Castrol India Limited A superior long-term play Viewpoint Castrol India Limited’s (Castrol) stock price has corrected by ~20% in the last Sector: Lubricants there months and offers a favourable risk reward given: 1) margin tailwinds from New Idea sharp 31% decline in base oil price (a crude oil derivatives) since January 2020 and premiumisation for BS-VI products and 2) well-placed to gain from a potential recovery in lubricant demand in H2CY2020 (as the government has relaxed the Change lockdown in 45% districts of India and expectation of gradual end of lockdown across the country) given strong market share of 22% in the Bazaar segment View: Positive and a 40-45% volume coming from personal mobility. Moreover, robust strong CMP: Rs. 119 free cashflow (FCF) yield of ~8-9% and consistent track record of high dividend payout (66-80% and dividend yield of 5-6%) provides comfort to investors. Upside potential: 25% Castrol’s valuation of 12.4x CY2021E EPS is attractive given steep discount of 51% to its historical average one-year forward PE multiple of 25.4x. Hence, we initiate our viewpoint coverage on Castrol with a Positive view and expect a 25% á Upgrade No change â Downgrade upside potential from current levels. Margin tailwinds amid lower base oil prices; focus to shift to volume recovery Company details in H2CY2020 with relaxation of lockdown: Castrol’s key raw materials (base oil and additives) are directly linked to a movement in crude oil prices, which have Market cap: Rs. 11,768 cr plunged by ~53% since January 2020. Lower raw material cost (base oil price declined by 31% since January 2020), better product mix (high share of personal 52-week high/low: Rs. 162/90 mobility) and premium pricing for BS-VI products makes a strong case for margin improvement from H2CY2020. Hence, we expect a strong growth in gross margin NSE volume: (No of to Rs. 112-115/litre over CY2020-CY2022 as compared to Rs. 104/litre in CY2019. 20.6 lakh shares) The Indian lubricants market was growing at a decent pace of 2-3% before the COVID-19 pandemic struck. However, the COVID-2019 led lockdown has impacted BSE code: 500870 demand for lubricants across the automotive and industrial segments, given the limited movement of personal vehicles and manufacturing activity has come to standstill from the last week of March 2020. Given a relaxation of lockdown in 45% NSE code: CASTROLIND of India’s districts (green zone) and expectation of the gradual end of the lockdown across the country, we believe that lubricant demand would also normalise as Sharekhan code: CASTROLIND the fundamental demand drivers (rising demand from personal mobility) are well- placed. We do expect Castrol’s lubricant volumes to decline by ~10% in CY2020 but Free float: (No of 48.5 cr expect a sharp recovery over CY2021-CY2020 as the economic activity normalises. shares) Our Call Valuation – Initiate viewpoint coverage on Castrol with Positive view; expect a 25% upside: The correction of ~20% in Castrol’s stock price in the last three months Shareholding (%) adequately factors in the concerns of volume de-growth in CY2020 and ignoring the benefit of sharp expansion in margin given decline in base oil prices. Moreover, Promoters 51.0 we believe that the focus should shift back to volume recovery in H2CY2020, given that the lockdown has been relaxed in 45% of districts (green zones) and FII 11.8 expectation of a gradual reopening of the economy. Castrol’s valuation of 12.4x CY2021E EPS is attractive given a steep discount of 51% to its historical average DII 18.3 one-year forward P/E multiple of 25.4x. Moreover, robust strong FCF yield of ~8- 9%, consistent track record of high dividend payout (66-80% and dividend yield Others 18.8 of 5-6%) and strong RoE of ~55-58% lends comfort to investors. Hence, we initiate viewpoint coverage on Castrol with Positive view and expect 25% upside potential from current levels. Price chart Key Risks Lower-than-expected volume growth amid economic slowdown in case of further 170 extension of lockdown in India and likely impact on margin if crude oil price rises 150 sharply. 130 110 90 70 Valuation Rs cr 50 19 20 19 20 Particulars CY18 CY19 CY20E CY21E CY22E - - - - Jan Sep May May Revenue 3,905 3,877 3,489 3,934 4,274 OPM (%) 27.4 29.7 31.8 32.5 31.1 Adjusted PAT 708 827 825 952 994 Price performance % y-o-y growth 2.4 16.8 -0.3 15.5 4.4 (%) 1m 3m 6m 12m Adjusted EPS (Rs) 7.2 8.4 8.3 9.6 10.1 P/E (x) 16.6 14.2 14.3 12.4 11.8 Absolute 12 -18 -22 -20 P/B (x) 10.1 8.6 7.6 6.7 6.2 EV/EBITDA (x) 10.3 9.4 9.6 8.2 7.7 Relative to 6 5 0 -3 Sensex RoNW (%) 64.8 65.3 56.6 57.8 54.4 RoCE (%) 100.6 90.7 76.0 78.5 73.7 Sharekhan Research, Bloomberg Source: Company; Sharekhan estimates May 06, 2020 7 Viewpoint Margin to improve supported by lower base oil price and premiumisation for BS VI products Castrol’s key raw materials (base oil and additives) are directly linked to movement in the crude oil prices, which has declined sharply by ~53% since January 2020. Lower raw material costs (base oil prices have declined by ~31% since January 2020) and better procurement