Margin erosion on the back of escalating raw material prices has been a key concern for paint companies in the past few quarters.

Many of the inputs used in the manufacturing of paints include monomers and crude oil derivatives, and account for about 30-35% of the total raw material cost of the sector. As Chart 1 shows, raw material cost as a percentage of sales for the industry declined during fiscal year 2016 (FY16) as prices of crude oil and titanium dioxide (TiO2) corrected. This helped paint makers clock strong margin expansion.

However, that trend reversed and as a result no major expansion has been seen in profit margins in FY17 compared to the previous year.

After touching a multi-year high in June 2017, prices of TiO2, a key input material, gradually eased and are currently down by around 14% from the peak (see Chart 2). Most Indian paint companies import TiO2 from countries including China. This means if the downward trend in TiO2 sustains, then the margins of paint makers can widen.

Sharing a similar view, foreign research house Jefferies initiated coverage on market leader in the decorative paints segment, Asian Paints Ltd, with a “Buy" rating. In a report dated 18 December 2017, it said that margin pressure is largely behind the company as raw material prices have stabilized.

Jefferies foresees a modest margin expansion going ahead, led by operating leverage, some improvement in product mix and cost savings.

Another research house, CLSA, initiated coverage with a buy call on the leader in industrial paints , Kansai Nerolac Ltd, back in November. CLSA does not see a significant risk to the company’s peak margins and expects price hikes, improvement in revenue mix and operating leverage to sustain margins.

As for demand, the outlook for both the decorative and industrial segments remains positive.

“We expect decorative segment of the paint market to grow in double digits in the coming years. Although there is a slowdown in the real estate space, most of the top players are dependent on replacement demand for growth. Similarly, automotive demand remains strong, which should also help in higher volumes," said Sameer Deshmukh, analyst at Reliance Securities Ltd.

CARE Ratings Ltd expects the overall Indian paints industry to grow by 8-10% in FY18. Further, the ratings agency anticipates 10-12% growth in the two-wheeler segment, which accounts for about 80% of the automobile industry’s sales, and augurs well for the industrial paints segment.

On the flip side, sharper-than-expected surge in crude oil prices could be a dampener. In the December quarter, crude oil prices inched 16% higher and continue to remain elevated.

In such a scenario, firms may resort to further price hikes. Paint makers took two consecutive price hikes aggregating to 5.5% in March and May of 2017. It should be noted that price hikes do not hurt consumers much as painting happens once in around 4.5 years.

“There is limited price-based competition in the sector. TiO2 prices are lower on quarter-on-quarter basis, but crude oil price remains a concern. However, we believe that the companies can easily pass on the hike to the consumers without impacting demand," added Deshmukh of Reliance Securities.

Meanwhile, shares of key paint makers rallied more than 25% in calendar 2017, outperforming the Sensex, and any further upside would largely depend on how margins move, say analysts.

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