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Castrol: On a weak operating turf… - Views on News from Equitymaster

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Castrol: On a weak operating turf…
Jan 23, 2007

Introduction to results
Castrol, the automotive lubricants major, has declared its results for fourth quarter and year ended December 2006. Topline and bottomline registered a growth of 26% YoY and 20% YoY respectively during 4QCY06. While the improved performance could be attributed to increase in prices of lubes, operating profits and bottomline have also received a boost due to lower advertising expenditure by the company in the quarter. If one is to exclude the impact of the reduced advertising expenses, the bottomline for the quarter would have declined by as much as 36% YoY. For the year ended December 2006, topline registered a growth of 23% YoY and bottomline registered a growth of 5% YoY. Subdued bottomline growth could be attributed to higher price of base oil and additives coupled with increased cost of packaging. During the year, company had sold its building and excluding the extraordinary income from the same, the bottomline would have fallen by 5% YoY.

Financial snapshot…
(Rs m) 4QCY05 4QCY06 Change CY05 CY06 Change
Net sales 3811.6 4,805 26% 14,304 17,524 23%
Expenditure 3441.2 4,094 19% 12,187 15,324 26%
Operating profit(EBDITA) 370.4 711.3 92% 2,116.8 2,199.8 4%
EBDITA margins(%) 9.7% 14.8%   14.8% 12.6%  
Other income 82 48 -41% 201 189 -6%
Interest expenses 5 22 370% 30 41 37%
Depreciation 34 47 37% 181 180 -1%
Profit before tax 413.1 690.6 67% 2,106 2,168 3%
Extraordinary income - - 0% - 154  
Tax 96 310 224% 638 777.5 22%
Profit after Tax 318 381 20% 1,468 1,545 5%
Net profit margin(%) 8.3% 7.9%   10.3% 8.8%  
No.of shares(m) 123.6 123.6   123.6 123.6  
Diluted earnings per share* 2.57 3.08   11.9 12.5  
Price to earning ratio.(x)         21.2  
*(Based on CY06 earnings, excluding extraordinary income).

What is company’s business?
Castrol India is the largest private sector MNC engaged in the production and marketing of lubricants. Castrol is part of the BP group Worldwide. The company’s business consists two main segments, automotive and industrial lubricants. Castrol is a market leader in the automotive segment. It markets its automotive lubricants under two brand names- Castrol and BP. Company has 5 manufacturing plants across the country, along with a wide distribution network of 270 distributors, servicing over 70,000 retail outlets. Castrol has a strong marketing network in the 'bazaar' segment and has a stronghold in the OEM (original equipment manufacturing) and tractors segment. Rising competition from PSU majors (that have competitive advantage owing to their own retail outlets) has put pressure on the company’s market share in recent times. To mitigate the impact of the same, the company has entered into an agreement with Essar Oil and Reliance to market its lubricants through their retail outlets.

What has driven performance?
Realisations drives topline: Topline registered a growth of 26% YoY and 23% YoY for 4QCY06 and CY06 respectively. Given the fact that the volumes growth in the sector spans in the range of lower single digit, it can be inferred that the increased realisations were the prime drivers for the higher sales growth. Castrol had resorted to several prices hikes in the year to prevent its margins from falling. Increased realisation was largely necessitated because of higher input cost and does not really reflect the bargaining power of the company with the customers. Moreover, as per our view, the increased prices had led to reduction in the market share of the company in the highly competitive Indian lubricant market.

Segmental analysis…
Particulars 4QCY05 4QCY06 Change CY05 CY06 Change
Segmental sales
Automotive segment 3,232 4,066 25.8% 12,059 14,821 22.9%
Non-automotive segment 580 740 27.5% 2,245 2,703 20.4%
Net revenues 3,812 4,805 26.1% 14,304 17,524 22.5%
Segmental EBIT
Automotive segment 321 602 88.0% 1,703 1,951 14.6%
EBIT margins 9.9% 14.8%   14.1% 13.2%  
Non-automotive segment 72 107 48.9% 330 369 12.0%
EBIT margins 2.2% 2.6%   2.7% 2.5%  
Total EBIT 393 710 80.8% 2,032 2,320 14.1%

