Is Castrol India a mispriced deep value bet or just a dividend play?

A storied debt-free MNC with RoE of 50% should ideally have investors bidding it up to the moon, without not much help from Tesla. That clearly has not been the case for lubricants major Castrol India which has seen a multiple de-rating over the years (See: Premium erosion). While a party pooper such as Tesla came into the picture much late, Castrol’s stock has been an underperformer for five years now. Domestic mutual funds have all but stayed away. Of the 3.09% mutual fund holding as of December 2020, 1.27% is held by Aditya Birla Sun Life Equity Fund, which itself has been gradually reducing its stake. Of the remaining 26.09% institutional holding, 11.99% is held by foreign investors and 13.43% by domestic insurers, of which LIC alone holds 10.57%. In hindsight, parent BP’s decision to dilute its holding from 71% to 51% in 2016 for $578 million seems astute. Today, Castrol India’s market cap stands at $1.75 billion having hit a 52-week low of $1.2 billion in March 2020.

Downhill journey

In recent years, Castrol has been plagued by stagnant or falling volume growth (See: Going nowhere). According to Reliance Securities, public sector oil marketing companies such as IOC, HPCL and BPCL dominate the lubricant market with ~45% market share. Castrol is the leading private player with ~12% market share followed by Gulf Oil (6%), Shell (6%), Valvoline (5%), Total (5%) and Veedol (4%), with the remaining players holding 17%. Along with intense competition, slowing economic growth has been the prime driver for falling volume. Then, there is the bugbear about electric vehicles (EVs) eventually replacing internal combustion engines, the mainstay of Castrol’s business.

The management maintains there is huge potential for lubricants in the Indian market as the shift to EVs is going to be gradual. Moreover, the company itself has developed a range of e-fluids to meet the needs of EV manufacturers. “These include transmission fluids, which improve efficiency and extend the life of the drivetrain system; coolants, which keep batteries cool during charging and driving; and greases, which protect motor components, so they last longer,” explains Sandeep Sangwan, managing director, Castrol India.

While the company has signed up with OEMs like Tata Motors and MG Motors to deliver EV fluids, Motilal Oswal Financial Services (MOFS) analyst Swarnendu Bhushan feels investor fear about falling volume growth is justified. “EVs have much smaller number of moving parts, so the amount of lubricant required would be much lower. Irrespective of whether EVs come or not, there is a concern on volume growth for the lubricants industry as there is a continued rise in drain intervals for the newer engines,” he elaborates. Bhushan’s report also mentions that Castrol accounts for ~30% of the total volume in the two-wheeler segment, which may be hugely impacted by EVs.

If there is fear about loss of volume growth, analysts are equally enthused by the alliance between BP and Reliance Industries for fuel retailing. “The strategic alliance in the form of Jio-BP fuel retail network will give the company enhanced reach and visibility at 1,400 retail sites across the country. These are planned to expand to 5,500 sites in the next five years and Castrol lubricants will be the sole supplier at these sites,” states Nidhi Doshi, AVP – research, Dolat Capital in her report. Yogesh Patil, senior research analyst, Reliance Securities expects the partnership to boost lubricant sales volume from 2% in 2020 to 9% in 2024.

The assumption is that with the Reliance tie-up, Castrol will have a level playing field when it comes to competing with OMCs. Historically, Castrol has not had access to fuel stations given that OMCs have used the network to push their own lubricants. While oil marketing companies spend millions on advertising their respective lubricant brands, the fact of the matter is fuel stations account for miniscule proportion of lubricant sales. According to the Reliance Securities report, of the auto replacement market of 38%, bazaar accounts for 27-28%, factory workshop for 8-9% and fuel stations 2%.

That said, lack of access to fuel stations was never a hindrance to Castrol competing effectively. It already has deep reach which the management cites as a strength. “Our distribution strength is a competitive advantage with a robust network of 350 distributors reaching over 100,000 independent workshops and retail counters, with sub distributors reaching out to additional outlets in rural markets and over 3,000 key institutional accounts being serviced directly," points out Sangwan.

