Longer-term story intact but
near-term headwinds on rawmaterial
and elastomer persist
Action/Valuation: Cut to Neutral; don’t see upside from current levels
We downgrade Pidilite to Neutral, as we believe the stock is now in a fair
value zone after its recent outperformance although concerns over raw
material prices and the elastomer project still persist. We continue to
derive our target price based on a P/E multiple of 17.5x on FY14F adj EPS
of INR9.66 (we have scaled back our FY14F estimate by ~3%).
Increasing VAM price and depreciating INR suggest margin pressure
We expect VAM prices to remain high, backed by strong demand for
ethylene (a key raw material for VAM) and high crude oil prices (Nomura
forecasts per barrel to average USD110 in FY13F and USD105 in FY14F
vs ~USD98 in FY12. Since VAM is imported, depreciation of the rupee vs
the US dollar would further add to raw material headwinds for Pidilite.
Slowing demand in domestic market & export to limit price increase
We expect moderating growth in consumer & bazaar (C&B) on slowing
new construction and industrial products, reflected in weak IIP numbers, to
constrain Pidilite’s ability to pass on rising raw material costs. For FY13F,
we build in margin declines in the C&B and industrial-product divisions.
Overseas subsidiaries performance remains a concern
Overseas subsidiaries (especially Brazil and the Middle East) continue to
be a drag on group performance.
Catalyst: Outcome on the progress of the elastomer project, which is
currently on hold, should remove an overhang on the stock’s
multiple
Raw material headwinds, as we expect higher VAM prices to
continue
Vinyl acetate monomer (VAM) is a key raw material for Pidilite. As shown below, VAM
prices dropped steadily in 2011 but started to increase from January 2012. Since Pidilite
maintains raw material inventory for 30-40 days, we believe the increase in VAM prices
in February-March 2012 will have an adverse impact on its margin in 1QFY12.
While management is suggesting a decline in VAM prices by USD50-100/tonne given
that Ethylene prices (raw material for VAM) have declined in the past two months, our
analysis indicates that ethylene prices will likely strengthen in FY13F-14F. Our analysis
is based on demand trends for ethylene (shown below) and Nomura’s view on crude
prices to which ethylene prices are strongly correlated with.
As per our interaction with Nomura’s European chemicals team, the increase in ethylene
prices during January-March 2012 was not completely passed on by VAM
manufacturers, thereby impacting their margins. Ethylene prices have fallen over the
past two months on uncertainty over crude oil prices, so buyers are waiting for ethylene
prices to fall further. Hence, even though ethylene prices fell in April-May 2012, VAM
prices have remained at high levels during this period, as shown below. As such,
although we believe that ethylene prices may fall in the near term, we believe VAM
prices will continue remain at current high levels.
We believe high crude oil prices will keep ethylene prices and thus VAM prices at
elevated levels.
We expect global demand for ethylene (the most important raw material for VAM) to be
strong and post a CAGR of ~4.6% over CY11-14F. Increased oil prices and increased
demand for ethylene will likely lead to higher ethylene prices and thus, stronger VAM
prices over FY13F-14F, in our view.
Pidilite imports (USD denominated) its entire VAM requirement, which means that the
impact of a depreciating rupee will further add to the raw material headwinds. The rupee
is at a 20-year low versus the US dollar, as shown in the chart above.
Will the proposed price increase in 1QFY12 enough to offset
margin pressure in the current demand backdrop?
Pidilite, at its 1QFY12 conference call, indicated that it planned to hike prices in 1QFY12
in order to pass on the rise in raw material prices. With growth moderating, we believe
taking enough price increases to offset the raw material headwinds may not be easy.
While it is relatively easier to hike prices in the C&B segment as this is consumer-facing,
it is more difficult to hike prices in the industrial-product business, which is a B2B
business. As shown in the diagram below, revenue growth has moderated in C&B (which
is linked to new construction, or discretionary expense such as furniture apart from the
repair-and-maintenance segment) and in the industrial-product business. In an
inflationary environment, slowing consumer discretionary spending, limited new
residential construction in India, a slowing export market and falling IIP will, in our view,
constrain Pidilite’s ability to hike prices, especially in the industrial-product business.
Pidilite reported top-line growth of ~4.1% in 4QFY12 against -1.8% in 3QFY12, due to
re-stocking in Q4 vs de-stocking in Q3. For FY13F, we have reduced our margin
estimates by 150bps for the C&B division. For the industrial-product business, we reduce
our margin estimates by 450 bps for FY13F and by 150 bps for FY14F.
No outcome yet on the elastomer project
Pidilite has so far (starting 2007) incurred a capex of~ INR3.55bn to build an elastomer
project in Dahej to manufacture Polycholoroprene. The project has already been delayed
once from March 2010 to FY13 because of the economic crisis and it continues to be “on
hold” currently. This project is “under review” as the company has appointed a consultant
to assess the prospects of the project. The final outcome, originally expected in 3QFY12
as mentioned at the 2QFY12 result conference call, was delayed again with no concrete
outcome disclosed in 4QFY12. According to management, after the consultant submitted
the report, the company board members wanted a further review of some aspects of the
project.
We remain of the view that it is better for Pidilite to shelve the project than to continue
pursuing it. Please see our detailed analysis published on 29th Nov 2011 in our report
“Risks outweigh rewards, concerns around the elastomer project”
Performance of overseas subsidiaries continues to be below
par
Pidilite has 14 overseas subsidiaries. Weak demand in the international markets,
particularly in Brazil, has lead to muted performance of the overseas subsidiaries and
export for the domestic business. The company is currently facing tough macro and
aggressive competition in Brazil (South America). The fact that it is not a market leader
in Brazil (Pidilite is a clear market leader in India in the adhesive business with products
such as Fevicol having a 70% market share, according to management) further
aggravates the situation in a market where competitors are focussed on gaining market
share over profitability.
In 4QFY12, total overseas subsidiaries sales declined by ~3.3% while South America
reported a loss of USD64mn at the EBITDA level, mainly due to weak performance in
Brazil. As shown below, Pidilite continued to post a loss (albeit lower than FY12) in the
Middle East at the operating level. The company took a provision of INR250mn (FY11) in
its investment in Pidilite Middle East. This was on account of continued
underperformance of Jupiter Chemicals (Dubai), a subsidiary of Pidilite Middle East.
Pidilite took a further provision of INR29mn in FY12 for a similar reason.
Investment Risks
Key upside risks to our view can emanate from:
1. Possible divestment of the elastomer project at a reasonable price, which may
re-rate the stock.
2. Significant decline in Vinyl Acetate Monomer (VAM) prices, which would be a
deviation from our current assumption of continued strength in the VAM prices.
3. Reversal in the macro –economic backdrop in India which results in
improvement in consumer sentiment.
Key downside risks to our view:
1. The company decides to invest further in the elastomer project, which in our
view could lead to a de-rating of the stock.
2. Further deterioration in the consumer sentiment and new–residential activity in
India, which could lead to lower-than-expected growth, especially in the C&B
(Consumer and Bazaar) segment.
3. Significant increase in VAM prices, which is higher than our current
assumption.
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