Castrol India: Book profit

Investors can consider booking profits in the stock of lubricant maker Castrol India. The company, which controls around a fifth of the country’s automotive lubricant market, has done badly over the past three quarters. Costs — primarily on account of high crude oil price, a weak rupee and high advertisement expenses — have risen sharply.

On the other hand, despite the company’s track record of strong pricing power, a difficult economic environment has meant slowing sales growth and inability to pass on costs fully. This has reduced Castrol’s profit and pruned margins significantly.

The company’s management, while hopeful about the long run, has indicated that the business challenges are likely to persist in the near term.

That said, Castrol remains a good franchise. It has market leadership in the lubricants business, strong technology and R&D focus, formidable brand strength, negligible debt, a healthy cash balance and a consistent high-dividend payout record — attributes which should help the company in the long-term. Meanwhile, the Castrol stock has had a strong run on the bourses.

Despite shedding around 6 per cent after its poor September 2012 quarter results, the stock is up around 46 per cent since January compared with the 21 per cent rise in the Sensex.

At its current price of Rs 305, the stock discounts its trailing 12-month earnings by almost 35 times, higher than levels it has traded at in the past (25 to 30 times).

Some more weak quarters, as expected, could push up valuations further. Weighed against the long-term strengths of Castrol, investors may be better off pruning their exposure to the stock and waiting for dips to re-enter.

Tepid volumes, weak pricing

A conscious shift in its product mix towards premium products over the past few years has seen Castrol’s sales volumes dip.

But this by itself was not a matter of concern since better realisations and robust pricing power ensured that the company’s sales and profits grew strongly.

For instance, Castrol’s volumes dipped from 220 million litres in calendar year 2007 to 208 million in 2011. But during this period, Castrol’s sales grew at an annual average of 12.1 per cent to Rs 2,982 crore while its profit grew faster at 21.8 per cent annually to Rs 481 crore. Operating margin grew from around 19 per cent to 25 per cent.

However, tepid volumes combined with low pricing power have taken a toll on Castrol’s profits and margins in recent times.

In the September quarter, the 3 per cent volume growth in the company’s mainstay automotive lubricants business (accounting for 87 per cent of sales and profits) was offset by a sharp fall in industrial and marine lubricant volumes.

This resulted in flat volume growth. Price hikes helped the company grow sales by around 7 per cent. But this was much slower than the 10 per cent rise in cost, primarily due to 33 per cent higher spend on sales and marketing.

Consequently, the company’s September quarter profit fell around 10 per cent year-on-year to Rs 86 crore. In the preceding June and March quarters, profit had fallen around 15 per cent and 10 per cent year-on-year.

The company’s operating margin is down to 18.7 per cent from around 22 per cent in September 2011.

The ebb in the company’s pricing power is a result of the weakness in the economy and increasing competition. During the current year, growth moderated significantly in the auto sector with a few sub-sectors such as commercial vehicles even seeing shrinkage.

As a result, Castrol’s automotive segment took a hit. Anaemic economic growth meant that the non-automotive segment suffered reversals.

Rising competition from the oil marketing companies on the price front also seems to have crimped the company’s leg-room to pass on cost hikes.

High raw material costs

Contributing to the company’s weak performance was the higher spend on raw material due to rise in the price of base oil, a derivative of crude oil.

The high price of crude oil combined with the weakness in the rupee resulted in Castrol’s raw material spend as a percentage of sales rise from 53.8 per cent in the first nine months of calendar 2011 to 55.4 per cent in the current year.

Near-term outlook weak

The auto sector’s prospects are likely to remain weak in the near-term, with implications for Castrol’s automotive lubricants business. Also, unless economic growth picks up meaningfully, sale of industrial lubricants may lag.

On the cost front, if crude oil continues to trade at current levels (Brent is at around $107 a barrel) or rises further due to financial easing in the US and Europe, the cost of base oil may exert pressure.

Further weakness in the rupee (currently trading at around 54 to the dollar) may add to the pain.

Risks to the recommendation include a dip in price of crude oil due to a global economic slowdown, sharp rupee appreciation, and a quicker-than-expected economic recovery in India.

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