Discretionary consumer July 10, 2013 Paintswebambit.ambit.co/reports/Ambit_Paints SectorUpdate_10Jul2013.pdf · Discretionary consumer July 10, 2013 Paints SECTOR UPDATE Ambit Capital

Discretionary consumer July 10, 2013

Paints

SECTOR UPDATE

Ambit Capital and / or its affiliates do and seek to do business including investment banking with companies covered in its research reports. As a result, investors should be aware that Ambit Capital may have a conflict of interest that could affect the objectivity of this report. Investors should not consider this report as the only factor in making their investment decision.

Please refer to the Disclaimers at the end of this Report.

Analyst contacts

Rakshit Ranjan, CFA [email protected] Tel: +91 22 3043 3201

Shariq Merchant [email protected] Tel: +91 22 3043 3246

ASIAN PAINTS BUY

CMP: `4,750

Target Price (12 months): `4,932

Previous TP: `4,932

Upside (%) 4%

EPS (FY14): `141.3

Change from previous (%) NA

Variance from consensus (%) 0

Stock Information

Mkt cap: `448bn/US$7.4bn

52-wk H/L: `5,050/3,432

3M ADV: `451mn/US$7.5mn

Stock Performance (%)

1M 3M 12M YTD

Absolute (0) (2) 23 5

Rel. to Sensex 0 (8) 12 5

BERGER PAINTS SELL

CMP: `235

Target Price (12 months): `204

Previous TP: `213

Downside (%) 15%

EPS (FY14): `7.2

Change from previous (%) -8

Variance from consensus (%) -5

Stock Information

Mkt cap: `82bn/US$1,357mn

52-wk H/L: `255/124



1M 3M 12M YTD

Absolute 1 20 72 47

Rel. to Sensex 1 14 61 47

Source: Bloomberg, Ambit Capital research

Asian Paints retains its lustre Berger stock, post the ~20% rally in the last quarter, now trades at par with Asian Paints on FY14 P/E multiple of 34x in contrast to the deserving 42% discount to latter over the last two years. We expect Berger’s valuations to correct and settle at atleast 20% discount to Asian Paints as we find the recent compression in gross margin differential between the two companies as temporary given the same is not led by premiumisation but by a weak base effect for Berger from FY12. Notably, Asian Paints continues to improve upon its supply chain and brand recall, thereby making it difficult for a competitor to gain ground in the short term. We maintain BUY on Asian Paints with a TP of `4,932 (implying 35x FY14 EPS) but turn SELLers on Berger with a TP of `204, (implying 28x FY14 EPS).

Compression of gross margin differential unsustainable: Our analysis of the compression in the gross margin differential between Berger and Asian Paints in recent quarters (to 220 bps in 4QFY13 from 500bps in FY12 and 350bps in FY11) suggests that the recent ourperformance of Berger’s gross margin over Asian Paints’ cannot be attributed to portfolio premiumisation. This is because in order to attain a 280bps compression in the gross margin differential, Berger’s portfolio should have undergone an increase in proportion of premium products from ~10% to ~45%, which has not been the case given lack of traction for its premium products at a dealer level (source: Ambit’s channel checks). We expect the gross margin differential between the two companies to increase again to over 300bps in FY14 and FY15.

Sustainability and strengthening Asian Paints’ competitive advantages: Asian Paints continues to build upon it competitive advantages built around supply chain efficiencies and brand recall, especially in the premium portfolio (18-20% of the market). We do not believe peers to replicate these over short period of time implying continuing market share gains for Asian Paints (50bps each year) and consistently high profitability.

History set to repeat itself: Asian Paints’ stock has consistently traded at a significant premium (~40%) to Berger’s on 1-year forward P/E, but on several instances, valuation differential between the two has narrowed temporarily and widened subsequently due to relatively lower eps growth of Berger.

One year forward P/E multiple comparison over the past decade

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Berger Asian

Source: Ambit Capital research

Valuations—Asian to trade at well deserved premiums: Whilst we continue to view Berger as the clear #2 player in the industry, ahead of Kansai and Akzo, we find its valuations (34x FY14 P/E) rich and hence turn SELLers (15% downside) with little cuts to our near-term estimates (8% eps cut for FY14 and 6% for FY15). We maintain our BUY on Asian Paints and maintain our valuation of `4,932 (implying 35x FY14E and 29x FY15 P/E).

Paints – Sector Update

Ambit Capital Pvt Ltd 2

Strengthening Asian Paints’ competitive advantages Asian Paints continues to build upon it competitive advantages built around supply chain efficiencies and brand recall, especially in the premium portfolio (~15% of the market). We do not believe peers to replicate these over short period of time implying continuing market share gains for Asian Paints (to 53% from 51% by FY18) and consistently high profitability. Sustainability of Asian Paints’ competitive advantages over Berger

Exhibit 1: Comparison of top-4 paint manufacturers across drivers of competitive advantages

Importance Asian Paints

Berger Paints

Kansai Nerolac

ICI/Akzo Nobel

Supply chain management HIGH Product range MEDIUM Products with special characteristics LOW Marketing initiatives MEDIUM Benefits to dealers/painters MEDIUM Quality of management professionals HIGH Source: Ambit Capital Research; Note: indicates very strong positioning relative to peers, indicates intermediate positiong relative to peers;

indicates weak positioning relative to peers

As shown in the table above, based on our competitive analysis framework for the Paints sector, we believe that the biggest driver of competitive advantage in the sector is an efficient supply chain, because: (a) the end consumer has limited appreciation for product differentiation; (b) Paints are bulky in nature, making transportation and storage uneconomical; (c) the sector demands a large distribution network with a wide range of SKUs; and (d) demand is seasonal and deferrable, making it difficult for manufacturers to ensure availability across the year. The ability of a paints manufacturer to achieve such supply chain efficiencies relates predominantly to a consistent focus by the senior management team over a long period of time. Due to the factors highlighted below, despite a renewed focus by Berger towards improving operational efficiencies and targeting premiumisation, we do not see Berger Paints gaining over Asian Paints in the near term in the Indian Decorative Paints segment.

Supply chain – whilst Berger is improving, Asian Paints continues to innovate further: Asian Paints’ supply is already best-in-class given its pro-active investments behind IT infrastructure, nationwide data collection and efficiencies around expansion of its regional distribution centres initially and distribution centres near manufacturing units more recently. More importantly, Asian Paints continues to improve its supply chain efficiencies by automating inventory management in depots through bar-coding and enabling GPS tracking on a real-time basis. Berger has only recently started investing in a centralised inventory management system and nationwide data collection, ~12-13 years after Asian Paints had launched these initiatives. Given the time it will take for Berger to build a superior data forecasting ability through such a centralised inventory management platform we do not expect the gap between supply chain efficiencies to narrow materially between these two players.

Marketing initiatives give Asian Paints the edge: Asian Paints’ heavy investments on ‘experience centres’ like Asian Paints’ Signature stores and Asian Paints’ Colour Ideas stores, which help customers experience the look and feel of products prior to purchase, have helped it build a strong presence in the premium paints segment.



Quality of management professionals: Whilst most paint manufacturers

focus on quality of top management recruits, Asian Paints is reputed to be the only player in the industry which also focuses on recruiting high-quality professionals from the top B-schools of India for junior and mid-level managerial roles, which gives Asian Paints a substantial long-term competitive advantage which it has proven through its execution capabilities and superior supply chain.

Berger’s recent strides towards investing behind brand-building and supply chain initiatives are a step in the right direction. However, given the nature of these competitive advantages and hence the number of years it takes to build them, we do not expect Berger’s recent initiatives to help it substantially narrow the competitiveness gap against Asian Paints over the short term.



Compression in gross margin differential between BP and AP in 4QFY13 unsustainable Our analysis of the compression in the gross margin differential between Berger and Asian Paints in recent quarters (to 220 bps in 4QFY13 from 500bps in FY12 and 350bps in FY11) suggests that the recent outperformance of Berger’s gross margin over Asian Paints’ cannot be attributed to portfolio premiumisation. This is because in order to attain a 280bps compression in the gross margin differential, Berger’s portfolio should have undergone an increase in proportion of premium products from ~10% to ~45%, which has not been the case given lack of traction for its premium products at a dealer level (source: Ambit’s channel checks). We expect the gross margin differential between the two companies to increase again to over 300bps in FY14 and FY15.

Berger’s recent gross margin expansion – reading between the lines

Except 1QFY13, Asian Paints’s revenues growth was ahead of Berger by 300bps during 2Q and 3Q last year and then settled at par with Berger’s in 4QFY13. However, Berger Paints’ gross margins have expanded at a faster pace than that of Asian Paints, especially in 4QFY13 where the gross margin differential between the two companies has narrowed down to only 220bps compared to over 350bps previously.

