Paint Stocks Might Soon Feel The Heat With Increasing Raw Material Costs And More Competition

Paint companies have witnessed a strong recovery in the first quarter of financial year 2021 (FY21). Listed firms like Asian Paints, Kansai Nerolac and Berger posted a volume growth higher than 90 per cent, along with a similar value growth.

Pent-up demand, a strong demand pick-up and a low base contributed to the strong growth in sales. The paint sector’s revival has been a positive surprise for investors as the sector is majorly dependent on discretionary spending for growth.

Margin Compression

But, increasing commodity prices, especially crude oil prices, could affect the margins of paint companies adversely. In the past, paint companies have seen a margin compression during high-inflation periods.

In order to maintain margins, paint companies have been increasing their price, but the price increases have been unable compensate for raw material inflation.

According to a research report on Asian Paints by HDFC Securities, the price increases by paint firms might not be commensurate with the increases in raw material costs, resulting in margin pressure.

According to the report, “Price hikes (3 per cent in the first quarter/1 per cent in July 2021) remain incommensurate vis-à-vis the steep RM (raw material) inflation (21-25 per cent in the past six months).”

For Asian Paints, gross margins have fallen from around 45 per cent to 39 per cent quarter-on-quarter, due to increasing raw material costs.

“Material Prices seeing steep inflation since Q3 FY20-21. Q4 FY21 saw about 8-10 per cent inflation from previous quarter and material prices have seen a further inflation, of 13-15 per cent in Q1 FY22. Price increases implemented across businesses negating only a part of this impact,” the company said in its investor presentation.

Other companies in the space have reported a similar slide in gross margins.

Growing Competition

A barrier to increasing prices is the strong competition in the industry. With several organised and unorganised players, the paint sector is already quite crowded.

Despite the competition, companies like Asian Paints, Nerolac and Berger have managed to generate high returns on invested capital with a strong focus on distribution and brand-building.

While the cost of setting up a manufacturing plant isn’t high, the expenses for distribution, advertising and brand-building act as a deterrent for new entrants.

The high returns have attracted several new players like JSW Paints and Grasim. Both are well-funded competitors looking to scale up in the paints space.

JSW has been operating in the paints space for some time, but its initial focus was on industrial paints. Now, JSW is looking to enter the decorative paint segment, where Asian Paints, Berger and Nerolac dominate.

As for Grasim, the company already operates in the construction space through UltraTech and has built a huge distribution network. Grasim is expected to leverage its existing network and build a strong presence in the paint sector.

Expensive Valuations

Despite the potential negatives, paint stocks continue to trade at high valuations. Asian Paints’ trailing price-to-earnings (PE) ratio stands at around 83.

Berger Paints’ PE ratio stands at 90. Similarly, Kansai Nerolac has a PE ratio of around 55. To put this in perspective, Nifty’s long-term average PE is 20. The high PE ratio implies that investors expect the companies’ sales and profits to continue growing at a rapid pace.

But, profitability might be under threat with new competitors in the space and higher raw material costs. Some brokerages have also put forward the idea that the paints sector might not be as underpenetrated as it is believed to be, which explains the moderate rate of growth in the past few years.

High valuations usually sustain only if companies demonstrate high growth. If the company is unable to grow fast, either the stock falls or remains stagnant until earnings catch up.

Several brokerages have recommended investors to sell or hold due to the high valuations. In the last year, out of 29 broker reports, 16 recommended a sell/hold on Asian Paints, according to data provided by Trendlyne.

Berger Paints too has received several sell ratings due to its valuations, which are higher than the market leader’s valuations. While the paints sector has generated strong returns for investors, higher raw material prices combined with increasing competition could reduce profitability.

In addition, the markets expect high rates of growth from the sector, and any disappointment on that front would mean low or negative returns for investors.