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  • Stock Recommendation | Asian Paints - REDUCE - Target price : 1,140

    Publish date: OCTOBER 24, 2018

    Short-term earnings prognosis sketchy. APNT delivered a disappointing 2QFY19 and the driver of disappointment was not RM pressure. RM pressure is likely to keep earnings growth in check in the near term. Management's commentary in the earnings call was more guarded than we have seen in a while and did not suggest confidence in a quick earnings growth inflection. Earnings forecasts see sharp cuts. One-year forward fair-value target stands revised down to ₹1,140/share (from ₹1,200). REDUCE stays.

    Consolidated financials-revenues grew 9% yoy to ₹46.4 bn, 6% below our estimate (2-year CAGR: 11.8%). Gross margins declined 148 bps yoy and 343 bps qoq to 39.8%. EBITDA was down 2% yoy to ₹7.84 bn, 23% below our estimate and nearly 14-15% below consensus (2-year CAGR: 5.4%). EBITDA margins declined 188 bps yoy and 302 bps qoq to a 14-quarter-low 16.9%. Recurring PAT declined 3% yoy to ₹4.93 bn, 23% below our estimate (2-year CAGR: 2.3%). TTM EPS stood at ₹21.8/share, up 13.2% yoy (2-year CAGR: 3.6%, multi-year low). This was the sixth consecutive quarter of single-digit 2-year CAGR in TTM EPS.
    Standalone financials-revenues grew 9% yoy (KIE 16%; 2-year CAGR: 12.3%). Revenue growth was below volume growth (low double digit) despite 3.4% price increase; net realization declined 2.2% yoy. The management attributed the big gap between pricing and realization to (1) higher sales of distempers (inferior product mix), and (2) higher trade discount ahead of GST rate cut implementation (July 27) to dispose stocks with higher MRP and avoid logistical issues. Gross margins declined 143 bps yoy and 382 bps qoq to 40.8%. EBITDA was up 1% yoy to ₹7.27 bn, 21% below our estimate (2-year CAGR: 7.3%). EBITDA margins declined 141 bps yoy and 368 bps qoq to 18.6%. Recurring PAT was up 2% yoy to ₹4.82 bn, 20% below our estimate (2-year CAGR: 5.2%).
    Aggregate subsidiary performance (consolidated less standalone)-aggregate subsidiary performance was weak again with double-digit EBITDA decline for the 4th consecutive quarter. Aggregate subs' PAT was the lowest 2Q PAT since FY2012.
    We cut our FY2019-21E EPS estimates by 9-12% as we trim our volume growth/realization assumptions and bake in higher RM costs. APNT's price hike of 2.35% in October 2018 was lower than needed to offset RM inflation; the management is cautious in view of antiprofiteering implications. We revise our DCF-based fair value target price to ₹1,140 (from ₹1,200). Even as valuations have corrected, we do not see enough margin of safety yet. We would wait for a better entry price to play what remains a solid medium-term story. REDUCE stays.
    Even as APNT's RM basket has non-crude-linked components as well, there has been a pretty strong correlation between crude inflation in INR terms and APNT's reported per-unit RM inflation (see Exhibit 2 on the next page). We compute per-unit RM inflation or volumeadjusted RM inflation simply as the gap between reported standalone COGS increase and indicated domestic decoratives volume growth. APNT's COGS (standalone) grew 11% yoy in 2QFY19 in absolute terms while indicated volume growth was 'low double digits'. Assuming volume growth in the 10-12% range, per-unit RM was flat yoy or there was zero volumeadjusted RM inflation. This is surprising given the 59% increase in crude price in INR terms. The last time INR crude inflation was this high (35-46% between 4QFY11 and 3QFY12), the company saw volume-adjusted RM inflation of 12-22%.
    We appreciate that mix movement could be at play here. HUVR-style UVG, which depicts mix-adjusted volume growth, would have been very helpful here. However, even if we were to assume a 500 bps mix impact, i.e. a UVG of 6%, volume-adjusted RM inflation would have still been a low 5% yoy. We are not sure (1) whether low inflation reflects smart RM forward and covers, and (2) if RM inflation impact will show up with a lag; if it does, price increases taken thus far may not be enough to prevent gross margins from going down further. Earnings call did not provide any insight to help us on this aspect.
    Explanation on net realization decline or price-realization delta gap-A 9% revenue growth in standalone financials despite a low-double-digit volume growth (KIE 11%) in decorative business and 3.4% price increase implies net realization decline of 2-3% yoy. The management attributed net realization decline to (1) deterioration in product mix. Higher sales of distemper in 2QFY19 and higher-than-usual contribution of emulsions in the base quarter adversely impacted realization, (2) higher trade discounts to liquidate about 170,000 KL of stock four days ahead of GST rate cut implementation. The management indicated that it helped the company avoid a logistical issue of changing MRP stickers on the stock, (3) some impact of discontinuation of Pthalic Anhydride sales on revenues (present in the base quarter but discontinued thereafter). We appreciate management's disclosures but are not sure if these factors explain 100% of the large (550 bps+) gap between price and realization delta.
    Commentary on demand-APNT management indicated that the demand environment is consistent with what they have seen over the past 18 months and they have not seen any signs of uptick. GST rate cuts, monsoons and imminent election season, expected to prop up volume growth, do not seem to be doing so yet. From a geographic standpoint, East is growing well and the company is seeing some signs of recovery in the South (weak for the past few years).
    Pricing, RM inflation and margins-APNT management has increased prices by 2.35% in October 2018 (cumulative price increase of 5.6%; first in March, second in May and third in October). The management indicated that October price increase was sufficient to offset the impact of high RM prices and weak rupee as of August 2018 levels. RM price inflation and depreciation of rupee since then calls for another price increase. It is considering another price increase in current quarter. Titanium dioxide is about 20-22% of RM costs and crude derivatives account for 30% of RM costs. APNT expects monomer (derivative of crude) prices to increase in the current quarter (usually follows crude inflation with lag). APNT management expects margins to be under pressure in the near term in view of timing gap between price increase and RM inflation.
    Commissioning of new capacities-first phase of Mysore plant has been commercially commissioned in September 2018. The upcoming facility at Vizag will be commissioned in 4QFY19. New facilities would reduce logistics costs and manufacturing costs to some extent.
    Capex-standalone capex for the year would be ₹10 bn including ₹8 bn pertaining to Mysore and Vizag expansions. Consolidated capex would be ₹12 bn (no change from previous guidance).
    International business performance-(1) Sri Lanka suffered from incessant rains, (2) Ethiopia continued to face challenges pertaining to currency availability for imports, (3) Egypt market was weak due to sluggish economy and reduction in fuel subsidies added to inflationary environment, (4) Dubai business was impacted from hypercompetition as volume leader in that market reduced prices to absorb 5% increase in VAT despite RM inflation, (5) greenfield operations in Indonesia are progressing as per plans with a focus on expansion of retail network.
    Industrial business-both JVs APPPG and PPGAP reported good growth in the industrial segment but price increases taken were not adequate to offset RM pressure. The management alluded to difficulty and delays in passing on RM costs to large B2B customers.