Exhibit 2: Quarterly revenue growth trends for Asian Paints and Berger

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16%20%

22%26%

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32%30%

8%11%

27%31%

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Asian Paints Berger Paints

Source: Company, Ambit Capital research

Exhibit 3: Quarterly gross margin trends for Asian Berger

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Asian Paints Berger Paints


Given the higher gross margins for premium products, the recent narrowing of the gross margin differential between Asian Paints and Berger raises the question, “Is the pace of premiumisation on Berger’s portfolio faster than that of Asian Paints, thereby justifying a faster and more sustainable gross margin expansion and resultantly higher earnings growth for Berger going forward?” The answer, we believe, is ‘no’ because of a combination of the following factors:

Based on our discussions with industry participants, whilst premium products comprise ~10% of Berger overall sales, this proportion is substantially higher for Asian Paints at ~25% (see the tables below).



Exhibit 4: Berger’s product portfolio across categories

Segment Products Current share

of revenues

Category value CAGR (FY06-

12)

Premium Luxol Silk, Satin; Weathercoat, Silk and Breathe Easy

10% 25-30%

Mid Rangoli, Luxol Enamel, Bison Super Emulsion

60%-70% 15-20%

Economy Jadoo, Butterfly 20%-30% 10-15%


Exhibit 5: Asian Paints’ product portfolio across categories

Segment Products Current share

of revenues

Category value CAGR

(FY06-12)

Premium Royale, Apex, Apcolite 25% 25-30%

Mid Tractor Emulsion, Ace, Melamyne Gold, Touchwood,

60%-65% 15-20%

Economy Tractor Distemper, Utsav, Gattu enamel

10-15% 10%-15%


We assume that premium products (i.e. products with a realisation of over `150/litre) generate ~1100bps higher gross margins as compared to the mid-tier and economy products.

Exhibit 6: Product mix assumptions for Asian Paints

Economy Mid-

tier Premium

Avg price

Current average price (`/litre) 40 120 200

Current Asian Paints mix* 15% 60% 25% 128

Three-year forward Asian Paints’ mix 12% 55% 33% 137

Gross margins (current) 37% 37% 48% 40.6%

Source: Ambit Capital research; Note:* Ambit’s assumptions based on discussions with dealers, competitors and other market participants

Exhibit 7: Product mix assumptions for Berger Paints

Economy Mid-

tier Premium

Avg price


Current Berger Paints mix* 20% 70% 10% 112

Three-year forward Berger Paints’ mix 20% 66% 14% 115


Source: Ambit Capital research; Note:* Ambit’s assumptions based on discussions with dealers, competitors and other market participants

The table below highlights the weighted average gross margin that a company would report based on: (a) mix of premium and non-premium products in the portfolio; and (b) assumption around the divergence between gross margins for premium products and those for non-premium products.

Exhibit 8: Increase in gross margins does not indicate premiumisation

Proportion of premium products in the portfolio Gross margin delta between premium and non-premium products 0% 10% 20% 30% 40% 50%

7% 36.0% 36.7% 37.4% 38.1% 38.8% 39.5%

11% 36.0% 37.1% 38.2% 39.3% 40.4% 41.5%

15% 36.0% 37.5% 39.0% 40.5% 42.0% 43.5%

19% 36.0% 37.9% 39.8% 41.7% 43.6% 45.5%

23% 36.0% 38.3% 40.6% 42.9% 45.2% 47.5%

Source: Ambit Capital research; Note: Highlighted column includes base case

In our base case (based on discussions with market participants), we assume a margin differential of 11% between the premium products and non-premium products in the portfolio. Berger’s gross margins expanded 530bps YoY from 35.7% in 4QFY12 to 41% in 4QFY13. Over the same period, Asian Paints’ gross margin expansion was at 280bps. Consequently, if we assume that the extent of compression in gross margin differential between the two companies relates to product portfolio premiumisation, it would imply that at least 45% of Berger’s portfolio currently consists of premium products. However, none of our discussions with Berger’s large dealers across India suggest the traction of premium products on Berger’s portfolio to be nowhere close to justifying such a high magnitude of a mix change.

Consequently, we do not believe that faster premiumisation has been the driver of compression in gross margin differential between the two companies.



History set to repeat itself Asian Paints’ stock has consistently traded at a significant premium (~40%) to Berger’s on 1-year forward P/E, but on several instances, valuation differential between the two has narrowed temporarily and widened subsequently due to relatively lower eps growth of Berger. Historical share price trends

Asian Paints has traded at an average premium of ~43% over Berger’s one-year forward P/E from April 2004 to June 2013, and at an average premium of ~42% over the past two years. Berger Paints’ recent share price rally has raised its valuations to 34x FY14 earnings at par with Asian Paints’ 34x FY14E EPS. Apart from the current instance, the past decade has seen Berger Paints’ valuations exceed that of Asian Paints’ on three different instances (see the exhibit below). This has historically prevailed for no more than a few months after which the valuation gap has widened again significantly. With no material fundamental change in the divergence in operational efficiencies between the two companies, we believe that the current similar valuations are unjustified. We expect the relative valuation gap between the two companies to widen, with our DCF-based valuations implying a reduction in Berger’s valuation and restoring premium for Asian Paints over Berger on one-year forward P/E multiples.

Exhibit 9: Asian Paints has maintained a 50% premium over Berger Paints

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Narrowing of valuation gap temporary in nature

Berger’s valuation has exceeded Asian Paints’ 3 times (in 1HFY07, 2HFY08 and 2HFY09) over April, 2004 and July, 2013 (excluding the present instance). All the 3 instances have been followed by strong out-performance by Asian Paints or underperformance by Berger; gap narrowed twice because of sharp declines in Berger (33% in 2HFY07, 30% in 2HFY08) and once by a rally by Asian Paints (43% in 2HFY10). We note that Asian Paints has also materially outperformed Berger on eps growth in each financial year of out performance.

Given the expensive valuations, we expect Berger to underperform Asian Paints. We believe that the underperformance will be led by a decline in share price of Berger Paints and expect this to be triggered by a) contraction of gross margins which had expanded strongly (by 530bps) in 4QFY13; b) poor performance of Berger Silk, its premium brand; and c) rupee depreciation likely to impact its cost structure more adversely. We estimate a fair premium of 22% for Asian Paints over Berger (versus its 2 year average of 42%) and arrive at a target price of `204 (15% downside).



Exhibit 10: Narrowing of valuation gap historically has been followed by out-performance by Asian Paints’ share price return and earnings growth

Berger’s return Asian’s return Asian's

outperformance Berger’s earnings

growth in the FY Asian’s earnings growth in the FY

Asian's outperformance

2HFY07 -33% 13% 45% 18% 33% 15%

2HFY08 -30% 19% 49% 6% 46% 38%

2HFY10 2% 43% 41% 45% 110% 65%

Source: Ambit Capital research, Bloomberg



Impact of a weakening INR Our analysis suggests an earnings impact of 11% on both Asian Paints and Berger Paints for a 10% rupee depreciation.

Key raw materials for paint manufacturers, including titanium dioxide, certain pigments and additives, are either directly imported in large quantities or have an exposure to locally procured crude derivates which are priced at import parity. This exposes the paint manufacturers to an adverse earnings impact from INR depreciation. The sensitivity of earnings (PBT) to INR depreciation is highlighted in the table below. This analysis is based on the net forex exposure (raw material imports and foreign currency expenses less exports). The positive impact of translation gains from its foreign subsidiaries is adjusted to the domestic business to arrive at the net impact of currency on PBT.

