The organised paints industry in India started with Shalimar Paints, which set up shop in Calcutta, back in 1902. During these 116 years, the industry navigated significant political and economic events, including the two World Wars, the Great Depression, India’s Independence and the economic reforms of the 1990s. All through, the industry remained stellar. A return of 330 times of the Indian paints industry in the last two decades—outperforming the stock market benchmark NIFTY (22 times)—proved the listed stocks in the paints industry to be worthwhile investments. Today, it contributes to 0.4% of GDP, besides contributing to employment in organised and unorganised sectors. This is despite a mere 4-kg per capita consumption in India, against the global average of 15-kg, indicating huge scope for growth. This can no better be explained by the P/E of 66 commanded by the Indian paints industry, compared with an industry average P/E ratio of 16 for the American paint firms.
Urbanisation, changing social structures, rising disposable incomes, industrial growth and infrastructure expansion, coupled with the easy availability of housing loans, are the drivers of decorative paints industry, which accounts for 75% of the estimated $8.2-billion Indian market. The track-record shows the industry clocked a growth of 1.5-2 times that of GDP growth. Research reports suggest that the decorative paints industry is expected to touch $10.42-billion in the next few years. However, the recent subdued growth signals from real estate and auto sectors are a challenge. With lower crude oil prices during CY2017, the industry remained attractive, as about three-fourths of its raw materials are derived from crude. The increase in raw material prices attributable to the increase in crude prices during CY2018 (till July)—estimated at an average of `4,387 ($66) compared with `3,320 ($51) per barrel that prevailed during CY2017—will remain a challenge.
For further penetration in the market, competitive and economic pricing will remain key factors. With raw materials accounting to about 50% of net sales, the paints industry is cost-sensitive. Key raw materials used can be divided into four categories: pigments, binders, solvents and additives. Titanium dioxide is widely used, and other raw materials including phthalic anhydride, pentaerythritol, methyl methacrylate, aromatics, etc, which act as binders, solvents and additives, are derivatives of crude oil distillate. Production costs will remain sensitive to the movement of the crude oil price, though with a lag. The change in raw material costs and the change in crude oil prices shows a strong correlation.
According to ChemQuest, a North American supplier of chemicals, there is a pass-through factor of 50%, i.e. if the crude oil price doubles, raw material prices for the paints industry are expected go up by 25%. In this context, it is worthwhile to note the estimates of the paints sector research reports—that a rise in crude oil prices may reduce earnings by 7-10%, for every 10% increase in crude oil prices.
Binders, solvents and additives make up 75% of the total composition of most paints, implying that three-fourths of the raw materials are derived from major distillates of crude oil and their costs are sensitive to movements in crude oil prices. Given that during the past couple of years crude oil prices were highly volatile—to the extent of annualised volatility of 35% and 24% during FY17 and FY18, respectively—the competitiveness of the organised paints industry continued to be challenging. Based on ChemQuest analysis, the best under Indian conditions, given the exposure of net sales of Indian manufacturers to the price movement of crude oil, and considering the industry size and crude volatility, we can estimate that about `5,800 crore would be the potential exposure to the crude oil price risk.
There are about 300 raw materials used in the paints industry, and they are usually sourced through third-party or imports. Given that most in the industry do not make raw material, makes them price-takers in the market. The prices of chemicals used for producing raw materials may outpace crude oil benchmarks and, unfortunately, paint companies might end up paying a fortune when prices rise.
One way of locking in input costs would be to hedge the price exposure through crude oil futures against an input delivery contract. With their prices quoted in the rupee, domestically-traded crude derivative contracts would help them manage their exposure in the domestic currency. The key to determine the amount of exposure in crude contracts that a hedger should take is determined by the hedge ratio that would need to be customised depending on the raw materials used and their correlation with crude oil. Distant derivatives (distillates) may respond with a time lag, as their respective inventory levels play a major role in determining the market price at any given point in time, as opposed to other intermediate distillates that may directly be benchmarked to the periodical crude oil price movement.
It is important to measure the outstanding risk of a company and find the best possible solution to hedge and manage it. Having locked in a major portion of the costs can give paint manufacturers a significant margin boost to achieve competitive pricing and hence healthy functioning. Currently, Indian paint manufacturers seem to rely largely on inventory control and access to newer raw materials and suppliers as the prevalent methods of managing market. With transparent crude oil prices in recent times and the market for various crude-based raw materials moving away from fixed to dynamic pricing, the suppliers of raw materials to the paints industry can’t remain oblivious. For the paints industry, raw material price risk may not be a challenge, but an opportunity to enhance competitiveness amongst industrial peers. As their raw materials move closer to market-based pricing, commodity risk will be a reality and managing it will be a necessity.
Shunmugam is head and Jayati Mukherjee is a senior analyst, Research, the Multi Commodity Exchange of India Ltd. Views are personal