    Definitions of ratings

    BUY - We expect this stock to deliver more than 15% returns over the next 12 months.
    ADD - We expect this stock to deliver 5-15% returns over the next 12 months.
    REDUCE - We expect this stock to deliver -5-+5% returns over the next 12 months.
    SELL - We expect this stock to deliver

    Our target prices are also on a 12-month horizon basis.

    Other definitions

    Coverage view. The coverage view represents each analyst's overall fundamental outlook on the Sector. The coverage view will consist of one of the following designations: Attractive, Neutral, Cautious.

    Other ratings/identifiers

    NR = Not Rated. The investment rating and target price, if any, have been suspended temporarily. Such suspension is in compliance with applicable regulation(s) and/or Kotak Securities policies in circumstances when Kotak Securities or its affiliates is acting in an advisory capacity in a merger or strategic transaction involving this company and in certain other circumstances.
    CS = Coverage Suspended. Kotak Securities has suspended coverage of this company.
    NC = Not Covered. Kotak Securities does not cover this company.
    RS = Rating Suspended. Kotak Securities Research has suspended the investment rating and price target, if any, for this stock, because there is not a sufficient fundamental basis for determining an investment rating or target. The previous investment rating and price target, if any, are no longer in effect for this stock and should not be relied upon.
    NA = Not Available or Not Applicable. The information is not available for display or is not applicable.
    NM = Not Meaningful. The information is not meaningful and is therefore excluded.

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