company insight apnt in equity december 6, 2013...

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Asian Paints SELL

COMPANY INSIGHT APNT IN EQUITY December 6, 2013

Too hot to handle Consumer

Recommendation Mcap (bn): `484/US$7.8 6M ADV (mn): `661/US$10.6 CMP: ` 505 TP (12 mths): ` 476 Downside (%): 6

Flags Accounting: GREEN Predictability: AMBER Earnings Momentum: AMBER

Catalysts

3QFY14 results announcement

Capital allocation decisions

Performance

Source: Bloomberg, Ambit Capital research

Analyst Details

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

Shariq Merchant +91 22 3043 3246 [email protected]

350380410440470500530560

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Oct-12 Feb-13 Jul-13

Sensex Asian Paint

Key financials

Year to March FY12 FY13 FY14E FY15E FY16E Operating income (` mn) 96,322 109,707 125,673 147,166 173,294 EBITDA (` mn) 16,161 18,465 21,512 26,160 31,822 EBITDA margin (%) 16.8% 16.8% 17.1% 17.8% 18.4% EPS (`) 10.3 11.6 13.2 16.4 20.1 RoE (%) 40.1% 36.3% 34.5% 36.3% 38.2% RoCE (%) 38.1% 35.3% 35.2% 38.0% 40.0% P/E (x) 49.0 43.5 38.1 30.9 25.1

Source: Company, Ambit Capital research

Asian Paints’ stock has rallied by 30% over the past 18 months, owing to to consistent demand for paints in India and sustainable competitive advantages (which supported market share gains). However, recent management commentary suggests that a substantial part of the future capital allocation will include: (a) development of ‘home improvement’ (lower RoCE vs paints) into the largest division for the firm in the long term; and (b) strategic initiatives around Berger International, a division that has generated sub-par RoCEs over the past decade. We believe its FY15 P/E multiple at 31.0x, which is at a ~10% premium to the FMCG sector average, is unjustified despite assuming market share gains and strong fundamentals of its Indian paints division. We turn SELLers with a DCF-based fair value of `476. The 3QFY14 results are likely to be a negative catalyst. Competitive position: STRONG Changes to this position: STABLE

Paints division continues to be fundamentally strong… Over the past 3-4 years, demand in the paints sector has been increasingly consistent. Against this backdrop, Asian Paints has sustained its outperformance against peers through superior supply chain management, strong brand recall with dealers/painters/customers, and high-quality talent at the middle management level. These competitive advantages are sustainable in the future.

… however, capital allocation likely to be an overhang on RoCEs The management recently stated that the ‘home improvement’ division is likely to be larger than the paints division in the longer term, even though home improvement is a lower RoCE business than paints. Also, the de-listing of Berger International is intended to help the firm explore ‘more options’ of operating in international markets despite the business generating sub-par returns historically. These statements come at a time when the firm is beginning to generate surplus capital amidst an inter-generational shift amongst promoters.

Current valuations are stretched – we change our stance to SELL At a valuation of 31.0x FY15 P/E, the stock is trading at over 30% premium to its peers and at ~10% premium to the broader FMCG sector average. Its premium rating against other paint companies is justified by its superior operational franchise. However, the stock would trade at a 10-15% discount to high-quality FMCG firms such as Nestle, owing to: (a) capital allocation risks which limit the visibility of its longer-term cash generation at the consolidated level; and (b) less efficient working capital cycle and higher capital intensity of its business. We make no material changes to our forecasts, and our DCF generates a fair value of `476 (6% downside).

3QFY14 is likely to be a negative catalyst The company would report a revenue growth of not more than 10% YoY in 3QFY14, owing to: (a) ‘wake’ effect of ‘channel stuffing’ in 2QFY14 (18% YoY revenue growth); and (b) base effect from a delayed Diwali last year.

Asian Paints

06 December 2013 Ambit Capital Pvt. Ltd.

Favourable macro, sustainable competitive advantages, and good management team We believe Asian Paints would benefit from the following key strengths as a business:

Paint demand becoming increasingly consistent As highlighted in the exhibit below, the Indian paints sector is in a sweet spot in the entry-level aspirational consumption category. Repainting cycles are shrinking with increasingly consistent consumer demand and consumers are upgrading from unorganised to organised products. These tailwinds are supported by structural trends around urbanisation, women empowerment, and increased media penetration. Thus, household incomes and expenditure towards lifestyle upgrades are increasing through entry-level discretionary spending categories. Consequently, the paints sector has reported stellar and consistent revenue growth over the past decade.

