Paint inventories may soon feel the heat with rising raw material costs and increased competition

Paint businesses experienced a strong recovery in the first quarter of fiscal 2021 (FY21). Listed companies like Asian Paints, Kansai Nerolac and Berger posted volume growth in excess of 90 percent, along with similar value growth.

Suppressed demand, a strong recovery in demand and a weak base contributed to the strong sales growth. The recovery in the paint industry came as a positive surprise to investors, as the industry relies heavily on discretionary spending for growth.

Margins compression

But, the increase in the prices of raw materials, especially the prices of crude oil, could negatively affect the margins of paint companies. In the past, paint companies have experienced margin squeeze during periods of high inflation.

In order to maintain their margins, the paint companies raised their prices, but the price increases could not compensate for the inflation of raw materials.

According to a research report on Asian Paints by HDFC Securities, paint companies’ price increases may not be proportional to rising raw material costs, leading to pressure on margins.

According to the report, “the price increases (3% in the first quarter / 1% in July 2021) remain beyond measure. vis à vis the high inflation of RM (raw materials) (21 to 25% over the last six months).

For Asian Paints, gross margins fell from around 45% to 39% quarter on quarter, due to higher raw material costs.

“Materials prices have experienced high inflation since the third quarter of fiscal year 20-21. The fourth quarter of FY21 saw inflation of about 8-10% from the previous quarter, and materials prices experienced further inflation of 13-15% in the first quarter of FY22. Price increases implemented in all companies offset only part of this impact, ”the company said in its presentation to investors.

Other companies in the industry have reported a similar drop in gross margins.

Increasing competition

One obstacle to the increase in prices is the strong competition in the industry. With several organized and unorganized actors, the painting sector is already quite crowded.

Despite the competition, companies like Asian Paints, Nerolac and Berger have managed to generate high returns on invested capital with a strong focus on distribution and brand building.

While the cost of setting up a manufacturing plant is not high, the expense of distribution, advertising, and brand development acts as a deterrent to new entrants.

The high yields have attracted several new players like JSW Paints and Grasim. Both are well-funded competitors looking to expand into the paint business.

JSW has been in the paint business for some time, but its original focus was industrial paints. Now JSW is looking to enter the decorative paints segment, where Asian, Berger and Nerolac paints dominate.

As for Grasim, the company already operates in the construction field through UltraTech and has built an extensive distribution network. Grasim is expected to leverage its existing network and establish a strong presence in the paint industry.

Expensive evaluations

Despite the negative potentials, paint stocks continue to trade at high valuations. Asian Paints’ price-to-earnings (PE) ratio is approximately 83.

Berger Paints’ PE ratio is 90. Likewise, Kansai Nerolac has a PE ratio of around 55. To put this in perspective, Nifty’s long-term average PE ratio is 20. The high PE ratio implies that investors expect business sales and profits. to continue to grow at a rapid rate.

But, profitability could be threatened with new competitors in the space and higher raw material costs. Some brokerage firms have also put forward the idea that the paints industry may not be as under-penetrated as one might think, which explains the moderate growth rate in recent years.

High valuations usually only hold up if companies show high growth. If the business is unable to grow quickly, the stock either falls or stagnates until profits catch up.

Several brokerage firms have recommended that investors sell or hold because of the high valuations. In the past year, out of 29 broker reports, 16 recommended a sale / hold on Asian Paints, according to data provided by Trendlyne.

Berger Paints has also received several sell ratings due to its valuations, which are higher than those of the market leader. While the paints business has generated strong returns for investors, rising commodity prices combined with increased competition could reduce profitability.

Additionally, markets expect high growth rates from the sector, and any disappointment on this front would translate into low or negative returns for investors.

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