would lower raw material cost and drive gross margin expansion. Moreover, better product mix (high share of personal mobility at 40-45% in volume mix) and premium pricing for BS VI products (backward compatible i.e usable for even BS-IV engines) would also improve realization for Castrol. Hence, given raw material tailwinds and a potential higher realisation, we see a strong case for margin improvement in H2CY2020. Hence, we expect strong growth in gross margins to Rs. 112-115/litre over CY2020-CY2022 as compared to Rs104.4/litre in CY2019. Sharp fall in Brent crude oil price since January 2020 Margins expected to improve sharply Sharp fall in oil price given demand 80 140.0 destruction amid Covi d-19 70 120.0 112.0 114.8 114.7 104.4 60 100.0 93.5 50 40 80.0 $/bbl 30 60.0 20 40.0 10 0 20.0 19 19 19 20 20 19 20 19 19 19 19 19 19 19 20 20 19 - - - - - - - - - - - - - - - - - 0.0 Jul Jan Jan Jun Oct Apr Apr Feb Sep Feb Dec Aug Nov Mar Mar May May CY18 CY19 CY20E CY21E CY22E Brent oil price Gross margin (Rs/litre) Source: Bloomberg Source: Company; Sharekhan Research Lockdown to hit lubricant demand in CY2020; recovery imminent as economy expected to open up post lockdown ends The Indian lubricant market was growing at a decent pace of 2-3% before the COVID-2019 pandemic. However, the COVID-2019 led lockdown has impacted lubricant demand across automotive and industrial segment given limited movement of personal vehicles and manufacturing activities has come to standstill from last week of March 2020 due to lockdown in India. However, with relaxation of lockdown in 45% of India’s districts (green zone) and expectation of gradual end of lockdown across the country, we believe that lubricant demand would also return to normalcy as the fundamental demand drivers (rising demand from personal mobility) are well placed. We do expect Castrol’s lubricant volumes to decline by ~10% in CY2020 but expect a sharp recovery over CY2021-CY2020 as the economic activity returns to normalcy. 3M deal to help enter vehicle care product market; capex of Rs. 140 crore to expand Silvassa capacity by 40 million litres Castrol India entered into a partnership with 3M India Ltd (3M) in June 2019 to bring a range of vehicle care products for the automotive after-market. The partnership would enable Castrol offer bike and car products like shampoos, glass cleaners, cream wax, dashboard and tyre dressers through its pan-India marketing and distribution network of over 1,10,000 retail outlets. The partnership provides Castrol an entry into the ~$200 million Indian vehicle care market and is aligned to its strategy of developing new businesses. Moreover, Castrol is also expanding capacity at its Silvassa plant at a capex of Rs. 140 crore and an incremental capacity of 40 million litres (expected to be completed by 2020). Post the expansion, the capacity at its Silvassa plant would increase to 140 million litre. May 06, 2020 8 Viewpoint Strong FCF generate to help maintain high dividend payout We expect Castrol to generate strong FCF to tune of Rs. 900-1,100 crore annually over CY2020E-CY2022E given limited capex plan of Rs. 140 crore for expansion capacity at Silvassa plant. Robust FCF generation would result in FCF yield of 8-9% and also ensure continued high dividend payout of 65-70%. Consequently, we expect dividend of Rs. 5.5-7/share with a healthy dividend yield of 5-6%. Strong FCF generation Consistent dividend payout ratio and healthy yield 1,200 9.4% 10.0% 8.0 7.0% 5.9% 8.5% 9.0% 7.8% 7.0 6.0% 1,000 7.6% 5.3% 8.0% 6.0 4.6% 4.6% 7.0% 5.0% 800 5.0 4.0% 6.0% 4.0% 600 5.0% 4.0 4.0% 1,104 Rs crore 7.0 3.0% 1,000 Rs/share 897 924 4.0% 3.0 6.3 400 5.5 5.4 3.0% 4.7 2.0% 2.0 2.0% 200 471 1.0% 1.0% 1.0 0 0.0% 0.0 0.0% CY18 CY19 CY20E CY21E CY22E CY18 CY19 CY20E CY21E CY22E FCF FCF yield DPS Dividend yield (%) Source: Company; Sharekhan Research Source: Company; Sharekhan Research May 06, 2020 9 Viewpoint Financials in charts Volume to fall in CY20 before recovery over CY21-22 Margin to improve sharply led by weak base oil price 220 140.0 214 214 215 120.0 112.0 114.8 114.7 210 104.4 204 205 202 100.0 93.5 200 195 80.0 190 184 60.0 185 180 40.0 175 20.0 170 165 0.0 CY18 CY19 CY20E CY21E CY22E CY18 CY19 CY20E CY21E CY22E Volume (mn litres) Gross margin (Rs/litre) Source: Company, Sharekhan Research Source: Company, Sharekhan Research Revenue trend EBITDA/PAT CAGR of 5%/6% over CY2019-CY2022 4,500 1,328 1,400 1,277 4,000 1,153 1,200 1,071 1,111 3,500 994 1,000 952 3,000 827 825 2,500 800 708 2,000 Rs crore Rs crore 600 1,500 400 1,000 500 200 0 0 CY18 CY19 CY20E CY21E CY22E CY18 CY19 CY20E CY21E CY22E Revenues EBITDA PAT Source: Company, Sharekhan Research Source: Company, Sharekhan Research RoE trend RoCE trend 70.0 64.8 65.3 120.0 100.6 56.6 57.8 60.0 54.4 100.0 90.7 50.0 76.0 78.5 80.0 73.7 40.0 60.0 30.0 40.0 20.0 10.0 20.0 0.0 0.0 CY18 CY19 CY20E CY21E CY22E CY18 CY19 CY20E CY21E CY22E RoE (%) RoE (%) Source: Company, Sharekhan Research Source: Company, Sharekhan Research May 06, 2020 10 Viewpoint May 06, 2020 Source: Sharekhan Research Source: SharekhanResearch levels.