Exhibit 1: Our price–utility matrix for B2C consumer

Source: Ambit Capital research

Exhibit 2: Total paint industry YoY growth rates


Asian Paints’ competitive advantages are sustainable Exhibit 3: 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 exhibit 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. The end consumer has limited appreciation for product differentiation and paints are bulky in nature, making transportation and storage uneconomical. Moreover, the sector demands a large distribution network with a wide range of SKUs, and demand is seasonal and deferrable, making it difficult for manufacturers to ensure availability across the year.

Rural FMCG

Apparel

Diamond

Watches

Beer

Spirits

Shoes

Kitchenware

Paints

LightElectrical

White goods (excl ACs)

Air Conditioner 4 Wheelers

2 Wheelers

Batteries

U T I L I T Y

P

R

I

C

E

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42

3

Urban FMCG

Macro = "Sweet Spot"

Gold Jewellery

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25%

FY05

FY06

FY07

FY08

FY09

FY10

FY11

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1HFY

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Value Volume Realisation

Asian Paints


Asian Paints has consistently invested in improving the supply chain initiatives over the past three decades. Hence, it has built capabilities around: (a) ability to use historical demand patterns to better forecast demand in micro-markets and hence maintain low levels of depot-level inventory; (b) digitising inventory management at a depot level; and (c) mapping the movement of trucks and other vehicles in the supply chain through the GPS networks. Not only have these initiatives helped Asian Paints service its dealer network better than its peers but the company has also continued to evolve its supply chain tools on an ongoing basis to further improve these service standards.

Asian Paints’ competitors would take time to build a superior data forecasting ability through such a centralised inventory management platform. Moreover, the company has a strong focus to further improve its supply chain through investments. Thus, we do not expect the gap in the supply chain efficiencies between Asian Paints and its peers to narrow materially at least over the next five years.

Consistent focus from the management team – so far Exhibit 4: Changes in promoters of Asian Paints and its peers since inception of the respective companies

Year Change in ownership Event details

Asian Paints

1942 No Formed by Choksey, Choksi, Vakil and Dani. Choksey moved out in 1997 after disputes with the promoters.

Berger Paints

1923 No Hadfields (India) was incorporated.

1947 Yes Acquired by British Paints.

1965 Yes British Paints was acquired by Celanese Corp.

1969 Yes Berger and Jenson Nicholson Ltd bought British Paints (India) from Celanese Corp.

1976 Yes Foreign holding in the company was diluted to below 40% by sale of shares to the UB Group.

1983 No Name of the company changed from British Paints India to Berger Paints.

1991 Yes The business was sold to the Dhingra brothers.

Kansai Nerolac

1920 No Formed as Gahgan Paints. Entered into collaboration with Goodlass Group UK.

1933 Yes Acquired by Lead Industries Group (creation of Goodlass Wall).

1957 No Goodlass Wall became Goodlass Nerolac Paints and went public.

1976 Yes Became part of the Tata Forbes Group on acquisition of a part of the shareholding by Forbes Gokak.

1999 Yes After selling 36% to Kansai Paint Co in 1986, Kansai bought the remaining holding of Tata Forbes in 1999 and renamed it Kansai Nerolac in 2006.

Akzo Nobel

1911 No Set up in India as Brunner Mond & Co.

1929 Yes Name changed to Imperial Chemical Industries after a merger at the parent level.

1984 No After entering several businesses, ICI merged all its group companies. 1987-2007 No Entered and exited various businesses (pharmaceuticals, catalysts, rubber chemicals,

adhesives, etc).

2008 Yes Akzo Nobel bought the entire share capital of Imperial Chemical Industries globally. The name of the company was changed to Akzo Nobel India.

Shalimar Paints

1902 No Incorporated as Shalimar Paint Colour & Varnish.

1928 Yes Pinchin Johnson bought the controlling stake and it became a part of the Red Hand Composition Group.

1963 No After going public in 1961, the name was changed to Shalimar Paints.

1964 Yes Red Hand Composition bought over by International Paints, which became part of the Courtaulds Group.

1989 Yes Sold to SS Jhunjhunwala and OP Jindal Group

Source: Ambit Capital Research

Asian Paints


Our discussions with ex-employees of various paint companies suggest that the intense focus on streamlining distribution and supply chain, and hence accelerating growth, has been driven by a combination of two key characteristics of the management team:

Fewer distractions amongst promoters: Asian Paints is the only paints company in the sector which has not seen a change in its controlling shareholder (promoter) over the past 70 years. As shown in the exhibit above, all its competitors have seen: (a) a change in the controlling shareholder; and (b) significant presence of a foreign entity on the board of directors. Our primary data sources suggest that this consistency at the board level has helped Asian Paints maintain focus on the execution of a stable long-term strategy over these decades.