Exhibit 11: Sensitivity of Asian Paints’ PBT to INR depreciation

Share of imports for Asian Paints (as % of Consolidated COGS) Depreciation

of rupee 20% 25% 30% 35% 40%

1% 0.8% 1.0% 1.2% 1.3% 1.5%

2% 1.5% 1.9% 2.3% 2.7% 3.1%

3% 2.3% 2.9% 3.5% 4.0% 4.6%

4% 3.1% 3.8% 4.6% 5.4% 6.1%

5% 3.8% 4.8% 5.8% 6.7% 7.7%

6% 4.6% 5.8% 6.9% 8.1% 9.2%

7% 5.4% 6.7% 8.1% 9.4% 10.7%

8% 6.1% 7.7% 9.2% 10.7% 12.3%

9% 6.9% 8.6% 10.4% 12.1% 13.8%

10% 7.7% 9.6% 11.5% 13.4% 15.3%

Source: Company, Ambit Capital research; Note: Highlighted center column indicates the current share of imports; data pertains to FY13

Exhibit 12: Sensitivity of Berger Paints’ PBT to INR depreciation

Share of imports for Berger Paints (as % of Consolidated COGS) Depreciation

of rupee 5% 10% 15% 20% 25%

1% 0.4% 0.7% 1.1% 1.5% 1.9%

2% 0.7% 1.5% 2.2% 3.0% 3.7%

3% 1.1% 2.2% 3.3% 4.4% 5.6%

4% 1.5% 3.0% 4.4% 5.9% 7.4%

5% 1.9% 3.7% 5.6% 7.4% 9.3%

6% 2.2% 4.4% 6.7% 8.9% 11.1%

7% 2.6% 5.2% 7.8% 10.4% 13.0%

8% 3.0% 5.9% 8.9% 11.8% 14.8%

9% 3.3% 6.7% 10.0% 13.3% 16.7%

10% 3.7% 7.4% 11.1% 14.8% 18.5%

Source: Company, Ambit Capital research; Note: Highlighted center column indicates the current share of imports; data pertains to FY12 as the FY13 annual report has not yet been published

Our analysis suggests that every 100bps depreciation in the INR affects the PBT of Asian Paints negatively by 1.15% and that of Berger by 1.11%. However, as both the companies benefit from translation of earnings of their foreign subsidiaries, the net impact after taking into account translation gains is 1.10% for Asian Paints and 1.09% for Berger Paints. Given a 10% depreciation in the INR, if no pricing action is taken, 2QFY14 (which will see the full impact of INR depreciation on COGS) will see a consolidated earnings impact of 11.52% for Asian Paints and 10.9% for Berger.

Ability to pass on the impact to consumers through price increases: Our channel checks suggest that demand elasticity of paints consumption is substantially higher than what it was three years ago. This was somewhat evident in the aftermath of the 25% depreciation in the INR as against the USD in FY12 (August 2011–December 2011). Manufacturers had increased prices by 12-13% on an average for decorative products to pass on the adverse impact of currency to customers. This not only led to a moderation in volume growth from 17% YoY in FY11 to 11% YoY in FY12, but also led to a gross margin contraction of ~200bps for large listed companies. Mr. Bharuka, MD & CEO, Kansai Nerolac, at their AGM last month, highlighted that the industry was not in a position to take further price increases in FY14 but would focus on cost-cutting measures and productivity improvements. Consequently, we expect only nominal price increases in FY14 given the dismal weak macro-economic environment and hence expect gross margins to remain flat in FY14, as the impact of a weak INR will offset any positives from mix changes.



Industry growth assumptions Key assumptions and estimates Revenue growth drivers

Exhibit 13: Summary assumptions for Paint industry

FY13 FY14E FY15E

Industry level drivers

Industry volume growth 6.0% 8.8% 11.2%

Contribution from shift from unorganised market to organised market

2.0% 1.0% 1.0%

Industry volume growth 8.0% 9.8% 12.2%

LFL price increase 3.5% 5.0% 5.0%

Industry value growth 11.5% 14.8% 17.2%


As shown in the exhibit above, we have segregated our revenue growth forecasts for the industry into the following components:

Overall market volume growth: As shown in the exhibit below, Industry volume growth has historically been linked closely to India’s GDP growth. We forecast industry volume growth rate of 8.8% in FY14. We have assumed a market volume to GDP growth multiplier of 1.5x and based our forecasts on a GDP growth assumption of 6.8% for FY14 and 7% for FY15.

Exhibit 14: Industry volume growth vs GDP growth

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16%

FY07 FY08 FY09 FY10 FY11 FY12 FY13 FY14E FY15E

1.01.11.21.31.41.51.61.71.81.92.0

GDP Growth Market Volume growth Multiplier (RHS)


Shift from unorganised market to organised market at the industry level: We have assumed that the organised proportion of the overall paints industry will increase to ~70% by FY18 from 66% currently. This corresponds to a 1% contribution to the growth rate of the organised market over FY14-18.

Exhibit 15: Growth led by shift from the unorganised to the organised market (%)

Shift from unorganised to organised FY14E FY15E FY16E FY17E FY18E

Organised market as a % of total 67.0 67.6 68.3 69.0 69.7

Unorganised to organised shift contribution 1.0 1.0 1.0 1.0 1.0


Like-for-like (LFL) product price increase: We have assumed that LFL product price increases will be ~5% per year. This is based on a historical ten-year CAGR in the realisation rate of 5%. We expect this to be no different going forward given that inflationary cost pressures are likely to be passed on to the customers through price hikes going forward.

Paints July 10, 2013

Berger Paints Bloomberg: BRGR IN EQUITY Reuters: BRGR.NS

Accounting: AMBER Predictability: GREEN Earnings momentum: GREEN

Ambit Capital and / or its affiliates do and seek to do business including investment banking with companies covered in its research reports. As a result, investors should be aware that Ambit Capital may have a conflict of interest that could affect the objectivity of this report. Investors should not consider this report as the only factor in making their investment decision.

Please refer to the Disclaimers at the end of this Report.

SELL

Key financials

Year to March FY11 FY12 FY13E FY14E FY15E

Operating income (` mn) 23,281 29,477 33,464 39,079 46,346 EBITDA (` mn) 2,373 3,035 3,712 4,425 5,341 EBITDA margin (%) 10.2% 10.3% 11.1% 11.3% 11.5% EPS (`) 4.3 5.2 6.3 7.2 9.0 RoE (%) 23.3% 24.3% 25.0% 24.1% 25.7% RoCE (%) 18.0% 19.1% 18.6% 17.8% 19.7% P/E (x) 55.6 46.3 38.2 33.5 26.9


CHANGE IN STANCE

Rakshit Ranjan, CFA [email protected] Tel: +91 22 3043 3201

Shariq Merchant [email protected] Tel: +91 22 3043 3246

Recommendation

CMP: `241

Target Price (12 months): `204

Previous TP: `213

Downside (%) 15

EPS (FY14): `7.2 Change from previous (%) -8%

Variance from consensus (%) -5%

Stock Information

Mkt cap: `82bn/US$1,357mn

52-wk H/L: `255/124


Beta: 0.9

BSE Sensex: 19,324

Nifty: 5,811


1M 3M 12M YTD

Absolute 1 20 72 47

Rel. to Sensex 1 14 61 47

1 year fwd P/E bandchart

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Not so premium Berger Paints’ current multiples are 18% higher than the peer group average for FY14. Whilst we believe that the premium to Kansai Nerolac and Akzo Nobel is justified, we believe that its at-par valuation to Asian Paints is unjustified given: (a) Berger lacks the competitive advantages that Asian Paints’ has built around supply chain management and superior brand equity through a consistent focus from the senior management on execution of its strategy over several decades; and (b) lower market share gains and slower margin expansion over next five years despite a rising mix of premium products. We reduce our estimates marginally and our valuation by 4% and turn SELLers on Berger Paints with a target price of `204.

Competitive position: MODERATE Changes to this position: STABLE

Compression of gross margin differential unsustainable: Our analysis of the compression in the gross margin differential between Berger and Asian Paints in recent quarters (to 220 bps in 4QFY13 from 500bps in FY12 and 350bps in FY11) suggests that the recent ourperformance of Berger’s gross margin over Asian Paints’ cannot be attributed to portfolio premiumisation. This is because in order to attain a 280bps compression in the gross margin differential, Berger’s portfolio should have undergone an increase in proportion of premium products from ~10% to ~45%, which has not been the case given lack of traction for its premium products at a dealer level (source: Ambit’s channel checks). We expect the gross margin differential between the two companies to increase again to over 300bps in FY14 and FY15.

Supply chain still playing catch up: While Asian Paints continues to invest in building further efficiencies in its supply chain (by automating inventory in depots through bar-coding and enabling GPS tracking of trucks on a real-time basis), Berger has only recently started investing in initiatives such as centralised inventory management, ~12-13 years after Asian Paints had launched such initiatives. Given the time it will take for Berger to build a superior data forecasting ability and given the continued investments by Asian Paints targeting futher efficiencies, we do not expect the gap between supply chain efficiencies to narrow materially between these two players.

Valuation and revision in estimates: Given the poor macro environment, we downgrade our revenue forecasts by 4% for FY14 and 5% for FY15, EBITDA forecasts by 7% for FY14 and FY15 and EPS forecasts by 7% for FY14 to `7.2 and 6% for FY15 to `9.0. We stand 2% ahead of consensus on the topline and 4% below on the bottomline for FY14 as we factor in lower gross margins and higher depreciation on account of the newly commissioned Hindupur plant. Our DCF-based approach values Berger Paints at `204 (implying 13% downside, 28x FY14E and 23x FY15E P/E). Berger currently trades at 34x FY14E and 27x FY15E earnings. We turn SELLers on Berger Paints.



