Berger Paints (₹679.90) | Why you should book profit in Berger Paints stock

Though Indian equity markets witnessed one of the steepest declines in March last year due to Covid-19 related demand slowdown, it has recovered well since then . Paint companies, in particular, have been resilient amid market volatility during this period. . Both Asian Paints and Berger have rallied giving 53 and 75 per cent returns respectively from March lows. .

Besides benefit from low crude oil prices last year, release of pent-up demand with economy fully opened up, and festive season gave a boost in the last quarter of 2020. This has reflected in the earnings of paint companies which have been improving in the last two quarters. In its recent December quarter, Berger Paints has reported double-digit volume growth in its mainstay business and decorative paints. It reported a revenue growth of 25 per cent y-o-y and profit growth of 51 per cent y-o-y.

Berger Paints holds a dominant position in select geographies, particularly in non-metro and rural areas across the country. The company’s fundamentals are good, and negligible debt levels provide room for future expansion. Despite these positives, investors can partially book profits in this stock. There are three main reasons.

One, in terms of valuation, Berger Paints is trading way ahead of the market leader. That is, at ₹679.9 Berger Paints is trading at 107 times its trailing 12-month (TTM) earnings, while Asian Paints is trading at 83 times its TTM earnings .Two, the benign raw material costs were a key factor that aided the earnings growth for the paint companies, including Berger Paints. Since November last year, crude oil prices, however, have been slowly inching up. From $35-$37 per barrel, it is around $65 per barrel now. Paint companies’ raw materials are predominantly crude oil derivatives and with crude prices rising, their margins could take a hit.

And three, the paint industry is tightly competitive. In recent years, new players, including Grasim and JSW Paints, have entered the market. This could not only impact their revenue growth/market share, but margins as well due to pricing pressure and higher marketing/sales costs.

Crude price impact

Raw materials of paint companies, including titanium dioxide and zinc oxide and other solvents and additives, are essentially crude oil derivatives and comprise around 50 per cent of sales. With countries across the globe implementing lockdown measures to control the spread of the virus, crude oil witnessed a substantial fall from $68 per barrel at the beginning of 2020 to a low of $21 per barrel in the month of March. This helped paint companies save on their costs. For Berger Paints, in the March quarter of FY20 the raw material cost (as a percentage of sales) stood at 56 per cent, about 4 percentage points lower compared to the same period last year. But in the June quarter of FY21, it stood at 35 per cent, compared to 48 per cent in the corresponding quarter last year. This helped in improving the company’s operating margin. But now with crude prices touching $65 per barrel and with more upside in the crude oil prices expected, the company’s margin is likely to come under pressure. For instance, when crude prices were at its peak in 2018 (went as high as $84 per barrel in September), Berger Paints reported margin of 14 per cent for the September quarter of 2018 lower than (16 per cent) same period the year before.

Considering the current scenario, Berger Paints’ management is renegotiating price increase in the industrial business due to the raw material inflation. According to the management, the company will wait for 1-2 quarters before increasing prices in the decorative business.

Competitive market

Berger Paints already faces stiff competition in both decorative and industrial paints segment. In decorative paints segment, the market share for Asian Paints (42 per cent) is higher compared to Berger Paints (12 per cent), where the former is better placed in terms of pricing and distribution of its products. Though Berger Paints has a dominant position in rural and urban markets (other than metro cities), Asian Paints has strong distribution network (of about 70,000 dealers) while Berger has about 30,000 dealers.

In industrial paints too, Berger Paints faces stiff competition, particularly from Kansai Nerolac, which has over 50 per cent of its revenue coming from this segment. In the recent years, the entry of players, including JSW Paints, and expected entry of Grasim is likely put further pressure on players in decorative paints business.

For instance, Graism has a planned capex of ₹5,000 crore over the next three years, with an eye on becoming the number two player in the decorative paints segment. Although it will take a while for Grasim and JSW to establish their presence, their deep pockets and existing large distribution network/customer relationships for their current products (cement, aluminium, steel, etc) will mean they could be formidable competitors for the current players.