Focus on quality of managers at all levels: Ex-employees of Asian Paints suggest that to properly execute its strategy of improving operational efficiencies, the company has always focused on hiring and retaining high-quality professionals. For example, the company has recruited graduates from top business schools in India including IIMs even during 1970s. As a result, the middle management team at Asian Paints usually includes relatively young professionals who are in the age group of 40-45 years and have had 15-20 years of experience in the industry, mostly with Asian Paints.

Asian Paints


However, capital allocation risks likely to be a material overhang on growth Asian Paints’ management team made the following two comments in its 2QFY14 analyst conference call:

’Home Improvement’ segment: The management stated that, “The ‘home improvement’ division for Asian Paints is likely to be bigger in size compared to the paints division in the longer term. From being a paints company currently, we really want to become a home improvements décor company”. Also, the management acknowledged that the ‘home improvement’ division generates lower RoCEs as compared to the paints business and that the firm will try to improve the RoCEs of home improvement over time towards that of the paints division.

Berger International: On being asked about the rationale behind the Berger International stake increase from 50.1% in FY13 to 96.5% currently, the management stated that “We want to delist Berger International Limited from the Singapore stock exchange and this gives us more options about how to operate in the international markets in future.”

Consequently we expect a high possibility of substantial capital allocation behind the home improvement division in India and Berger International over the short term as well as the long term.

Moreover, the timing of these comments from the management team is congruent with the following events:

Transition of decision-making from the second generation to the third generation of promoter families: In FY10, members from the second generation of the promoter families stepped down from executive roles on the board, leaving the non-promoter family CEO & MD, Mr. P.M. Murty (who was succeeded by Mr. K.B.S. Anand), as the only non-executive director on the board. Since then, several incremental responsibilities have been awarded to the senior members of the third generation of the promoter family, with the current family trees shown in the exhibits below.

Exhibit 5: Vakil family tree - Shareholding (%) and responsibilities (where information was available)

Source: Ambit Capital research; Note: The family trees have been made based on the information available and may not be completely accurate.

Bhairavi Vakil (0.23%)

Arvind Vakil (family heads Domestic decoratives business)

Abhay Vakil (Age 62) (2.97%) Amar Vakil (Age 61) (1.36%)

Vivek Vakil (Age 26) (0.33%) (Executive Trainee – Finance)

Nehal Vakil (0.25%)

Amrita Vakil (0.27%)

Varun Vakil (Age 29) (0.23%) (Manager – Customer Centricity)

Dipika Vakil (0.21%)

Asian Paints


Exhibit 6: Dani family tree - Shareholding (%) and responsibilities (where information was available)


Exhibit 7: Choksi family tree - Shareholding (%) and responsibilities (where information was available)


Need for active capital deployment given accumulation of surplus: As shown in the exhibit below, Asian Paints’ balance sheet has not had material surplus capital available for active deployment in the past, given capital expenditure into the existing paints division. However, following the recent `20bn capex for capacity expansion in its Rohtak and Khandala plant (350,000KL per annum in all), the firm is not likely to invest materially behind core capex over the next few years. Existing manufacturing capacity for the firms is good enough to last at least till FY18.

With the management clearly indicating in our discussions that an increase in the dividend payout ratio is not being considered currently as an option, we expect the capital surplus on the balance sheet to increase materially in the coming years. This, we believe, calls for active capital deployment decisions at a board level for the firm. It is also worth highlighting that the RoCE of the international business (using the incremental capital deployment towards these international subsidiaries) has been less than 10% in the past. Hence the firm’s comments around the rationale behind Berger International’s recent stake purchase are not comforting.