Key assumptions and estimates Revenue growth drivers

Exhibit 1: Summary assumptions for Berger Paints

FY13 FY14E FY15E


Organised Industry volume growth 8.0% 9.8% 12.2%

Company level drivers

Contribution from market share gain/loss vs peers 1.1% 0.6% 0.6% LFL price increase 3.0% 5.0% 5.0%

Contribution from mix change (economy/mid-tier to premium) 0.9% 0.9% 0.9%

Total volume growth for Berger Paints 9.1% 10.4% 12.8%

Contribution from realisation rate increase for Berger 3.9% 5.9% 5.9%

Total value 13.1% 16.3% 18.7%


Market share gains from Akzo Nobel and Kansai Nerolac: Though we expect Berger to gain share from Akzo Nobel and Kansai Nerolac, we expect Asian Paints to gain share from all the players including Berger in the foreseeable future. Consequently, we expect a 10bps increase in market share for Berger each year, implying a market share gain of 50bps over FY14-18.

Exhibit 2: Comparison of the top-4 paint manufacturers across drivers of competitive advantages

Asian Paints

Berger Paints

Kansai Nerolac

ICI/Akzo Nobel

Supply chain management Product range Products with special characteristics Marketing initiatives Benefits to dealers/painters Quality of management professionals Source: Ambit Capital Research; Note: indicates very strong positioning relative to peers, indicates intermediate positiong relative to peers; indicates weak positioning relative to peers

Exhibit 3: Shift in industry market share from FY07-17E

44.4% 50.9% 53.2%

18.3%17.2% 17.7%

37.3% 31.9% 29.1%

0%10%20%30%40%50%60%70%80%90%

100%

FY07 FY13 FY18

Others

Berger Paints

Asian Paints


Product mix change from economy/mid-tier to premium: Given Berger’s weak positioning in the premium paints segment, we expect Berger to be slower than Asian Paints (and hence the market average) in benefiting from the shift from economy/mid-tier segment to the premium segment, as shown in the exhibit below. Our discussions with the management teams and industry



participants suggest that gross margins on premium products are 10-12% higher than the economy/mid-tier products. Consequently, we expect the mix change to contribute 90bps annually to Berger Paints’ revenue growth over the next three years (versus 220bps annually for Asian Paints).

Exhibit 4: Product mix assumptions

Economy Mid-tier Premium Average

price % price CAGR**


Current Berger Paints mix* 20% 70% 10% 112

3 Year forward Berger Paints mix 20% 66% 14% 115 0.9%


Source: Ambit Capital research; Note:* Ambit’s assumptions based on discussions with dealers, competitors and other market participants; ** Price CAGR implies change in average product price in Rs/litre due to change in product mix across various segments.

Change in estimates

Exhibit 5: Change in estimates [` mn]

New Estimates Old Estimates Change Comments

FY14E FY15E FY14E FY15E FY14E FY15E

Revenue 39,079 46,346 40,666 48,410 -4% -4% Decrease in our forecasts is driven by a lower market growth rate assumption and lower base effect of FY13 whilst assumptions around market share gains remain the same.

EBITDA 4,425 5,341 4,809 5,773 -8% -7%

EBITDA margin 11.3% 11.5%

11.8% 11.9% (50) (40)

Reduction in EBITDA margin is due to higher advertisement spends (by 60bps) given its promotion of premium brands and higher cash discounts paid (by 20bps).

PAT 2,489 3,103 2,711 3,323 -8% -7%

EPS 7.2 9.0 7.8 9.6 -8% -6% Lower EBITDA flows down to the PAT level.




Other assumptions and forecasts

Exhibit 6: Other assumptions and forecasts

FY11 FY12 FY13 FY14E FY15E Comments

Profit and Loss

Standalone revenue growth

24.4% 26.9% 12.7% 18.5% 18.6% Derived using market volume growth, shift from unorganised to organised, market share shift, change in product mix and price increases, as explained above.

International business revenue growth

3.6% 24.6% 22.0% 16.0% 17.4% Factor in slight moderation in growth from the Nepal and Poland business given exposure to developed markets.

Consolidated revenue growth

23.1% 26.6% 13.5% 16.8% 18.6%

Gross margins 36.9% 36.4% 38.5% 38.6% 38.7% Factor in moderate increase in gross margins given improving portfolio mix.

Salaries and wages (% of sales

6.2% 5.6% 5.6% 5.6% 5.5% We expect employee costs to remain stable.

Freight & Handling (% of sales) 5.5% 5.6% NA 5.7% 5.7% We expect freight expenses to remain stable.

Advert & Publicity (% of sales)

4.9% 5.1% NA 5.9% 5.9%

Cash discount (% of sale) 3.3% 3.4% NA 3.4% 3.4%

We expect the company to gain increase advertisement spends given its investments in the premium portfolio. We expect cash discounts to remain fairly stable

Others as a % of sales 6.8% 6.4% NA 6.6% 6.6% We expect other expenses to remain stable.

EBITDA Margins 10.2% 10.3% 11.1% 11.4% 11.6%

Tax rate 30.5% 29.2% 29.1% 30.0% 30.0% We expect stable tax rates.

Net Profit Margins 6.4% 6.1% 6.5% 6.4% 6.8%

Balance Sheet

Capex (` mn) 401 1,160 2,192 1,500 1,000

Capital work in progress (` mn)

818 730 1,000 500 500

No material capex plans likely after the current capex is through in FY14.

Working Capital Days 51 49 58 56 55 We expect working capital days to remain stable.

Debtor days 43 44 45 44 44 We expect debtor days to stabilise at 44 days.

Creditor days 64 68 60 60 60 We expect creditor days to remain constant.

Inventory days 70 69 69 68 67 Build in an improving inventory cycle given its investments in the supply chain.

Net debt to equity 0.3 0.2 0.3 0.2 0.1 We expect Berger to turn debt-free in FY16,

Cash Flows (` mn)

Operating cash flows 1,274 1,760 1,819 3,066 3,321

Free cash flows 234 397 -644 2,066 2,321 Capex to affect cash flows until FY14.


Exhibit 7: Explanation for our forensic accounting scores

Segment Score Comments

Accounting AMBER Berger scores well on cash conversion, related party advances and return on surplus cash; however, its working capital cycle and RoEs are average and provisions for debtors outstanding for more than six months is significantly low as compared to its peers.

Predictability GREEN Predictability of earnings remains high for Berger given: (a) high correlation for industry volume growth rates with GDP; (b) strong correlation of raw material costs with crude and foreign exchange rates; and (c) market share changes across various players in the industry..

Earnings Momentum GREEN On the back of higher-than-expected volume growth, Berger’s consensus EPS estimates have been upgraded by 4% for FY14 and 6% for FY15 over the past six months.




Valuation Berger Paints is a highly cash-generative business, which is either re-paid to shareholders as dividends (payout ratio of ~35% historically) or re-invested to expand the business. Consequently, we use a DCF-based model to arrive at a fair value for Berger Paints. The assumptions for weighted average cost of capital and terminal growth rates are shown in the exhibit on the left.

Our DCF model uses a WACC of 13.2% and a three-stage approach for Berger Paints.

Stage 1 includes explicit forecasts for the income statement and balance sheet for the next five years, with sales CAGR of 18%, EBITDA CAGR of 20% and EPS CAGR of 23% (FY08-FY13 EPS CAGR of 19%). These forecasts are based on the market growth rates, product mix change, market share gains and EBITDA margins explained earlier in this note. We forecast the Group’s tax rate to remain stable at 30%.

Stage 2 includes a decline in sales growth rate over seven years from 18.1% in FY18 to 6% in FY25 i.e. sales CAGR of 12% and a FCF CAGR of 16% over this period. Our capex forecasts assume a growth in maintenance capex in line with revenues going forward.

Stage 3 includes terminal growth forecasts with a growth rate to perpetuity of 5%. Our DCF model generates a fair value for Berger Paints of `204/share (implying 13% downside, 28x FY14E P/E and 23x FY15E P/E).

The cash flow and return profiles generated by our DCF model are shown in the exhibits below. Whilst Berger Paints has reported 15% CFO CAGR over FY08-13, we forecast 23% CFO CAGR over FY13-18. Our DCF model generates a one-year forward fair value of `204 (13% downside).

