Margin concerns may limit upsides in Asian Paints stock

While volume performance has been strong, valuations factor in the gains

Despite the impact of the second wave on demand, India’s largest paint maker did not disappoint on the revenue front. Led by pent-up demand, sales of Asian Paints saw a sharp rebound in June helping the company restrict the sales decline on a sequential basis to 16 per cent. Given the low base last year, a comparison with Q1FY20 indicates a 9 per cent uptick in revenues which is impressive given lockdowns in multiple states in recent months. Investors too cheered the result and the stock gained 6 per cent sending its market capitalisation over the Rs 3 trillion mark.

While South India was impacted more due to the lockdown and tier-3 and 4 markets also saw weak sales, growth was robust in other markets including metro, tier-1 and 2 segments. Within decorative paints, it is the luxury and economy segments which drove the volumes in the quarter. While volumes over the weak base doubled, (year ago volumes had dipped by 38 per cent), the three year average stood at 15 per cent.

The management indicated that demand trends remain strong and the company has been gaining share from unorganised players. Most brokerages expect volume growth in decorative paints to be double digits going ahead. What should add to growth at the consolidated level are the aggressive growth initiatives with stronger innovation/network addition and expansion of new segments, says Ashit Desai of Emkay Global.

This outlook for growth can be partly attributed to the stock's 6 per cent surge on Tuesday. The results came during market hours on Tuesday.

Going ahead, while volume growth is expected to remain strong, the street will keenly track the margin trend. Gross profit margins declined a sharp 630 basis points YoY to 38 per cent due to higher input costs and a weaker product mix. Raw material costs as a percentage of sales were up about 600 basis points to 61.6 per cent and was the primary reason for the weak profitability.

The impact at the operating profit level, however, was restricted to a 20 basis points decline at 16.4 per cent due to higher volumes (operating leverage), sharply lower employee costs and other expenses. The reported margins were lower than what the street was expecting despite a three-per cent price hike in the June quarter. The price increase was a first in eight quarters. With raw material costs expected to remain high in the near term, there could be more hikes going ahead. The management is looking at maintaining operating profit margin in the 19-21 per cent band going ahead.

The street is cautious about the stock given worries on raw material inflation, ability to sustain volumes as well as valuations. At the current levels, the stock is trading at the 65-70 times FY23 earnings estimates. Say analysts at Motilal Oswal Research, “Higher raw material inflation will continue to put pressure on margin, while a continued weak mix will chip away at our double-digit sales forecast upgrade.” Some of the street’s caution is probably reflecting on the stock---from the highs of January the stock has barely moved if Tuesday’s gains are ignored. While Asian Paints’ execution has been flawless and is reflected in the volume and market share gains, investors should await consistency on the margin front before considering the stock.