Suryakant Dani (family heads international business

Ashwin Dani (0.22%)

Ina Dani (0.05%)

Hasit Dani (Age 41) (0.42%) (Non exec director in APNT from 2001-2011;

Presently, Director of Gujarat Organics Ltd)

Jalaj Dani (Age 43) (0.17%) (President -

International Business

Ishwara Dani

Malav Dani (Age 38) (0.34%)

Mudit Dani (0.02%)

Shubhlakshmi Dani (0.01%)

Smiti Dani (0.01%)

Vita Dani (0.05%)

Wife

Ashish Choksi (0.09%) (Not

with the Group)

Urvashi Choksi (0.09%)

Prafulika Choksi (0.22%)

Jigish Choksi (0.21%)

(Executive – Marketing )

Vishal Choksi (0.31%) (Was management

trainee with APNT in FY06)

Shailesh Choksi (0.45%)

Ashwin Choksi (Age 70) (0.08%)

Chimanlal Choksi (family heads domestic non-decorative business)

Druhi Choksi (0.01%)

Ashay Choksi (0.01%)

Binita Choksi (0.01%)

Mahendra Choksi (Age 72) (0.23%)

Rupen Choksi (Age 36) (0.1%) (ED, Resins & Plastics

Ltd. (Associate of APNT)

Margi Choksi (0.01%)

Nysha Choksi (0.01%)

Anay Choksi (0.01%)

Rupal Anand Bhat (0.2%)

Rita Choksi (0.1%)

Manish Choksi (age 38) (0.25%) (President – Home Improvement, IT & Supply

Chain)

Ami Choksi (0.05%)

Rhea Choksi (0.07%)

Richa Choksi (0.02%)

Asian Paints


Exhibit 8: Asian Paints’ cash flow generation and its utilisation (` mn)


Other issues that investors should be cognizant of: In 2010, the Dani family increased its stake in the company from ~18% to ~21% (source: trade press). Prior to this, the three families had an almost equal stake in the company. Changes in shareholding can, over a period of time, become a source of tension.

Also, some tensions did crop up a few years back (in 2002) when Asian Paints acquired Berger International (based in Singapore, with operations across 11 countries in South East Asia, the Middle East and the Caribbean Islands). Whilst two of the families were not completely in favour of the decision, the Dani side of the family wanted to go ahead, and the company did go ahead. In the international business, over the last ten years, the company has capital employed ranging from 24% to 55% of overall capital employed (vs 26% in FY13) and the return on capital employed has been a poor -6% to +8%. By any yardstick, the returns in the international business have been inadequate but the company has persisted with its growth ambitions.

Exhibit 9: Asian Paints’ capital employed and returns generated in the international and consolidated business

FY04 FY05 FY06 FY07 FY08 FY09 FY10 FY11 FY12 FY13

Capital employed in consolidated business (` mn) 6,988 8,067 9,075 10,840 12,576 15,118 19,392 24,167 30,844 36,220

Capital employed in international business (` mn) 3,870 4,226 4,899 4,738 4,871 7,150 6,256 6,491 7,438 9,248

International CE as % of overall CE 55% 52% 54% 44% 39% 47% 32% 27% 24% 26%

ROCE in international business -2.4% -5.8% 2.8% -0.4% 2.9% 3.9% 6.4% 7.5% 2.5% 5.8%

Consolidated ROCEs 23.4% 24.3% 26.4% 30.2% 38.5% 31.8% 52.3% 41.2% 38.1% 35.3%


Conclusion: Asian Paints’ acquisition of both Sleek (home improvement) for `1.2bn as well as the stake purchase in Berger International for `650mn is small as compared to the size of the firm’s balance sheet. But, we see the likelihood of material capital deployment behind such initiatives in the future, which could likely be a drag on overall RoCEs, dividend payout ratios and hence valuations.

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Dividends (LHS) Capex (LHS)

CFO (RHS) Net Cash and Investments (RHS)

Asian Paints


Valuations appear stretched – turn SELLers On one-year forward P/E multiples, Asian Paints has been re-rated from ~20.0x average multiple over FY08-13 to 30.0-35.0x multiple recently. Part of the re-rating is justified by the increasingly consistent and high macro demand growth for the sector, sustainability of competitive advantages of Asian Paints as compared to its peers in the sector, and a good-quality professional management team.

Exhibit 10: Premium one-year forward P/E justified


Exhibit 11: Premium one-year forward EV/EBITDA justified


However, our DCF-based valuation generates a fair value of `476 (6% downside from current levels), an implied FY15 P/E multiple of 29.1x. We expect negative catalysts for the stock price to include capital allocation decisions (as highlighted previously in the note) towards segments which are less cash-generative and low RoCE.

Relative valuations Asian Paints is trading at an over 30% premium to the other listed paint companies in India on FY15 P/E multiples. This premium rating is justified by the firm’s strong competitive advantages around supply chain efficiencies, superior brand recall with the dealers, painters as well as the end consumer and high-quality talent retention at a the middle management level.

The stock is also trading at an over 70% premium to non-Indian listed paint companies. This is justified, given the superior long-term growth potential of the Indian players, relatively lower competitive intensity in the Indian paints sector, and most importantly, higher brand-relevance of paint products in India vs abroad.