Exhibit 9: Cash flow profiles (` mn)

(3,000)

(2,000)

(1,000)

-

1,000

2,000

3,000

4,000

5,000

6,000

FY08

FY09

FY10

FY11

FY12

E

FY13

E

FY14

E

FY15

E

FY16

E

FY17

E

FY18

E

CFO FCF


Exhibit 10: Return profiles generated by our DCF (%)

-15%

-10%

-5%

0%

5%

10%

15%

20%

25%

30%

35%

FY08

FY09

FY10

FY11

FY12

E

FY13

E

FY14

E

FY15

E

FY16

E

FY17

E

FY18

E

EPS Growth (RHS) EBIT MarginsROE YoY growth in sales


Poor competitive positioning does not justify re-rating: As shown in the charts below, Berger Paints’ stock has traded between 16x-22x over the past three years vs the current FY14 multiple of 33x. Whilst the re-rating in the stock has been led by the company’s ability to match Asian Paints’ volume growth and gross margin expansion, we believe that this is unsustainable. Our checks do not suggest that Berger has been able to challenge the competitive advantages that Asian Paints has built for itself around its branding, supply chain and product portfolio.

Exhibit 8: Valuation assumptions Particulars Amount

Risk free rate (%) 8.5

Beta (2 year monthly) 0.85

Equity risk premium 7.0

Cost of equity (%) 14.5

Cost of debt (%) 12.0

Debt/equity ratio 20%

Tax rate (%) 30.0

WACC (%) 13.2




Exhibit 11: Berger’s P/E re-rating unjustified

10

40

70

100

130

160

190

220

250

Apr

-08

Sep-

08

Mar

-09

Sep-

09

Mar

-10

Sep-

10

Mar

-11

Sep-

11

Mar

-12

Sep-

12

Mar

-13

12x

17x

22x

30x

27x


Exhibit 12: Berger’s P/E re-rating unjustified

1030507090

110130150170190210230250

Apr

-08

Sep-

08

Mar

-09

Sep-

09

Mar

-10

Sep-

10

Mar

-11

Sep-

11

Mar

-12

Sep-

12

Mar

-13

7x

10x

13x

19x

16x


Change in stance from BUY to SELL Our change in stance on Berger Paints is driven solely by the rally in its share price to an extent where it currently trades in line with Asian Paints and at a substantial premium to its historical multiples without having demonstrated any fundamental positive change to its business for deserving such a premium rating.

Our previous BUY stance on Berger was based on our expectation of a gain in market share for Berger in the mid-tier products segment from Kansai Nerolac and Akzo Nobel, but without losing market share to Asian Paints in the premium products portfolio. Berger Paints’ current multiples are ~18% higher than the peer group average for FY14. Whilst we believe that the premium to Kansai Nerolac and Akzo Nobel is justified, we believe that Berger deserves to trade at a discount to Asian Paints (our analysis suggests that 22% is a fair premium for Asian Paints over Berger) given: (a) Asian Paints’ competitive advantages around supply chain management, product offerings, and a better-managed franchise; (b) relative outperformance as against peers, with Asian Paints reporting around 24% EPS CAGR over FY08-13 as against 19% for Berger; and (c) prospects for market share gain from peers and likely margin expansion over the next five years. Our DCF fair value implies valuation multiples of 28x for FY14 and 23x for FY15.

Ambit vs consensus

Exhibit 13: Ambit vs consensus

Ambit Consensus Divergence from

consensus Comments

FY14E

Net sales (` mn) 39,080 38,264 2% Factor in stronger industry growth and build in market share gains of 10bps for Berger in FY14

EBITDA (` mn) 4,425 4,472 -1% We do not expect margin expansion through premiumisation as explained earlier

EPS (`/share) 7.2 7.6 -5% Factor in higher depreciation on account of commissioning of the new Hindupur plant

FY15E

Net sales (` mn) 46,347 44,941 3% Factor in stronger industry growth and build in market share gains of 10bps for Berger in FY15

EBITDA (` mn) 5,341 5,430 -2% We do not expect margin expansion through premiumisation as explained earlier

EPS (`/share) 9.0 9.3 -3% Factor in higher depreciation on account of commissioning of the new Hindupur plant




Key catalysts Decline in gross margins from the strong margin expansion reported in

4QFY13 (41%) due to a combination of (a) its premium portfolio not gaining traction as strongly as that of its largest peer, Asian Paints; and (b) sharp depreciation of the INR, impacting raw material prices.

Poor performance of premium brands like Berger Silk in light of strong competition from Asian Paints’ premium portfolio.

Risks to our SELL stance We see the following key risks to our SELL stance on Berger Paints:

Strong off take in the premium Berger Silk portfolio and larger than expected success in the new construction chemicals business.

Sharp decrease in input costs due to either INR appreciation or commodity price correction.



Balance sheet

Year to March (` mn) FY11 FY12 FY13 FY14E FY15E

Shareholders' equity 692 692 693 693 693

Reserves & surpluses 6,203 7,223 8,839 10,396 12,364

Total networth 6,895 7,915 9,532 11,089 13,056

Minority Interest 0 0 0 0 0

Preference share capital 0 0 0 0 0

Debt 3,022 3,410 5,497 5,497 5,097

Deferred tax liability 263 312 408 408 408

Total liabilities 10,181 11,637 15,436 16,993 18,561

Gross block 7,157 8,317 10,509 12,009 13,009

Net block 4,341 5,089 6,714 7,479 7,672

CWIP 818 730 1,000 500 500

Investments 526 40 108 108 108

Cash & equivalents 1,265 1,824 2,270 2,928 3,319

Debtors 2,753 3,586 4,114 4,711 5,587

Inventory 4,437 5,544 6,364 7,280 8,507

Loans & advances 560 987 1,194 1,394 1,654

Other current assets 0 60 108 107 127

Total current assets 9,015 12,001 14,050 16,421 19,194

Current liabilities 4,068 5,530 5,514 6,439 7,636

Provisions 452 701 922 1,077 1,277

Total current liabilities 4,520 6,231 6,436 7,516 8,914

Net current assets 4,495 5,770 7,614 8,905 10,280

Miscellaneous 0 8 0 0 0

Total assets 10,181 11,637 15,436 16,993 18,561


Income statement


Operating income 23,281 29,477 33,464 39,079 46,346

% growth 23.1% 26.6% 13.5% 16.8% 18.6%

Operating expenditure 20,908 26,442 29,752 34,654 41,005

Operating profit 2,373 3,035 3,712 4,425 5,341

% growth 19.1% 27.9% 22.3% 19.2% 20.7%

Depreciation 401 472 567 735 807

EBIT 1,971 2,563 3,145 3,691 4,534

Interest expenditure 238 323 377 465 448

Non-operating income 428 305 314 330 346

Adjusted PBT 2,161 2,545 3,083 3,556 4,432

Tax 660 744 898 1,067 1,330

Adjusted PAT/ Net profit 1,501 1,801 2,184 2,489 3,103

% growth 25% 20% 21% 14% 25%

Prior Period Items - - - - -

Reported PAT / Net profit 1,501 1,801 2,184 2,489 3,103


Share of associates 0 0 0 0 0

Adjusted Consolidated net profit 1,501 1,801 2,184 2,489 3,103

Reported Consolidated net profit 1,501 1,801 2,184 2,489 3,103




Cash flow statement


EBIT 2,399 2,868 3,459 4,021 4,880

Depreciation 401 472 567 735 807

Others (131) (431) 88 (17) (85)

Tax (705) (794) (898) (1,067) (1,330)

(Incr) / decr in net working capital (691) (355) (1,398) (633) (984)

Cash flow from operations 1,274 1,760 1,819 3,038 3,289

Capex (1,040) (1,363) (2,462) (1,000) (1,000)

(Incr) / decr in investments 795 487 (68) - -

Other income (expenditure) 118 161 - - -

Others 15 10 - - -

Cash flow from investments (111) (705) (2,530) (1,000) (1,000)

Net borrowings 348 190 2,087 - (400)

Issuance of equity - 6 1 - -

Interest paid (237) (274) (465) (448) (363)

Dividend paid (421) (406) (729) (932) (1,135)

Others - - - - -

Cash flow from financing (310) (484) 893 (1,380) (1,898)

