing activity. If the strong results of two-wheeler makers for the December quarter are any indication, good growth can be expected for Castrol in this key-focus area.

Other positives

Castrol benefits from strong parentage (BP) and has been consistently leveraging technology to provide premium products such as synthetic lubricants to derive better margins. Also, its financial position is quite strong with negligible debt on its books. Adding to the comfort is the company's healthy dividend paying track record, with dividend payouts of 140-250 per cent over the past few years.

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