Asian Paints is currently trading at a 10% premium to the broader FMCG sector average P/E multiple. Whilst it is trading at a 7-8% discount to the top-rated FMCG firm, Nestle India, we believe that this discount deserves to increase further given: (a) superior capital allocation of Nestle as compared to risks around capital mis-allocation for Asian Paints; and (b) higher cash generation and negative working capital cycle of Nestle.

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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


Asian Paints


Exhibit 12: Relative valuations for Indian and global paint companies

CMP Mcap EPS CAGR P/E EBITDA CAGR EV/EBITDA Sales CAGR EV/Sales ROE

Company name (LC) (US$ mn) FY13-15 FY14E FY15E FY13-15 FY14E FY15E FY13-15 FY14E FY15E (%)

Indian companies Asian Paints 505 7,850 18% 38.2 30.9 17% 22.4 18.4 16% 3.8 3.2 34.5

Berger Paints 236 1,327 18% 32.3 26.7 18% 19.8 16.6 16% 2.2 1.9 24.2

Kansai Nerolac 1,066 931 -1% 23.6 20.1 18% 14.5 12.3 13% NA NA NA

Akzo Nobel 836 650 9% 19.8 15.0 19% 16.0 12.8 17% 1.4 1.1 11.0

Mean 11% 26.7 23.2 18% 18.3 15.1 15% 2.5 2.1 23.2

Median 13% 27.9 23.4 18% 17.9 14.7 16% 2.2 1.9 24.2

International companies Dupont (EI) De Nemours 60 55,807 20% 15.7 13.9 23% 9.7 8.8 5% 1.8 1.7 30.4

PPG Industries 183 25,983 25% 22.3 19.2 3% 11.7 11.1 2% 1.8 1.7 27.1

Sherwin Williams 181 18,349 22% 23.9 19.8 20% 13.8 11.9 8% 1.9 1.7 42.8

Akzo Nobel NV 54 17,684 NA 19.0 16.0 11% 9.6 8.2 -1% 1.0 1.0 9.8

Kansai Paint 1,442 3,852 8% 18.8 18.4 12% 10.5 9.5 7% 1.2 1.2 9.8

Nippon Paint 1,644 4,275 24% 14.9 14.2 12% 11.1 10.7 6% 1.7 1.6 16.7

Dulux Group 5 1,830 22% 19.0 17.2 20% 11.2 10.5 7% 1.5 1.4 44.0

Mean 20% 19.1 17.0 15% 11.1 10.1 5% 1.6 1.5 Median 22% 19.0 17.2 12% 11.1 10.5 6% 1.7 1.6


Exhibit 13: Relative valuations for the Indian FMCG sector

CMP Mcap P/E EV/EBITDA EV/Sales Div Yield EPS Growth

(`) ($mn) FY14E FY15E FY14E FY15E FY14E FY15E FY14E (%) FY13-15

Marico 215 2,237 28.1 23.7 19.64 16.74 2.95 2.53 0.63 24%

ITC 309 39,402 28.1 23.8 19.88 16.93 7.28 6.30 1.97 17%

HUL 566 19,746 33.7 30.9 28.67 25.27 4.48 3.98 1.78 10%

Nestle 5,060 7,835 41.5 34.9 26.53 22.97 5.80 4.97 1.29 14%

Dabur 163 4,582 30.2 25.9 26.45 22.89 4.45 3.85 1.01 15%

GCPL 846 4,639 35.7 28.6 24.15 19.41 3.73 3.17 0.79 23%

GSK Consumer 4,645 3,147 28.8 31.7 32.86 27.48 5.16 4.40 1.37 18%

Colgate 1,259 2,762 35.9 29.6 26.88 22.88 5.29 4.57 2.01 10%

Emami 470 1,721 26.9 23.1 24.04 20.38 5.64 4.85 1.29 22%

Britannia 879 1,697 30.2 26.0 21.57 18.56 1.61 1.40 1.30 25%


Asian Paints


Industry growth assumptions Key assumptions and estimates Revenue growth drivers

Exhibit 14: Summary assumptions for paint industry

FY13 FY14E FY15E FY16E

Industry level drivers

Industry volume growth 6.0% 7.1% 9.6% 11.2% Contribution from shift from unorganised market to organised market 2.0% 1.0% 1.0% 1.0%

Industry volume growth 8.0% 8.1% 10.6% 12.2%

LFL price increase 3.5% 4.0% 4.0% 4.0%

Industry value growth 11.5% 12.1% 14.6% 16.2%


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

Overall market volume growth: Industry volume growth has historically been linked closely to the overall GDP growth, as shown in the exhibit below. We forecast industry volume growth rate of 7.2% in FY14. We have assumed a market volume to GDP growth multiplier of 1.5x for FY14, which would recover to its five-year average of 1.6x in FY15. This is based on our forecasts of GDP growth of 4.8% for FY14, 6% for FY15 and 7% thereafter.

