Asian Paints- Timing mismatch in cost inflation and price increases: Kotak Sec

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Asian Paints (APNT)
Consumer products
Timing mismatch in cost inflation and price increases impact margins. 3FY11:
Positive surprise – 30% domestic volume growth; negative surprise – retail price stability
during a festival season hurting margins. While input cost inflation is starting to hurt
consumer companies now (palm oil for HUL and GCPL, copra for Marico, LLPO for
Marico and Dabur etc.), TiO2, a key input for paints has been inflationary through
CY2010 and paint industry has managed gross margins well. Channel checks suggest a
further 3% price increase by APNT to be implemented in early February 2011. Price
elasticity is not a tool for competition to improve market position, in our view. ADD.
Robust volume growth; margins disappoint on timing mismatch
APNT reported higher-than-expected standalone net sales of Rs17.5 bn (+37%, KIE Rs16.5 bn),
lower-than-expected EBITDA of Rs3 bn (+16%, KIE Rs3.2 bn) and PAT of Rs2.1 bn (+16%, KIE
Rs2.2 bn).
In our view, the volumes have likely grown ~30% during the quarter and pricing/mix witnessed
growth of 7%. Headline sales beat expectations due to (1) positive impact of seasonality – Diwali
in 3QFY11 versus 2QFY10 in base, (2) likely trade down-stocking in 2QFY11 and (3) higher
number of rainy days this year versus drought conditions last year impacting the demand
conditions in 2QFY11 and postponement of consumption to the current quarter.
Gross margins declined 390 bps to 40.5% as price increase of ~7% in 9MFY11 was lower than
input cost inflation. Moreover, timing mismatch between input cost inflation and price increases
have also likely hurt margins for the quarter, in our view. We note that the company typically
prefers price stability in the market during a festival season.
Key variables to watch
􀁠 Price elasticity is not a tool for competition. We continue to believe that (despite timing
mismatch in input cost inflation and price increases in the current quarter) price competition in
the industry is rational as competitors have realised that pricing is not a tool for consumer
recruitment. While paint is an MRP product, it is rarely sold at MRP (distributor offers varied
discounts to the painter/consumer).
􀁠 Potential increase in Cenvat in the Budget. We believe that the industry will likely pass on
the impact of higher Cenvat, if it is increased in the current Budget (to 12% from 10%).


􀁠 We highlight that while input cost inflation is starting to hurt consumer companies now
(palm oil for HUL and GCPL, copra for Marico, LLPO for Marico, Dabur etc.), titanium
dioxide, a key input for paints, has been inflationary since the beginning of CY2010. The
timing mismatch between input cost inflation and price increases in the current quarter
were an exception, in our view. Channel checks suggest a further 3% price increase
to be implemented by APNT in early February 2011.
􀁠 Continuing mix improvement. We highlight that APNT is witnessing a secular
improvement in mix (uptrading to emulsions) – emulsions are growing 2X growth rate of
other segments. This will likely cushion margins as emulsions have the highest per unit
realization and lower linkages to crude oil as key input
􀁠 Increasing focus on non decorative paints. To enhance presence in the non-decorative
paint segment, APNT and PPG Industries have decided to expand their existing 50:50 joint
venture and establish a new 50:50 joint venture. We view this as a significant positive as
it opens avenues for APNT to diversify its revenue stream (so far, APNT derived ~80% of
sales from decorative paints).
Reiterate ADD; retain TP at Rs3,000
We reiterate our ADD rating as the underlying demand conditions for paints continue to be
good and competition is still rational (as evidenced by price increase to defend gross margins
in 9MFY11). Our standalone EPS estimates are broadly maintained. We continue to believe
that there is upside risk to our EPS estimates for FY2012-13E as APNT could benefit from
supply chain savings due to the new distribution centers which it is building (apart from any
potential benefits due to implementation of GST).
Key risks include higher-than-expected impact of raw material costs due to higher crude
prices, significant slowdown in construction and housing demand and inability of the
company to effect adequate price increases.