Net change in cash 853 571 181 658 390

Closing cash balance 1,265 1,824 2,005 2,928 3,319

Free cash flow 234 397 (644) 2,038 2,289


Ratio analysis

Year to March (%) FY11 FY12 FY13 FY14E FY15E

EBITDA margin (%) 12.0% 11.3% 12.0% 12.2% 12.3%

EBIT margin (%) 10.3% 9.7% 10.3% 10.3% 10.5%

Net profit margin (%) 6.4% 6.1% 6.5% 6.4% 6.7%

Dividend payout ratio (%) 34.9% 31.5% 33.4% 37.4% 36.6%

Net debt: equity (x) 0.3 0.2 0.3 0.2 0.1

Working capital turnover (x) 5.2 5.1 4.4 4.4 4.5

Gross block turnover (x) 3.3 3.5 3.2 3.3 3.6

RoCE (%) 18.0% 19.1% 18.6% 17.8% 19.7%

RoIC (%) 20.5% 23.6% 23.1% 21.9% 24.1%

RoE (%) 23.3% 24.3% 25.0% 24.1% 25.7%


Valuation parameters


EPS (`) 4.3 5.2 6.3 7.2 9.0

Diluted EPS (`) 4.3 5.2 6.3 7.2 9.0

Book value per share (`) 99.6 114.4 137.6 160.1 188.5

Dividend per share (`) 1.3 1.4 1.8 2.3 2.8

P/E (x) 55.6 46.3 38.2 33.5 26.9

P/BV (x) 2.4 2.1 1.8 1.5 1.3

EV/EBITDA (x) 30.9 26.0 22.1 18.7 15.6

EV/EBIT (x) 36.1 30.3 25.7 22.1 18.2




Asian Paints Key assumptions and estimates Revenue growth drivers

Exhibit 14: Summary assumptions for Asian Paints

FY13 FY14E FY15E


Organised Industry volume growth 8.0% 9.8% 12.2%

Company level drivers

Contribution from market share gain/loss vs peers 0.0% 0.6% 1.0%

LFL price increase 3.5% 5.0% 5.0% Contribution from mix change (economy/mid-tier to premium) 2.2% 2.2% 2.2%

Total volume growth for Asian Paints 8.0% 10.4% 13.2%

Contribution from realisation rate increase for Asian 5.7% 7.2% 7.2%

Total value 13.7% 17.7% 20.4%


Market share gains to continue but at a slower pace

Asian Paints has gained ~10 percentage points in market share over the past seven years. It has achieved this through a combination of efficient supply chain management (ensuring better availability of products at dealers’ shop floors), superior marketing campaigns vs peers, and a wider product offering. Given the scale benefits available to Asian Paints, we expect the competitive advantages related to marketing spends to continue.

Moreover, since the company continues to focus on a) further improving its reach; and b) supply chain across semi-urban, rural and slow-moving product categories, we expect Asian Paints to continue to win market share from its competitors. However, this is likely to be at a slower-than-historical run rate, given that Asian Paints already controls more than 50% of the market share controlled by the top-5 players. Consequently, we have assumed from the current market share of around 51% amongst the top-5 organised players in the paints industry that Asian Paints will gain 0.5 percentage points each year. This translates to a 1 percentage point contribution to the annual revenue growth rate for Asian Paints over the next five years and implies a market share of 53.2% by FY17 for Asian Paints (amongst the top-5 players) from 50.9% currently.

Exhibit 15: Shift in industry market share from FY07-17E

44.4% 50.9% 53.2%

18.3%17.2% 17.7%

37.3% 31.9% 29.1%

0%10%20%30%40%50%60%70%80%90%

100%

FY07 FY13 FY18

Others

Berger Paints

Asian Paints




Product mix change from economy to premium

Based on our discussions with market participants, we estimate that around 25% of product sales in decorative paints for Asian Paints are premium products, with the balance coming from economy/mid-tier products (see exhibit below). This proportion of premium products is higher than the industry average of around 20%, because Asian Paints has grabbed a larger pie of the shift from the economy/mid-tier segment to the premium segment over the past decade.

Whilst we expect the proportion of premium products for the industry to rise to 26% over the next three years, we expect this share for Asian Paints to rise to 33% over the same period. Our discussions with the management teams and industry participants suggest that gross margins on premium products are 10-12% higher than the economy/mid-tier products. Consequently, we expect the mix change to contribute 220bps annually to Asian Paints’ revenue growth over the next three years (versus 90bps annually for Berger).

Exhibit 16: Product mix assumptions

Economy Mid-tier Premium Average price

% price CAGR**


Current Asian Paints mix* 15% 60% 25% 128

3 Year forward Asian Paints mix 12% 55% 33% 137 2.2%


Source: Ambit Capital research; Note:* Ambit’s assumptions based on discussions with dealers, competitors and other market participants; ** Price CAGR implies change in average product price in Rs/litre due to change in product mix across various segments.



Other assumptions and forecasts

Exhibit 17: Other assumptions and forecasts for Asian Paints

FY11 FY12 FY13 FY14E FY15E Comments

Profit and Loss

Standalone revenue growth

23.4% 24.9% 12.4% 19.6% 20.2%

Derived using market volume growth, shift from unorganised to organised, market share shift, change in product mix and price increases, as explained above.

International business revenue growth

-18.5% 26.8% 25.9% 12.0% 12.0% Factor in muted growth in the international business given slowdown in global markets.

Consolidated revenue growth 15.3% 25.0% 13.9% 18.5% 19.1%

Gross margins 41.9% 40.0% 41.3% 41.3% 41.5% Factor in lower gross margins in FY14 given the sharp depreciation in the INR.

Salaries and wages as a % of sales

5.9% 5.5% 5.7% 5.6% 5.5% Benefits of economies of scale factored in.

Freight & Handling (% of sales)

4.0% 4.1% 4.2% 4.2% 4.2% We expect freight expenses to remain stable.

Advert & Publicity (% of sales)

4.4% 4.3% 4.8% 4.5% 4.4%

Cash discount (% of sale) 4.1% 4.1% 4.2% 4.1% 4.1%

We expect the company to gain from scale benefits in advertising and high base in FY13 due to rebranding, whilst cash discounts will remain fairly stable.

Others as a % of sales 6.5% 6.4% 6.8% 6.5% 6.4% We expect scale benefits from new plants to favourably impact margins.

EBITDA Margins 17.0% 15.7% 16.2% 16.6% 17.1%

Tax rate 30.1% 29.8% 28.8% 30.0% 31.0% We expect stable tax rates.

Net Profit Margins 10.9% 10.3% 10.7% 10.5% 10.8%

Balance Sheet

Capex (` mn) 4,874 1,166 12,808 4,000 2,000 Capital work in progress (` mn)

433 6,171 592 2,000 1,000 No material capex plans likely after the current capex is through in FY14.

Working Capital Days 10 16 13 13 13 We expect working capital days to remain stable.

Debtor days 27 30 33 30 30 We expect debtor days to stabilise at 30 days.

Creditor days 77 81 77 77 77 We expect creditor days to remain constant.

Inventory days 62 61 61 61 61 We expect inventory days to remain constant.

Net debt to equity (0.2) (0.1) (0.2) (0.2) (0.3) We expect higher cash accumulation as there are no material capex plans after FY14.

Cash Flows (` mn)

Operating cash flows 7,613 8,263 12,502 15,983 18,930

Free cash flows 6,052 1,532 6,135 10,575 17,930 Capex to affect cash flows until FY14.


Exhibit 18: Explanation for our forensic accounting scores

Segment Score Comments

Accounting GREEN Asian Paints has, in the past, reported high cash conversion, efficient management of working capital and low levels of loans and advances and contingent liabilities. Consequently, we give a high rating to the quality of its accounting.

Predictability AMBER

Due to a combination of high pricing power, presence across products, categories and SKUs, and predominant exposure to consumer-activity-led sector of the economy, earnings show stability. However, the current economic environment and volatility in raw material prices can lead to some volatility in earnings.

Earnings Momentum AMBER The slowdown in discretionary consumption has led to consensus downgrading its EPS forecast for Asian Paints by 3% for FY14 and 5% for FY15 over the past six months.




Valuation Asian Paints is a highly cash-generative business, with a CFO/EBITDA ratio of ~100%. The cash generated is either re-paid to shareholders as dividends (payout ratio of 45-50% historically) or re-invested to expand the business. Consequently, we use a DCF-based model to arrive at a fair value for Asian Paints.

The assumptions for weighted average cost of capital and terminal growth rates are shown in the exhibit on the left. We have assumed zero debt on Asian Paints’ balance sheet in the future given its strong cash generation. Hence, enough surplus cash is available on the balance sheet to fund capital expenditure in the future.

Our DCF model uses a WACC of 12.8% and a three-stage approach for Asian Paints.

Stage 1 includes explicit forecasts for the income statement and balance sheet for the next five years, with sales CAGR of 19%, EBITDA CAGR of 22% and EPS CAGR of 22% (FY08-FY13 EPS CAGR of 22%). These forecasts are based on the market growth rates, product mix change, market share gains and EBITDA margins explained earlier in this note. We forecast the group’s tax rate to rise from 30% currently to 32% by FY17.

Stage 2 includes a decline in sales growth rate over seven years from 18.5% in FY18 to 5% in FY25 i.e. sales CAGR of 12% and a FCF CAGR of 12% over this period. Our capex forecasts assume a growth in maintenance capex in line with revenues going forward.