Exhibit 15: Industry volume growth vs GDP growth


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 16: 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 amounts to ~4% per year. This is based on a historical ten-year CAGR in the realisation rate of 4-5%.

1.0 1.1 1.2 1.3 1.4 1.5 1.6 1.7 1.8 1.9 2.0

0%

2%

4%

6%

8%

10%

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14%

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FY07 FY08 FY09 FY10 FY11 FY12 FY13 FY14E FY15E FY16EGDP Growth Market Volume growth Multiplier

Asian Paints


Key assumptions and estimates Revenue growth drivers

Exhibit 17: Summary assumptions for Asian Paints

FY13 FY14E FY15E FY16E

Industry level drivers Organised Industry volume growth 6.0% 7.2% 9.6% 11.2%

Company level drivers

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

LFL price increase 3.5% 4.0% 4.0% 4.0%

Contribution from mix change (economy/mid-tier to premium) 2.2% 2.2% 2.2% 1.5%

Total volume growth for Asian Paints 8.0% 8.8% 11.6% 13.2%

Contribution from realisation rate increase for Asian 5.7% 6.2% 6.2% 5.5%

Total value 13.7% 15.0% 17.8% 18.7%

Source: Company

Market share gains to continue: Asian Paints has gained ~10 percentage points in market share over the past seven years. This has been achieved 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.

Also, since the company continues to focus on further improving its reach 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 18: Shift in industry market share from FY07-18E


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 derived from premium products, with the balance coming from economy/mid-tier products (see the exhibit below). This proportion of premium products is higher than the industry average of around 20%, because Asian Paints has

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

Asian Paints


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 (vs 90bps annually for Berger).

Exhibit 19: Product mix assumptions

Economy Mid-tier Premium Average price

% price CAGR**

Current average price (`/litre) 40 120 200

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

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

Gross margins (current) 36% 36% 48% 37.8%

Source: Ambit Capital research; Note:* Our assumptions are 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.

Asian Paints


Other assumptions and forecasts Exhibit 20: Other assumptions and forecasts

FY12 FY13 FY14E FY15E FY16E Comments

Profit and Loss

Standalone revenue growth 24.9% 14.1% 15.1% 17.8% 18.5% 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 26.8% 15.3% 10.1% 12.0% 12.0% Factor in muted growth in the international business given

slowdown in global markets Consolidated revenue growth 25.0% 13.9% 14.5% 17.1% 17.8%

Gross margins 40.0% 41.3% 41.7% 41.9% 42.0% Factor in lower gross margins in FY14 given the sharp depreciation in the INR

Salaries and wages as a % of sales 5.5% 5.7% 6.1% 5.9% 5.8% Benefits of economies of scale factored in

Freight & Handling (% of sales) 4.1% 4.2% 4.2% 4.2% 4.2% We expect freight expenses to remain stable

Advert & Publicity (% of sales) 4.3% 4.8% 4.6% 4.4% 4.3% 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 Cash discount (% of sale) 4.1% 4.2% 4.1% 4.1% 4.1%

Others as a % of sales 6.4% 6.8% 6.6% 6.5% 6.3% We expect scale benefits from new plants to favourably impact margins

EBITDA Margins 15.7% 15.6% 16.1% 16.8% 17.3%

Tax rate 29.8% 29.9% 30.5% 31.0% 31.0% We expect stable tax rates

Net Profit Margins 10.3% 10.2% 10.1% 10.7% 11.2%

Balance Sheet

Capex (` mn) 1,166 12,808 2,000 2,000 2,000 No material capex plans expected after the current capex is through in FY14 Capital work in progress (` mn) 6,171 592 2,000 1,000 1,000

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

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

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

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

Net debt to equity (0.1) (0.2) (0.2) (0.4) (0.5) Expect higher cash accumulation as there are no material capex plans after FY14

Cash Flows (̀ mn)

Operating cash flows 8,263 11,868 15,252 18,028 21,809 Capex to affect cash flows until FY14

Free cash flows 1,532 5,501 11,844 17,028 19,809


Exhibit 21: 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 are stabile. 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 7% for FY14 and 9% for FY15 over the past six months.


