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Announces a bold entry into Paints High IRR potential, but tough to grab market share

* We view GRASIM’s announced foray into the Indian Decorative Paints industry as a bold step. While it would be challenging to gain market share in an oligopolistic industry, if it can execute well, supported by the existing brand strength and distribution network of Ultratech’s white cement and putty businesses, the company could significantly improve its RoCE profile (currently only ~5-6%).

* While GRASIM is still formalizing the blueprint for this venture, planned capex of INR50b over the next three years would make it the second largest company in the sector in terms of capital employed (after Asian Paints).

* While RoCE of 15-25% earned by incumbents (Asian Paints, Berger, Kansai Nerolac, Akzo Nobel) and the 20% IRR targeted by GRASIM’s management are impressive, challengers like JSW, Sherwin Williams, Nippon Paint, etc., in the past 10-12 years failed to make in a dent in the market share of incumbents (given their strong brand recall and product innovations).

* With standalone planned capex (including ongoing expansions in its core Viscose and Chemicals businesses) of INR9-10b, spread over the next three years, the risk of any capital misallocation or investments in Vodafone IDEA Ltd (VIL) is lower.

* We therefore reduce our holding company discount to 50% (from 60% earlier) to align it to its 10-year average of 47% and raise our TP to INR1,110/share. We, however, maintain our Neutral rating and prefer subsidiary UltraTech (Buy, TP: INR6,650/share) which offers more upside.

Highlights from the management commentary

The management cited the consistent high growth in the Paints business over the last decade, due to inherent growth potential and migration to organized from the unorganized sector, as reason to enter this business segment. It plans to manufacture, trade, sell, and export all types of Paints and allied products and services. Here are the key highlights from the management discussion.

Eyes 20% IRR on capex of INR50b; would leverage Birla White’s distribution

* GRASIM plans to spend ~INR50b towards capex over FY22-24. The same will be funded through internal accruals and debt. It targets to be the second largest player through calibrated growth of the business and an IRR of 20%.

* The management has already started working on technological and product differentiation aspects. It has been undertaking consumer, influencer and trade partner research to understand market trends.

* Profitability would be driven by scale, cost structure (significantly lower than peers), and use of the latest technology.

* The company will be setting up plants at multiple locations and is already in talks with various state governments.

* GRASIM would leverage the existing brand equity of Aditya Birla Group, including the strong brand and distribution network of Birla White and Birla Wall Care Putty. Birla White has 100k influencers and 54k dealers spread across 6,000 towns. Around 70% of its dealers also sell Paints.

Industry insights

* The market size of the Decorative Paints business stands at INR400b and has been growing at 11% CAGR since FY14.

* It’s an oligopolistic industry with four major players. The unorganized sector commands a 25% market share. The largest player has a pan-India distribution network of 70k dealers.

* In the long run, demand growth for Paints is expected to be driven by Tier II and III cities and rural areas. The management expects its entry to accelerate the shift to organized from unorganized players.

Paints foray would give investors clarity on capital allocation

* The Paints business would drive the third leg of growth for GRASIM, reduce volatility (VSF and the Chemicals business are highly volatile in terms of prices), and provide clarity on capital allocation to a scalable business, thus addressing concerns on capital allocation to VIL.

* Capex on the Paints business would not cannibalize expansion of VSF and the Chemicals business, which have a scheduled capex of INR70b till FY22.

* It targets to maintain net debt-to-EBITDA ratio below 3.5x.

Valuation and view

* While the outlook in the core Viscose and Chemicals businesses has been improving, we expect margin to remain muted due to significant over-capacity in the industry, which would remain for the next three years. We, therefore, expect RoE to remain weak ~3% in FY22E.

* Given GRASIM’s conglomerate business structure, we value it on a SoTP basis. Our TP values: a) the standalone business (Viscose, Chemicals, etc.) at 6x FY22E EV/EBITDA, b) UTCEM at a 50% holding company discount to our TP, and c) other listed investments (ABCAP, IDEA, HNDL, and ABFRL) at a 50% holding company discount to the market price. We thus arrive at a fair value of INR1,110 per share. Maintain Neutral.