The Asian Paints Ltd management had warned of tough times in fiscal 2011, chiefly due to rising raw material prices. Investors took this warning with a pinch of salt, because the company’s leadership position in decorative paints in India gives it enough leeway to hike prices and protect margins.

Also See | Margin concerns (Graphic)

The market for decorative paints, too, appears bright, with demand for housing increasing. Strong economic growth and rising disposable incomes ensure good prospects for the repainting segment as well.

In the June quarter, Asian Paints’ performance gave no scope for concern, with sales rising by 25% and its operating profit margin was steady, at about 19%. But in the September quarter, the realization dawned on investors that Asian Paints’ performance may get affected.

Sales growth was low at 5%, partly because of a late Diwali, resulting in sales spilling over to the third quarter. But margins fell by about 30 basis points. And this is despite hiking prices thrice between May and August. One basis point is one-hundredth of a percentage point.

Paint firms are again contemplating a price hike of about 3% on decorative products. In effect, for Asian Paints, that would mean an average 12% price hike since May.

But raw material prices are threatening to keep rising. Globally, chemical companies had shut down plants to curb supply, and now demand has risen to give them pricing power.

A key input for paints is titanium dioxide. Kronos Worldwide Inc.’s selling prices as of September were 16% higher compared with December 2009 prices. It expects prices to rise in the current quarter as well as in 2011. Pigments and allied products contribute to nearly one-third of Asian Paints’ raw material costs. Other materials, too, are showing inflationary signs.

On demand, the outlook is bright and the December quarter numbers should confirm if slower sales growth in September was related to a late Diwali. The ability of large paint companies to pass on cost hikes in full may be affected due to higher supply expanded capacities, higher competition from new entrants and the desire to protect demand growth in the longer term. As a result, margins may remain under the weather, for some more time.

Asian Paints’s non-decorative business is doing well, with industrial coatings and automotive paint sales rising by about 27%. But margins are likely to be hit, as hiking prices is a difficult task in this segment. Its international business, 14% of consolidated sales, has underperformed, too.

With raw material prices showing no signs of easing, Asian Paints will have to count on strong demand for decorative paints for its performance to improve. The next few quarters will reveal if consumer demand is actually robust.

If domestic paint volumes can even maintain the 16% volume growth seen in fiscal 2010, investors will rest easy, knowing that profitability will eventually return, once the cost pressures ease.

That confidence explains why the Asian Paints’ share price has not fallen much. But that confidence may come under stress if the December quarter sales growth numbers are lower than expected.

Graphic by Yogesh Kumar/Mint

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