Kansai’s margin compression issue is severe given its big exposure to industrial paintsSmall wonder, its shares have declined by 30% in the past one-year, under-performing peers

Cost inflation has not spared anyone, be it the leader in decorative paints business Asian Paints Ltd or the leader in industrial paints segment Kansai Nerolac Paints Ltd. However, we should not paint them with the same brush. For Kansai, gross margin compression is a more severe issue than Asian Paints because the industrial paints segment contributes about 45% to its overall revenues. So, when inflation is steep, Kansai’s problems tend to compound, said analysts. The company’s standalone gross margin hit an all-time low of 28% in the March quarter (Q4FY22).

“They sell more solvent-based paints in the industrial segment, so the impact of crude oil price increase is higher than it is for the water-based products in the decorative category. Further, the negotiating power is lower because of the business-to-business nature of the industrial segment and the ongoing woes of the automobile industry," said Varun Singh, analyst, IDBI Capital Markets and Securities Ltd.

Automobile paints are estimated to account for around 30% of the revenues of the industrial paints segment. Maruti Suzuki India Ltd is Kansai’s key client. Kansai’s auto paints segment can be expected to remain sluggish, at least in the near-term. Note that Kansai has raised prices of industrial paints by 18% in FY22 and is negotiating further price hikes with business partners, the management said in a post earnings call.

In the decorative segment, Kansai hiked prices by around 16% in solvent-based paints, but lost market share in North India during the quarter. “If you are a consumption company and have lost market share (decorative) despite being in the number three spot, it is a big concern," said an analyst who covers the paints sector, seeking anonymity.

In Q4, Asian Paints saw decorative paints volumes grow 8% year-on-year (y-o-y). For Kansai, decorative paints’ volumes fell by around 7-8% because of deterioration in the product mix, the management said. Further, Asian Paints and Berger Paints India Ltd are quite aggressive in the decorative premium paints category unlike Kansai, according to the analyst quoted above. So, Kansai has not been able to capture the premiumization story.

Against this backdrop, it is not surprising that Kansai’s shares have declined by around 30% in the last one year. Berger has seen a relatively lower fall of around 10%, while the Asian Paints stock has risen 19%. Berger is yet to announce its March quarter earnings.

That Asian Paints has been able to navigate margin contraction with steep price hikes has kept the stock in good stead. In Q4FY22, consolidated gross margin at 38.7%, improved 195 basis points (bps) sequentially. One basis point is 0.01%. Asian Paints’ management expects gross margins to recover to around 40-42% in FY23. In FY22, it saw 32-34% inflation and increased prices by 24-25%. For incremental inflation of 5-7% seen in Q1FY23, price increases of about 2% would be effective in May and June.

Not surprisingly, the Kansai stock is trading a steep valuation discount to peers. Based on FY24 earnings estimates, Kansai’s price-to-earnings ratio is at 26x, according to Bloomberg data, far lower than the 55x of Asian Paints and Berger’s 48x multiples. “The valuation gap between Kansai Nerolac and Asian Paints is likely to remain in the foreseeable future. In the decorative paints segment, there was always a gap between their volume growth, but now it has reached a historical high," said Amnish Aggarwal, head of research at Prabhudas Lilladher. “Higher exposure to industrial paints and loss of market share in decorative segments, makes Kansai more vulnerable than peers," he said.

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