Asian Paints


Key catalysts 3QFY14 results announcement: The 2QFY14 results for the sector (including

Asian Paints) benefitted from two temporary factors supporting YoY revenue growth: (a) ‘channel stuffing’, especially during August, with dealers piling up inventory on shop floors ahead of a price increase of 4-6% across most products announced for 1 September; and (b) Diwali this year being two weeks earlier than last year, which led to a shift in Diwali-related demand from 3QFY14 last year to 2QFY14 this year. Consequently, Asian Paints reported a revenue growth of 18% YoY during 2QFY14. However, due to a wake effect from both these factors, the reported revenue growth during 3QFY14 is not likely to be more than 10% YoY.

Capital allocation decisions: Any further announcements around capital deployment towards international expansion or M&A in the home improvement division of India are likely to lead to a downgrade to our RoCE estimates for Asian Paints for the future.

Risks to our SELL stance Rapid market share gains by Asian Paints due to a weaker-than-expected

competitive intensity in the sector, which could then lead to a revenue and EPS upgrade risk to our current forecasts.

Substantial revival in overall discretionary consumption demand in India over the next six months, which could warrant an upgrade to our earnings forecasts for FY14 and FY15.

Ambit vs consensus As shown in the exhibit below, our revenue forecasts are marginally lower than consensus for FY14 and marginally higher for FY15.

Exhibit 22: Ambit vs consensus

Ambit Consensus Divergence from

consensus Divergence from consensus

FY14E

Net sales (` mn) 125,673 126,276 -0.5% In line with consensus

EBITDA (` mn) 20,275 20,346 -0.3% In line with consensus

EPS (̀ /share) 13.2 13.6 -2.9% Factor in higher depreciation on account of the new Khandala plant coming on stream

FY15E

Net sales (` mn) 147,166 147,028 0.1% In line with consensus

EBITDA (` mn) 24,676 24,103 2.4% Build in margin expansion on account of benefits from improving product mix as well as scale benefits from the new plant

EPS (̀ /share) 16.4 16.1 1.9% EBITDA margin expansion to flow down to PAT


Change in estimates Exhibit 23: Change in estimates (` mn)

New estimates Old estimates Change Comments

FY14E FY15E FY14E FY15E FY14E FY15E Revenue 125,673 147,166 125,563 147,036 0.10% 0.10% Na material changes

EBITDA 20,275 24,676 20,259 24,083 0.10% 2.50% Factor in scale benefits from new plant and better mix improvement in FY15 EBITDA Margin (%) 16.10% 16.80% 16.10% 16.40% 0 39

