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Marred by severe cost inflation, paint manufacturers have been on a price hiking spree lately. Post the September quarter, market leader in decorative paints Asian Paints Ltd took a price hike of 8-9%, effective 12 November. This was followed by another 4-6% price hike, effective December 5, according to Axis Capital Ltd. On a cumulative basis, in FY22, Asian Paints has raised prices by more than 20%, said the domestic brokerage house in a report on 6 December.

Competitor Berger Paints India Ltd is also said to have announced a cumulative price rise of around 18% in FY22 with the two recent rounds of nearly 9% in November and 4% in December, added the Axis Capital report. Past trends show that other paint manufacturers such as Kansai Nerolac Ltd, Akzo Nobel Ltd and Indigo Paints Ltd usually follow suit on price increases.

The steep gross margin compression reported by paint companies in the past quarters is well known by now. In the September quarter, Kansai’s gross margin saw a steep fall of 1,040 basis points (bps) on a year-on-year (y-o-y) basis primarily owing to a delay in passing on higher raw material costs, especially in the industrial paints segment. One basis point is one-hundredth of a percentage point. Asian Paints saw its gross margins fall by a massive 970 bps and the same measure for Berger saw 449 bps y-o-y contraction in Q2FY22.

These trends weighed on their stock performances. Year-to-date, the aforementioned three stocks have under-performed the benchmark Nifty50 index, which has rallied by around 22%.

In short, price hikes were the need of the hour and have been taken to protect margins from further erosion. What’s more, the recent moderation in prices of crude-based raw materials such as titanium dioxide and other monomers is an additional breather. Brent crude has declined to $73 per barrel from the level of $84 per barrel a month ago. Raw material costs account for about 55% of the sector’s total operating expenses.

This means that gross margins of paint makers are poised to recover hereon.

“Asian Paints’ unprecedented 14-15% price increase within a month indicates course correction and shift of focus on profitability. This price increase should almost fully mitigate gross margin pressure starting 4QFY22 and drive swift recovery in profitability for the industry," analysts at Kotak Institutional Equities said in a report on 7 December. The domestic brokerage house has raised FY2022-24 earnings estimates for decorative paints stocks under its coverage by 3-14%.

Axis Capital has also raised FY22-24 earnings per share estimates for Asian Paints by 5-8% and for Berger by 2-4%.

What is also underpinning optimism is the robust demand outlook. The latest management commentaries by paint companies point to a strong demand recovery in quarters ahead aided by a pick-up in the residential real estate sector.

That said, paint stocks are not cheap. Shares of Asian Paints and Berger are trading at a one-year forward price-to-earnings ratio of 92 times and 89 times, respectively, Bloomberg data shows. Although their valuations have corrected from earlier peaks, it is difficult to justify these rich multiples unless gross margins improve substantially. On the downside, it remains to be seen if these bold price hikes weigh on volume growth.

"The focus has shifted to improving profitability with aggressive price hikes, but we need to see whether this impacts market share gains of large paint makers. Also, the rising competition with the entry of new players and its impact on volume is another key monitorable for paint investors. On the demand front, a faster sales recovery in smaller cities and towns is important," said an analyst with a domestic brokerage house requesting anonymity.

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