In the consumer's hierarchy of needs, the importance of housing cannot be understated. Given the fact that the housing sector has been growing at an impressive rate in the last five years on the back of various factors like tax incentives and the decline in interest rate, it is pertinent to look at sectors that benefit from this scenario. Apart from banks, cement, steel, the paint sector also benefits in a large way. In this article, we look at factors that have to be borne in mind while identifying a paint stock.
The application of paints can be broadly divided into three categories viz. decoratives, industrial and automotive. The decorative segment is broadly divided into interior paints (emulsions, enamels, wood finishes) and exterior paints. Historically, not much emphasis was placed on the level of technology in the manufacturing of decorative paints in light of the large presence of unorganised sector. The growth in revenues is dependent on the housing sector. Here demand is from both new houses and repainting.
The industrial and automotive paint manufacturing however, is technology intensive wherein domestic majors have tied up with select global majors like Nippon Paints, DuPont, PPG and Kansai for technology. Industrial paints have applications in automobiles, consumer durables, infrastructure projects (roads and ports) and in the manufacturing sector (protection and powder coatings). The growth in revenues therefore, is directly linked to investments by corporate sector and infrastructure development.
Having looked at the profile of the sector in general, the next step is to analyse factors that impact revenues and costs. We have concentrated on operating profit here because the sector is not capital intensive in nature as compared to commodity sectors. Since depreciation to sales on an average is low at 3% of sales, it is pertinent to consider operating profits.
Since Revenues = Quantity sold * Average price, we consider factors that affect these two broader heads independently.
A. Quantity Sold
The Indian paint sector is highly fragmented i.e. there are both organised and unorganised players. It is estimated that organised players account for around 60% of paint sales in the country. This has risen from around 40% five to six years back. One of the key reasons for this shift is the decline in excise duty over the years. Since unorganised players were not paying taxes, they were able to sell products at a cheaper rate without any significant investments in technology. With the advent of fall in excise duty, unorganised players are losing competitiveness. This is further helped by lowering of customs duty, which results in cheaper raw material cost for organised players. So, watch out for announcements on these fronts in the annual Budget.
As we mentioned earlier, there is the decorative paint segment and industrial paint segment.
Demand for this segment is seasonal in nature i.e. demand increases in festive seasons. Festive season demand in turn is dependent on monsoons and economic performance. Good monsoons result in higher agricultural output and has a positive effect on the banks, GDP growth. Decorative paint demand has a good co-relation with GDP growth. So, when GDP growth is higher, the paint sector will benefit and vice versa. In order to capitalize on the demand, paint companies like FMCG companies, need a well spread distribution network. A retail network with a computer dealer tinting machines has proved to be highly productive.
Reforms also play a vital role in providing a fillip to decorative paint demand. By reforms we mean change in interest rates, land reforms, increased thrust on infrastructure by the government, better irrigational facilities to the rural sector and excise/customs duty structure. Investors therefore, have to place utmost importance to any change in regulation on these broader factors.
Increased demand for automobiles tends to have a positive impact on automotive paint manufacturers. Demand for automobiles in turn is dependent on income growth prospects and interest rates. Automotive paint manufacturing is technology intensive and Indian manufacturers have technical collaboration with foreign players like Kansai, Nippon and PPG of USA. In the case of automotive paint manufacturers, the ability to pass on any rise in input is weaker i.e. bargaining power of customers is higher. As far as industrial paint segment is concerned, increased spending in infrastructure plays a vital role in boosting paint demand. So, when the government announces higher public spending, it benefits industrial paint manufacturers.
The ability of a paint manufacturer to increase prices depends on which segment it operates in either decorative or industrial. In industrial paints, the bargaining power of customers (i.e. auto manufacturers, industrial majors and government agencies), is higher. As a result, whenever there is an escalation in input cost, industrial paint manufacturers are not in a position to pass on the cost to customers. The importance of economies of scale is higher in industrial as compared to decorative paints.
However, though decorative paint sector is extremely competitive, there is room for raising prices. This would depend on factors like brands, product-mix (exteriors, wood finishes and interiors) and the market share. Since paint demand is seasonal, manufacturers tend to decrease prices in the festive season. Unlike the past where paint selection was restricted to construction companies, the dealer tinting machines have played a vital role in increasing customer involvement. Therefore, the sector is investing more on brand building and consequently has a FMCG aura to it.
So, investors have to understand the industrial and decorative sales mix. If a predominantly decorative paint player has plans to increase contribution from industrial sector, margins could come under pressure and vice versa.
Having looked at the revenue side, consider the factors that impact the cost side.
Crude prices and dollar rate
Raw material cost typically account for around 50% of sales of a paint company. There are more than 300 raw materials used in manufacturing of paints with titanium dioxide being the key raw material. It accounts for around 30% of sales. While some are crude derivatives, in the manufacturing process of some materials, crude is used as a source of energy. So, whenever there is an increase in crude prices in the international markets, paint companies feel the pressure. Of course, factors like economies of scale in sourcing do have a positive impact on large players.
Since domestic manufacturers mostly import titanium dioxide due to lack of quality (there are two types here) in the domestic market, rupee-dollar movement in critical. When a spurt in crude prices is accompanies by rupee depreciation against dollar, paint manufacturers face a double-whammy. So, investors need to keep a close watch on this factor. Another critical factor is the strength of the supply-chain of a company. Since this sector is highly working capital intensive (more than 300 raw materials), manufacturers with a wide spread distribution network benefit.
Having looked at the broader sector dynamics, what are the ratios that investors have to analyse before investing in a paint company?
Operating margin: Margin for a paint company, as we mentioned earlier, is dependent on the industrial/decorative sales mix and economies of scale. Ascertain the sales mix and where the sales mix is heading. If the sales mix is shifting favorably towards decorative, margins could improve provided the distribution is well spread.
Working capital to sales: Since the sector is working capital intensive, high working capital to sales ratio indicates cash locked in inventory or debtors. Compare working capital to sales with competitors and ascertain the reason for any diversion. The lower the working capital, the better it is, as cash flow tends to be strong. To that extent, interest costs tend to be lower.
Price to earnings: Since revenue growth prospects of paint majors are co-related to economic growth, price to earnings ratio is a good indicator. Premium will be accorded to those companies that have managed to perform GDP consistently over a five-year period. Companies will higher operating margin, favorable decorative mix and lower working capital to sales will command a premium.
Management: Indian paint sector has both domestic and international players. For MNC paint majors, it is pertinent to look at the parent's strategy for India in the broader context. Ascertain whether the management of the company has managed to outperform competitors in a downturn. Since the paint sector is fragmented, consolidation is a long-term reality. Therefore, it is important to consider whether a company can survive in the long-term and reward shareholders adequately, as there are a number of Indian family managed business houses.
The Indian paint sector is slowly shredding its commodity image and moving towards a FMCG status. A study of global players like Sherwin Williams of US and Kansai of Japan would also help investors.
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