PAT 12,707 15,685 12,666 15,615 0.30% 0.40% No material changes

EPS 13.2 16.4 13.2 16.3 0.40% 0.30%


Asian Paints


Balance Sheet

Year to March (̀ mn) FY12 FY13 FY14E FY15E FY16E

Shareholders' equity 959 959 959 959 959

Reserves & surpluses 26,526 32,884 38,857 45,564 53,665

Total net worth 27,485 33,843 39,817 46,523 54,625

Minority Interest 1,367 1,608 2,178 2,891 3,783

Preference share capital 0 0 0 0 0

Debt 3,359 2,377 0 0 0

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

Total liabilities 33,139 39,371 43,539 50,959 59,951

Gross block 21,458 34,294 36,294 38,294 40,294

Net block 13,006 24,410 24,144 23,749 23,224

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

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

Cash & equivalents 6,243 7,520 8,918 16,968 25,555

Debtors 7,813 9,809 10,329 12,096 14,243

Inventory 15,989 18,303 21,003 24,595 28,961

Loans & advances 5,135 3,211 4,132 4,838 5,697

Other current assets 1,059 1,215 1,377 1,613 1,899

Total current assets 36,238 40,058 45,759 60,110 76,356

Current liabilities 21,374 23,101 26,512 31,046 36,558

Total current liabilities 25,823 28,495 32,365 37,900 44,629

Net current assets 10,415 11,562 13,394 22,210 31,727

Miscellaneous 0 0 0 0 0

Total assets 33,139 39,371 43,539 50,959 59,951


Income statement


Operating income 96,322 109,707 125,673 147,166 173,294

% growth 25.0% 13.9% 14.6% 17.1% 17.8%

Operating expenditure 81,235 91,754 105,398 122,490 143,327

Operating profit 15,087 17,319 20,275 24,676 29,967

% growth 14.9% 14.8% 17.1% 21.7% 21.4%

Depreciation 1,211 1,546 2,265 2,395 2,525

EBIT 13,876 15,773 18,010 22,281 27,441

Interest expenditure 410 367 143 0 0

Non-operating income 1,074 1,145 1,237 1,484 1,855

Adjusted PBT 14,540 16,552 19,104 23,765 29,297

Tax 4,335 4,957 5,827 7,367 9,082

Adjusted PAT/ Net profit 10,205 11,595 13,277 16,398 20,215

% growth #REF! 14% 15% 24% 23%

Prior Period Items 0 0 0 0 0

Reported PAT / Net profit 10,205 11,595 13,277 16,398 20,215

Minority Interest 319 456 571 713 891

Share of associates 0 0 0 0 0

Adjusted Consolidated net profit 9,887 11,139 12,707 15,685 19,323

Reported Consolidated net profit 9,887 11,139 12,707 15,685 19,323


Asian Paints


Cash Flow statement


EBIT 14,950 16,919 19,247 23,765 29,297

Depreciation 1,211 1,546 2,265 2,395 2,525

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

Tax (4,296) (4,385) (5,827) (7,367) (9,082)

(Incr) / decr in net working capital (2,795) (1,587) (433) (766) (931)

Cash flow from operations 8,263 11,868 15,252 18,028 21,809

Capex (6,732) (6,367) (3,408) (1,000) (2,000)

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

Other income (expenditure) 478 438 - - -

Others 57 113 - - -

Cash flow from investments (5,121) (4,843) (4,601) (1,000) (2,000)

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

Issuance of equity - - - - -

Interest paid (404) (371) (143) - -

Dividend paid (3,831) (4,621) (6,733) (8,978) (11,222)

Others - - - - -

Cash flow from financing (3,265) (6,007) (9,252) (8,978) (11,222)

Net change in cash -123 1,018 1,398 8,050 8,587

Source: Company, Ambit Capital research,

Ratio Analysis

Year to March (%) FY12 FY13 FY14E FY15E FY16E

EBITDA margin (%) 16.8% 16.8% 17.1% 17.8% 18.4%

EBIT margin (%) 15.5% 15.4% 15.3% 16.1% 16.9%

Net profit margin (%) 10.3% 10.2% 10.1% 10.7% 11.2%

Dividend payout ratio (%) 45.1% 46.3% 53.0% 57.2% 58.1%

Net debt: equity (x) (0.1) (0.2) (0.2) (0.4) (0.5)

Working capital turnover (x) 23.1 27.1 28.1 28.1 28.1

Gross block turnover (x) 4.7 4.0 3.6 4.0 4.5

RoCE (%) 38.1% 35.3% 35.2% 38.0% 40.0%

RoIC (%) 53.3% 46.4% 42.5% 50.7% 61.7%

RoE (%) 40.1% 36.3% 34.5% 36.3% 38.2%


Valuation Parameter


EPS (`) 10.3 11.6 13.2 16.4 20.1

Diluted EPS (`) 10.3 11.6 13.2 16.4 20.1

Book value per share (`) 28.7 35.3 41.5 48.5 56.9

Dividend per share (`) 40.0 45.0 6.0 8.0 10.0

P/E (x) 49.0 43.5 38.1 30.9 25.1

P/BV (x) 17.6 14.3 12.2 10.4 8.9

EV/EBITDA (x) 30.2 26.4 22.5 18.5 15.2

EV/EBIT (x) 32.6 28.8 25.2 20.4 16.5

Source: Company, Ambit Capital research,

Asian Paints


Institutional Equities Team

Saurabh Mukherjea, CFA CEO, Institutional Equities (022) 30433174 [email protected]

Research

Analysts Industry Sectors Desk-Phone E-mail

Aadesh Mehta Banking & Financial Services (022) 30433239 [email protected]

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

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

Ashvin Shetty, CFA Automobile (022) 30433285 [email protected]

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

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

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

Karan Khanna Strategy (022) 30433251 [email protected]

Krishnan ASV Banking & Financial Services (022) 30433205 [email protected]

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

Nitin Jain Technology (022) 30433291 [email protected]

Pankaj Agarwal, CFA Banking & Financial Services (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 & Financial Services (022) 30433181 [email protected]

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

Ritu Modi Automobile / Healthcare (022) 30433292 [email protected]

Shariq Merchant Consumer (022) 30433246 [email protected]

Tanuj Mukhija, CFA 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 / USA (022) 30433053 [email protected]

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

Parees Purohit, CFA USA (022) 30433169 [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

Asian Paints


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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