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Castrol: Changing profit mix
Jul 20, 2005

Performance summary
Castrol announced its results for the second quarter ended June 2005 yesterday (December ending fiscal). While topline growth at 9% in 2QCY05 was encouraging, despite higher oil prices in the international markets, operating profits grew by 5%. Even as base oil prices were high on a YoY basis in the international markets, favourable exchange rate and the focus of the company on better sourcing has been the highlight during the quarter. For the first half of 2005, operating margins have actually increased marginally.

(Rs m) 2QCY04 2QCY05 Change 1HCY04 1HCY05 Change
Net sales 3,619 3,955 9.3% 6,512 7,152 9.8%
Expenditure 2,911 3,209 10.3% 5,419 5,940 9.6%
Operating profit (EBDITA) 708 746 5.3% 1,094 1,212 10.8%
EBDITA margin (%) 19.6% 18.9%   16.8% 16.9%  
Other income 27 29 7.3% 99 84 -14.9%
Interest 5 8 68.9% 11 16 46.7%
Depreciation 36 50 37.7% 72 99 38.5%
Profit before tax 695 718 3.3% 1,110 1,181 6.4%
Extraordinary expenditure - -   - -  
Tax 223 223 -0.2% 370 366 -1.1%
Profit after tax/(loss) 471 495 5.0% 740 815 10.1%
Net profit margin (%) 13.0% 12.5%   11.4% 11.4%  
No. of shares (m) 123.6 123.6   123.6 123.6  
Diluted earnings per share (Rs)* 15.3 16.0   12.0 13.2  
Price to earnings ratio (x)         17.2  
(* annualised)            

What is the company's business?
Castrol India is the country’s largest MNC sector lubes manufacturer and marketing company with a market share of nearly 20%. The company 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 retail outlets) is one of the major threats Castrol is faced with. However, the company has entered into an agreement with Essar Oil and Reliance to market its lubricants through their retail outlets. Although, not of much help currently, this pact is likely to help Castrol from a long-term standpoint. The company is also making concerted effort towards lowering its dependence on lube sales.

What has driven performance in 2QCY05?
Industrial segment takes the lead:  As is evident from the table below, the company's business is divided into two broad categories viz. automotive (sale of lubricants at the retail outlets and supply to original equipment manufacturers like Telco) and non-automotive (largely industrial sector). While the former has grown by 9% in 2QCY05, the topline of the latter is higher at 12%, which is in line with the indications of management in its latest annual report. The company expects the industrial segment to grow faster than the automotive segment in the next three years led by increased industrial sector activity. Castrol is one of the major suppliers to companies like L&T, Hitachi, JCB and so on, which is a positive. The performance of the automotive segment, though linked to demand for automobiles, is likely to be muted. This is because of improvement in better road infrastructure and lower consumption of lubes by the diesel sector. Overall, the topline growth at 10% in 1HCY05 is encouraging.

Non-automotive segment sparks…
(% sales) 2QCY04 2QCY05 % change 1HCY04 1HCY05 % change
Automotive 3,117 3,393 8.8% 5,560 6,066 9.1%
PBIT margin 22.2% 20.4%   19.1% 17.8%  
Non-automotive 501 562 12.1% 953 1,085 13.9%
PBIT margin 10.0% 16.0%   9.8% 15.7%  
Overall PBIT margin 20.5% 19.8%   17.7% 17.5%  

Margins - Good signs:  As far as operating margins of the company are concerned, there has been a decline in 2QCY05 on a YoY basis. However, if one were to consider the trend over the last few quarters, there has been a sharp improvement. This, despite unfavourable base oil prices (the key raw material) is commendable. Like in 2004, the company has managed to reduce the impact on three counts. One, the average realisation has increased (owing to price increases and due to higher contribution from higher-end lubes). Secondly, the exchange rate continues to be favourable for big importers like Castrol and thirdly, better sourcing of raw materials has also helped matters. The interesting aspect to note is that while the PBIT margins of the automotive division has declined, the non-automotive segment has seen a sharp improvement. This has supported the overall profitability.

Expenditure table…
(% sales) 2QCY04 2QCY05 1HCY04 1HCY05
Consumption of raw materials 58.1% 57.8% 58.6% 58.8%
Staff cost 4.8% 4.5% 5.4% 4.5%
Advertisement 3.6% 3.6% 4.5% 4.1%
Freight and insurance 3.5% 4.1% 3.7% 4.2%
Other expenditure 10.5% 11.2% 10.9% 11.3%

As can be the seen from the table, while raw material costs to sales is lower marginally in 2QCY05, freight and insurance expenses have increased. This, like in 2004, is largely on account of diesel price increase and we expect this to remain on the higher side for the rest of 2005. Staff cost is lower in 1HCY05 on account of the closure of the manufacturing facility in Ballabgarh in New Delhi (43 employees opted for VRS, starting November 2004).

Over the last few quarters:  The graph below highlights the growth in sales over the last few quarter on a YoY basis. While the rate of growth has declined, as we had mentioned earlier, this is on account of steady improvement in engine technology in the diesel segment and higher competition. Operating margins, after tumbling last fiscal year owing to almost 20% rise in base oil prices, have improved due to factors mentioned earlier. We have a conservative view on margins going forward.

What to expect?
At the current price of Rs 227, the stock is trading at a price to earnings multiple of 17.7 times its 1HCY05 annualised earnings. Historically, the company's valuation multiples have been higher owing to its dominant presence in the lubricants segment and more importantly, sheer brand value. We believe that there is a need for revision of valuations downward owing to the changing nature of the lube sector. Not only is competition higher, given the fact oil PSUs are bleeding on the petroleum products front, there is a strong move towards increasing lubricants sales. This, we believe, will result in pricing power, in both automotive and non-automotive segments. However, the company's initiative to de-risk revenues are a positive. Overall, we believe that the risk-return matrix is skewed towards risks.

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