Core performance still weak: Cost of the basic raw material in the form of base oil and additives reached historical highs in CY06. Refinery capacity shortages across the globe coupled with increase in the demand of the petrol and diesel has made production of higher value products (like motor spirits (petrol), diesel and LPG more remunerative for the refineries. Thus, the refineries worldwide have shifted from the production of base oil to production of high value products. This led to significant rise in the price of base oil, as the product crack widened. Castrol largely fulfills its raw material requirements through imports as compared to the integrated peers like HPCL, BPCL and IOC. This puts the company at a disadvantage vis-à-vis its peers. However, product prices were hiked to combat higher input costs. Consumption of raw material as a % of sales increased by as much as 410 basis points and 710 basis points in 4QCY06 and CY06 respectively. EBDITA margins increased by as much as 510 basis points during 4QCY06 and the increase is largely attributed to lower advertisement cost during the quarter. Advertising cost reduced from 9% of net sales (in 4QCY06) to current 3% of net sales. For the complete year, the margins continued to be under pressure, registering a decline of 220 basis points.

Expenditure break-up…
(Rs m) 4QCY05 4QCY06 Change CY05 CY06 Change
Consumption of raw material 2,322.7 3,123.4 34.5% 8,479.70 11,631.40 37.2%
as a % of sales 60.9% 65.0%   59.3% 66.4%  
Staff Cost 192.2 181.2 -5.7% 682.4 703.1 3.0%
as a % of sales 5.0% 3.8%   4.8% 4.0%  
Advertisement Cost 339.6 162.1 -52.3% 776 648 -16.4%
as a % of sales 8.9% 3.4%   5.4% 3.7%  
Freight cost 162.2 165.7 2.2% 618.0 658.6 6.6%
as a % of sales 4.3% 3.4%   4.3% 3.8%  
Other expenditure 424.5 461.6 8.7% 1,631.40 1,683.10 3.2%
as a % of sales 11.1% 9.6%   11.4% 9.6%  

Advertising cost effect: Other income (1.1% of the net sales) witnessed a sharp decline of 41% in the quarter, while the same declined at a slower pace (6%) in CY06. Interest expenditure has increased significantly over the period with 37% YoY increase in CY06. However, the same did not have a significant impact due to low leverage of the firm, but it appears that higher prices of inputs has led to increased working capital requirements for the company, thereby forcing the company to borrow. However, improved operating performance on the back of lower advertising cost has led to an improved bottomline show.

Performance over the recent past…
(Rs m) 2QCY05 3QCY05 4QCY05 1QCY06 2QCY06 3QCY06 4QCY06
Sales growth(YoY) 9.6% 10.1% 8.1% 17.5% 20.6% 25.5% 26.1%
Operating profit margins 18.9% 16.0% 9.7% 13.3% 12.1% 9.9% 14.8%
Net profit margins 12.5% 10.1% 8.3% 8.6% 10.6% 8.1% 7.9%
Net profit growth(YoY) 5.0% 8.2% 41.5% 0.6% 1.7% 1.1% 19.9%

What to expect?
At the current price of Rs 239, the stock trades at a price to earnings multiple of 21 times trailing twelve month earnings (excluding the extraordinary income). Considering the weakening fundamentals, we believe that the valuations are at a significant premium and therefore, suggest investors to exercise caution at the current juncture. Operating margins have declined over the last 10 years (from the highs of over 20% to 10% levels) signaling higher input costs and competition. Dynamics and competitive landscape of the Indian lubricant industry are changing.

Increased competition has paved the way for faster commoditisation of the sector. With battle for market share intensifying, margins are expected to be under pressure across the industry. However, PSU lubricant sellers like HPCL, BPCL and IOC, with their in-house base oil production, are expected to take inherent advantage of managing their business in an integrated manner. The drain life (usage period) of the lubricants and the improved technology has led to lower consumption of the lubricants, which along with intense competition will lead to significantly higher advertising expenditure for the company in the future.

On the flip side, recent reduction in the price of the crude oil is expected to ease a bit of the pressure on the margins. However, benefits are not likely to be immense. Also, the shift of lubes from the petrol pumps to bazaar segment is likely to help the company due to its strong presence in the segment.

However we believe risks outweighs returns are the current juncture and also the growth prospects seem to be bleak. Company has declared final dividend of Rs 5 per share (Rs 4 interim dividend earlier). Thus, total dividend during the year is Rs 9 per share reflecting a payout ratio of 72%, which inturn reflects lower growth prospects of the sector in general and company in particular. We maintain our view and advise investors to ‘SELL’ the stock at the current juncture.

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