Premium play
During the past decade, Castrol rode the growth in two- and four-wheeler sales along with premium pricing. Its strength is the neighbourhood garage or the friendly mechanic that you rely on for a quick fix. The garage mechanic is the influencer when it is time to change engine oil and enjoys discretion on which lubricant to push when a car comes in for servicing. While Castrol has deep roots in the trade and enjoys pricing power, the other players are also equally aggressive.

An August 2018 Kotak Institutional Equities report had questioned if Castrol had stretched the price-value proposition too much over the past few years, allowing other players in a semi-branded space to offer better price-value proposition. That very report also mentioned, “If consumers were to have confidence about the basic quality of a product, the gap between price and value may close dramatically through (1) acceptance of new products with lower price points with similar value and/or (2) downtrading to products that may offer better price-value proposition.”

That just might be the reality confronting Castrol in a weak economy. High dealer margin ensured that the dealer/mechanic had skin in the game. During an economic downturn, though, everyone tends to be in penny-pinching mode. Patil’s channel check reveals, “Lockdown has badly affected the financial health of the people, which is forcing them to switch to local/cheaper engine oils in place of branded premium engine oils.” Hence, despite having a superior offering, Castrol might just have to counter the risk of downtrading. With competition intensifying and the industry likely to grow in low single digits, Castrol’s brand strength will be put to the test.

Limited downside?
The moot question now is whether the worst is behind for Castrol India in terms of falling volume growth and hence multiple de-rating. “Personal mobility remains our focus area to drive profitable growth and we continue to invest aggressively in our key brands. The revival in the commercial segment has not been as quick as we would have liked, but we are well poised to take advantage of growth in segments such as mini trucks and tractors in the agri sector,” reiterates Sangwan.

The company’s performance in Q3CY20 was better than expected and has led to MOFS revising its earnings estimates. Bhushan, who has a 12-month price target of Rs.170, says, “We have revised our volume estimate for CY21 to 196 million litres from 184 million litres, resulting in earnings per share change of +15% to Rs.7.7. We value the stock at 20x CY22 estimated earnings per share.”

For now, the immediate worry is the rising crude price. That sustaining could lead to input cost pressure if there is not enough uptick in volume. “Base Oil (BO) prices usually follow crude prices with a lag. Hence, the company expects input cost pressure due to BO price at some point in time in H1CY21, if crude price stays at these levels or go up,” says Sangwan. An accompanying risk is the exchange rate and the company could well experience a double whammy if the rupee were to depreciate steeply either on account of sustained rise in crude or re-emergence of global volatility.

Nevertheless, Patil feels Castrol can pass on rise in base oil prices to the consumer as, “Rise in crude price is an indicator of improvement in oil product demand (higher vehicular movement/industrial activity) which indirectly improves demand for lubricants.”

Along with stagnant volume growth, Castrol’s high RoE has also seen a gradual slide (See: Days of glory). Steady operating cash flow and efficient working capital management has not only enabled it to stay debt free but also pay consistent dividend. On whether the company’s operating cash flow will be healthy enough to sustain its dividend, Sangwan says, “Castrol has a healthy balance sheet and our cash balances have always averaged Rs.9 billion. We have a dividend payout ratio of close to 80% and the dividend yield is upward of ~4%. We aim to maintain this track record.”

Its ability to sustain its dividend should prove reassuring to potential investors. As things stand, improvement in the core business is still hostage to economic growth. “Although there may not be meaningful rise in sales volume, the mix would keep changing towards higher margin products which would help the company in sustaining its dividends,” opines Bhushan. Even Patil, who has a two-year price target of Rs.169 expects the company to keep dividend payout high at 64-71% over CY20-22 owing to limited investment opportunities (See: Generous payout).

While Doshi’s October 2020 report has a price target of Rs.134, it states, “Given the under performance of the stock price for a prolonged period, Castrol’s business performance in the next couple of quarters will be crucial.” Along with economic growth, investor favour returning to Castrol will also be a function of the overall market. If other stocks start correcting after their recent rise, Castrol could well attract those fishing for steady dividend.