Stage 3 includes terminal growth forecasts with a growth rate to perpetuity of 5%. Our DCF model generates a fair value for Asian Paints of `4,932/share (implying 4% upside, 35x FY14E P/E and 29x FY15E P/E).

The cash flow and return profiles generated by our DCF model are shown in the exhibits below. Whilst Asian Paints has reported 20% CFO CAGR over FY08-13, we forecast 23% CFO CAGR over FY13-18. Our DCF model generates a one-year forward fair value of `4,932 (4% upside).

Exhibit 20: Cash flow profiles (` mn)

-

5,000

10,000

15,000

20,000

25,000

30,000

35,000

FY08

FY09

FY10

FY11

FY12

FY13

FY14

E

FY15

E

FY16

E

FY17

E

FY18

E

CFO FCF


Exhibit 21: Return profiles generated by our DCF (%)

0%

5%

10%

15%

20%

25%

FY08

FY09

FY10

FY11

FY12

FY13

FY14

E

FY15

E

FY16

E

FY17

E

FY18

E

-20%

0%

20%

40%

60%

80%

100%

120%

EBIT Margins (LHS) EPS GrowthROE YoY Growth in sales


Current premium valuation justified: As shown in the charts below, Asian Paints’ stock has traded between 22x-30x one-year forward earnings over the past three years vs the current FY14 multiple of 33x. We believe that this premium rating is justified by the sustainability of its competitive advantages and consistency in earnings growth that the company has delivered.

Exhibit 19: Valuation assumptions Particulars Amount

Risk free rate (%) 8.5

Beta (2 year monthly) 0.62

Equity risk premium 7.0

Cost of equity (%) 12.8

Cost of debt (%) 12.0

Debt/equity ratio 0

Tax rate (%) 30.0

WACC (%) 12.8




Exhibit 22: Premium 1-year forward P/E justified

200600

1,0001,4001,8002,2002,6003,0003,4003,8004,2004,6005,000

Jan-

08

Sep-

08

May

-09

Jan-

10

Sep-

10

May

-11

Jan-

12

Sep-

12

May

-13

12x

32x

27x

22x

17x


Exhibit 23: Premium 1-year forward EV/EBITDA justified

200600

1,0001,4001,8002,2002,6003,0003,4003,8004,2004,6005,000

Apr

-08

Sep-

08

Mar

-09

Aug

-09

Feb-

10

Jul-

10

Jan-

11

Jul-

11

Dec

-11

Jun-

12

Nov

-12

May

-13

8x

11x

14x

17x

20x


P/E is the right relative valuation metric

Given that Berger is the only firm with a positive net debt:equity ratio of 0.2x amongst the top-4 Indian players and given that all players have similar tax rates, we look at the P/E ratios for relative valuation comparisons in the sector. Asian Paints’ stock currently trades at an earnings multiple of 34x for FY14 and at 29x for FY15. This is 18% higher than the peer group average for FY14. We believe this premium is justified given: (a) Asian Paints’ competitive advantages around supply chain management, product offerings and a better-managed franchise; (b) relative earnings growth outperformance against peers, with Asian Paints reporting around 22% EPS CAGR over FY08-13 as against 19% for Berger; and (c) high likelihood of market share gain from peers and likely margin expansion over the next five years. Our DCF fair value implies valuation multiples of 35x for FY14 and 29x for FY15, because we expect Asian Paints to pull more market share from its peers over the next five years and hence widen its financial outperformance.

Exhibit 24: Relative valuation

CMP P/E EBITDA

CAGR EV/EBITDA EV/SALES Company

name (LC)

Mcap (US$ mn)

EPS CAGR FY13-15

FY14E FY15E FY13-15 FY14E FY15E

Sales CAGR FY13-15

FY14E FY15E

ROE (FY14)

Indian companies

Asian Paints 4,763 7,595 22% 34.1 28.6 23% 21.8 18.4 19% 3.6 3.1 35

Berger Paints 241 1,387 19% 33.5 26.9 20% 19.3 16.0 18% 2.3 1.9 24

Kansai Nerolac 1,165 1,044 2% 24.5 20.7 20% 15.2 13.0 13% 2.0 1.7 17

Akzo Nobel 1,101 878 14% 21.2 18.1 23% 17.9 15.8 16% 1.8 1.5 11

Mean 14% 27.9 23.3 21% 18.5 15.8 16% 2.4 2.1 22

Median 17% 28.1 23.3 21% 18.6 15.9 17% 2.1 1.8 21

International companies

Dupont De Nemours

54 49,484 20% 14.1 12.5 23% 8.4 7.8 5% 1.6 1.5 30

PPG Industries 153 21,858 22% 19.4 16.8 2% 10.3 9.4 3% 1.5 1.4 27

Sherwin Williams

182 18,807 25% 23.0 19.1 25% 13.6 11.5 10% 1.9 1.7 38

Akzo Nobel NV 46 14,352 NA 15.2 12.4 17% 8.1 7.1 1% 1.0 0.9 10

Kansai Paint 1,330 3,588 8% 17.7 17.2 12% 9.9 8.9 8% 1.1 1.1 10

Nippon Paint 1,237 3,248 11% 14.4 13.4 7% 9.1 8.8 5% 1.3 1.2 13

Dulux Group 4 1,509 6% 18.4 15.7 26% 11.2 9.9 23% 1.4 1.3 49

Mean 15% 17.4 15.3 16% 10.1 9.1 8% 1.4 1.3 25

Median 15% 17.7 15.7 17% 9.9 8.9 5% 1.4 1.3 27

Source: Bloomberg, Ambit Capital research; Note: International companies follow a calendar year-end where FY14=CY13 and FY15=CY14



Ambit vs consensus As shown in Exhibit 26, our revenue forecasts are in line with consensus forecasts in FY14 and higher by 2% in FY15. This divergence is due to:

Market share gains: Consensus views the renewed aggression of peers like Berger and Akzo Nobel to have a detrimental impact on Asian Paints’ market share. However, we believe that not only are Asian Paints’ competitive advantages around supply chain efficiencies deep-rooted but the company continues to improvise on its operational efficiencies to further widen the outperformance gap against peers.

Exhibit 25: Quarterly revenue growth for Indian paint companies

32%36%

16%20%

22%26%

17% 17%

24%

15%19%

28%

15%

30%

8%11%

27%31%

8%

27%

13%11% 11%

3%

0%

5%

10%

15%

20%

25%

30%

35%

40%

1QFY12 2QFY12 3QFY12 4QFY12 1QFY13 2QFY13 3QFY13 4QFY13

Asian Paints Berger Paints Kansai Nerolac

Source: Company, Ambit Capital research. Note: Growth rates pertain to standalone numbers; results reflect domestic decorative business for Asian Paints and a mix of domestic decorative and industrial business for Berger and Kansai

Exhibit 26: Ambit vs consensus

Ambit Consensus Divergence from consensus Comments

FY14E

Net sales (` mn) 129,988 125,807 3% Factor in stronger-than-industry growth and build in market share gains of 30bps for Asian in FY14

EBITDA (` mn) 21,362 20,935 2% Net sales likely to flow down to EBITDA

EPS (`/share) 141.3 141.3 0% Factor in higher depreciation on account of commissioning of new plant

FY15E

Net sales (` mn) 154,770 146,591 6% Factor in stronger-than-industry growth and build in market share gains of 50bps for Asian Paints in FY15

EBITDA (` mn) 26,194 24,745 6% Net sales likely to flow down to EBITDA

EPS (`/share) 172.8 168.8 2% Factor in higher depreciation on account of commissioning of new plant


Key catalysts Growth of the industrial products JV with PPG, which is likely to gather

momentum, especially as the industrial market growth revives in the future

Supply chain efficiencies from complete replacement of regional distribution centres, with distribution centres next to manufacturing units; automation of depots and GPS-enabled trucks; this will reduce inter-depot transfers and hence further improve operational efficiencies

Revenue and gross margin expansion due to premiumisation of the product portfolio mix

Acceleration of consumer discretionary spending, thereby further reducing re-painting cycles



Risks to our BUY stance We see the following key risks to our BUY stance on Asian Paints:

Poor capital allocation decisions by Asian Paints going forward, given that there are no material capex or debt-repayment-related capital utilisation requirements; whilst the recently announced acquisition of kitchen retailer ‘Sleek’ is small as compared to its balance sheet size, there is a risk of more and larger acquisitions around home décor which could be detrimental to its RoEs

Sustained sluggish economic growth for India over the next two years

Sharp increase in input costs due to either INR depreciation or commodity price increases along with high price elasticity of demand in the paints industry; this scenario will not allow Asian Paints to pass on input price inflation to the customers without moderation in customer demand



