Castrol India - Case for a re-rating

Castrol's 2Q profit growth of 26% yoy indicates the company's strategy to raise prices in anticipation of surging base oil prices is proving succesful. Hence, we believe PEs should grow. We maintain our Buy rating and raise our target price to Rs360 (from Rs340).

2QCY08 net profit up 26% yoy
Castrol has reported 2QCY08 net profit of Rs828, up 26% yoy, and in line with our expectation. While costs of input lube base oil have been climbing fast, Castrol has raised prices by 20% since January 2008 to protect its margins. Despite price hikes, volumes for 1HCY08 were up 4% yoy, although we are forecasting a significant slowdown over next 18 months due to expectations of lower growth in auto fuels.

The new aggressive Castrol strategy
The surge in base oil prices in CY08 is similar to that in CY06, but Castrol's response is radically different. In CY06, it raised product prices after input costs rose. Thus absolute profits were maintained, but margins suffered. In CY08, Castrol has raised prices in anticipation of cost increases, thereby ensuring margins do not drop and profits grow. The potential success of this strategy is based on two key factors. First, Castrol's ability to position its brand in the premium segment, which is less price sensitive and more value conscious. Second, competition has no choice but to follow.

BikeZone medium-term impact is not significant
Ninety-six BikeZone outlets have been set up, but the rate of rollout has been below expectations due to rising real-estate costs. While BikeZone looks an exciting long-term prospect, we believe its earnings potential over at least the next three years will be limited in relation to Castrol's balance sheet. Our valuation does not assume any additional upside from BikeZone rollout.

Valuation yet to reflect pricing power
Castrol has shown its ability to grow earnings despite a very difficult operating environment. Obviously, outlook could improve substantially in the event of a decline in oil prices. Our CY08-10 EPS estimates have gone up by 2-23%. We maintain our Buy rating and raise our target price from Rs340 to Rs360, which would value the company at 16x CY08F EPS. This compares to our expectation of a 21% EPS CAGR over CY08-10.