Balance sheet


Shareholders' equity 959 959 959 959 959

Reserves & surpluses 20,915 26,526 32,884 39,701 47,297

Total net worth 21,874 27,485 33,843 40,660 48,257

Minority Interest 1,099 1,367 1,608 2,178 2,891

Preference share capital 0 0 0 0 0

Debt 2,292 3,359 2,377 0 0

Deferred tax liability 852 928 1,544 1,544 1,544

Total liabilities 26,117 33,139 39,371 44,382 52,692

Gross block 20,249 21,458 34,294 38,294 40,294

Net block 13,099 13,006 24,410 26,079 25,554

CWIP 433 6,171 592 2,000 1,000

Investments 4,290 3,547 2,807 4,000 4,000

Cash & equivalents 6,262 6,243 7,520 7,673 16,625

Debtors 5,731 7,813 9,809 10,684 12,721

Inventory 13,054 15,989 18,303 21,724 25,866

Loans & advances 2,107 5,135 3,211 4,274 5,088

Other current assets 1,130 1,059 1,215 1,425 1,696

Total current assets 28,284 36,238 40,058 45,779 61,996

Current liabilities 16,321 21,374 23,101 27,422 32,650

Provisions 3,668 4,449 5,394 6,054 7,208

Total current liabilities 19,989 25,823 28,495 33,476 39,859

Net current assets 8,296 10,415 11,562 12,303 22,138

Miscellaneous 0 0 0 0 0

Total assets 26,117 33,139 39,371 44,382 52,692 Source: Company, Ambit Capital research

Income statement


Operating income 77,062 96,322 109,707 129,988 154,770

% growth 15.3% 25.0% 13.9% 18.5% 19.1%

Operating expenditure 63,933 81,235 91,754 108,626 128,576

Operating profit 13,130 15,087 17,319 21,362 26,194

% growth 7.0% 14.9% 14.8% 23.3% 22.6%

Depreciation 1,131 1,211 1,546 2,330 2,525

EBIT 11,998 13,876 15,773 19,032 23,669

Interest expenditure 222 410 367 119 0

Non-operating income 826 1,074 1,145 1,260 1,386

Adjusted PBT 12,602 14,540 16,552 20,172 25,054

Tax 3,789 4,335 4,957 6,052 7,767

Adjusted PAT/ Net profit 8,814 10,205 11,595 14,121 17,288

% growth 0% 16% 14% 22% 22%

Prior Period Items 0 0 0 0 0

Reported PAT / Net profit 8,814 10,205 11,595 14,121 17,288


Share of associates 0 0 0 0 0

Adjusted Consolidated net profit 8,432 9,887 11,139 13,550 16,574

Reported Consolidated net profit 8,432 9,887 11,139 13,550 16,574 Source: Company, Ambit Capital research



Cash flow statement


EBIT 12,825 14,950 16,919 20,291 25,054

Depreciation 1,131 1,211 1,546 2,330 2,525

Others (652) (807) (625) (0) (0)

Tax (3,924) (4,296) (4,385) (6,052) (7,767)

(Incr) / decr in net working capital (1,767) (2,795) (1,587) (587) (883)

Cash flow from operations 7,613 8,263 11,868 15,983 18,930

Capex (1,561) (6,732) (6,367) (5,408) (1,000)

(Incr) / decr in investments (3,109) 1,075 973 (1,193) -

Other income (expenditure) 460 478 438 - -

Others 62 57 113 - -

Cash flow from investments (4,148) (5,121) (4,843) (6,601) (1,000)

Net borrowings 56 970 (1,016) (2,377) -

Issuance of equity - - - - -

Interest paid (222) (404) (371) (119) -

Dividend paid (3,168) (3,831) (4,621) (6,733) (8,978)

Others - - - - -

Cash flow from financing (3,335) (3,265) (6,007) (9,229) (8,978)

Net change in cash 129 -123 1,018 153 8,953

Closing cash balance 6,516 6,243 7,515 7,673 16,625

Free cash flow 6,052 1,532 5,501 10,575 17,930Source: Company, Ambit Capital research

Ratio analysis

Year to March (%) FY11 FY12 FY13 FY14E FY15E

EBITDA margin (%) 18.1% 16.8% 16.8% 17.4% 17.8%

EBIT margin(%) 16.6% 15.5% 15.4% 15.6% 16.2%

Net profit margin(%) 10.9% 10.3% 10.2% 10.4% 10.7%

Dividend payout ratio(%) 42.3% 45.1% 46.3% 49.7% 54.2%

Net debt: equity (x) (0.2) (0.1) (0.2) (0.2) (0.3)

Working capital turnover (x) 37.9 23.1 27.1 28.1 28.1

Gross block turnover (x) 4.4 4.7 4.0 3.6 4.0

RoCE(%) 41.2% 38.1% 35.3% 37.0% 38.9%

RoIC(%) 52.1% 53.3% 46.4% 43.6% 50.2%

RoE(%) 43.3% 40.1% 36.3% 36.4% 37.3%Source: Company, Ambit Capital research

Valuation parameters


EPS (`) 87.9 103.1 116.1 141.3 172.8

Diluted EPS (`) 87.9 103.1 116.1 141.3 172.8

Book value per share (`) 228.0 286.5 352.8 423.9 503.1

Dividend per share (`) 32.0 40.0 45.0 60.0 80.0

P/E (x) 54.0 46.1 40.9 33.6 27.5

P/BV (x) 20.8 16.6 13.5 11.2 9.4

EV/EBITDA (x) 32.8 28.4 24.8 20.1 16.5

EV/EBIT (x) 35.7 30.7 27.1 22.5 18.2 Source: Company, Ambit Capital research



Institutional Equities Team

Saurabh Mukherjea, CFA Head of Equities (022) 30433174 [email protected]

Research

Analysts Industry Sectors Desk-Phone E-mail

Aadesh Mehta Banking / NBFCs (022) 30433239 [email protected]

Achint Bhagat Cement / Infrastructure (022) 30433178 [email protected]

Ankur Rudra, CFA Technology / Telecom / Media (022) 30433211 [email protected]

Ashvin Shetty Automobile (022) 30433285 [email protected]

Bhargav Buddhadev Power / Capital Goods (022) 30433252 [email protected]

Dayanand Mittal Oil & Gas (022) 30433202 [email protected]

Gaurav Mehta Strategy / Derivatives Research (022) 30433255 [email protected]

Jatin Kotian Metals & Mining / Healthcare (022) 30433261 [email protected]

Karan Khanna Strategy (022) 30433251 [email protected]

Krishnan ASV Banking (022) 30433205 [email protected]

Nitin Bhasin E&C / Infrastructure / Cement (022) 30433241 [email protected]

Nitin Jain Technology (022) 30433291 [email protected]

Pankaj Agarwal, CFA NBFCs (022) 30433206 [email protected]

Pratik Singhania Real Estate / Retail (022) 30433264 [email protected]

Parita Ashar Metals & Mining (022) 30433223 [email protected]

Rakshit Ranjan, CFA Consumer / Real Estate (022) 30433201 [email protected]

Ravi Singh Banking / NBFCs (022) 30433181 [email protected]

Ritika Mankar Mukherjee Economy / Strategy (022) 30433175 [email protected]

Ritu Modi Healthcare (022) 30433292 [email protected]

Shariq Merchant Consumer (022) 30433246 [email protected]

Tanuj Mukhija E&C / Infrastructure (022) 30433203 [email protected]

Utsav Mehta Telecom / Media (022) 30433209 [email protected]

Sales

Name Regions Desk-Phone E-mail

Deepak Sawhney India / Asia (022) 30433295 [email protected]

Dharmen Shah India / Asia (022) 30433289 [email protected]

Dipti Mehta India / Europe / USA (022) 30433053 [email protected]

Nityam Shah, CFA USA (022) 30433259 [email protected]

Parees Purohit, CFA USA (022) 30433169 [email protected]

Pramod Gubbi, CFA India / Asia +65 86066476 [email protected]

Praveena Pattabiraman India / Asia (022) 30433268 [email protected]

Sarojini Ramachandran UK +44 (0) 20 7614 8374 [email protected]

Production

Sajid Merchant Production (022) 30433247 [email protected]

Joel Pereira Editor (022) 30433284 [email protected]

E&C = Engineering & Construction



Explanation of Investment Rating

Investment Rating Expected return

(over 12-month period from date of initial rating)

Buy >5%

Sell <5%

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Documents

Discretionary consumer July 10, 2013 Paintswebambit.ambit.co/reports/Ambit_Paints SectorUpdate_10Jul2013.pdf · Discretionary consumer July 10, 2013 Paints SECTOR UPDATE Ambit Capital