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BERGER PAINTS

Analyst:

Berger Paints: The Coffee Can story

Rakshit Ranjan, [email protected]: +91 22 3043 3201

December 2015

Only paintsFOCUS

Best affordable qualityTALENTHIRING

When the Piano is Steinway,the walls are Luxol Silk

MARKETING

CULTURE Freedom to innovate& make mistakes

CAPITALControlled capital allocation

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FFEE CA

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Berger Paints

December 07, 2015 Ambit Capital Pvt. Ltd.

CONTENTS

Berger Paints (BUY): The coffee can story…………………………………………. 3

250 years in the making…………………………………………………………….. 4

What is Berger Paints’ secret sauce?........................................................... 9

Understanding the sustainability of growth………………………………………16

Valuations – Upgrade to BUY, factoring in longevity of growth……………… 21

Ambit vs consensus; changes to estimates; and forensic……………………… 24 accounting scores

Risks and catalysts……………………………………………………………………25

Appendix: John Kay’s IBAS framework…………………………………………… 28

As highlighted in our 2nd November 2015 thematic, ‘The Coffee Can Portfolio…the Coffee Works’, companies which deliver healthy financial performance (revenue growth > 10% & ROCE > 15%) over long periods of time (at least ten years) deliver outstanding share price returns when they are a part of long term portfolio such as the Coffee Can Portfolio.

On average only a dozen companies make it into a given Coffee Can Portfolio (which is based on the preceding ten years of financial statements and which once invested is left untouched for the next ten years). However, nine companies – Berger Paints, Asian Paints, ITC, Marico, Page Industries, Ipca, Astral Poly, HDFC Bank and Axis Bank – appear in four or more of the Coffee Can Portfolios that we have built over the past 15 years. To understand better why these champion companies are able to deliver what no other company in India can, we are publishing a series of deep dives on these companies. This note contains the deep dive on Berger Paints.

http://reports.ambitcapital.com/reports/Ambit_Stratey_Thematic_TheCoffeeCanPortfoliothecoffeeworks_02Nov2015.pdf

Ambit Capital and / or its affiliates do and seek to do business including investment banking with companies covered in its research reports. As a result, investors should be aware that Ambit Capital may have a conflict of interest that could affect the objectivity of this report. Investors should not consider this report as the only factor in making their investment decision.

Key financials Year to March FY13 FY14 FY15 FY16E FY17E

Operating income (` mn) 33,464 38,697 43,221 48,345 57,298

EBITDA (` mn) 3,712 4,314 5,107 6,459 7,821

EBITDA margin (%) 11.1% 11.1% 11.8% 13.4% 13.7%

EPS (`) 3.2 3.6 3.8 5.2 6.6

RoE (%) 25.0% 24.1% 22.2% 26.3% 27.9%

RoCE (%) 18.6% 17.4% 16.5% 20.0% 22.3%

P/E (x) 74.0 64.8 61.0 44.5 35.2

Source: Company, Ambit Capital research

The Coffee Can story

Berger has built a strong foundation around high quality talent, a strong work culture and prudent capital allocation over four decades. Having cemented its position as India’s second-largest paint firm, the company has implemented initiatives over FY13-15 around supply chain, marketing, operational efficiencies and talent hiring, which should help it increase its market share/EBITDA margins by 500bps/300bps over FY15-25E. We expect revenue CAGR of 18% & EPS CAGR of 28% over FY15-20 with RoCE rising from 17% to 29% over this period. Factoring in the longevity of industry revenue growth and Berger’s sustained dominance, we arrive at a DCF-based fair value of `266 (14% upside), implying an FY17E P/E of 40x. Competitive position: STRONG Changes to this position: POSITIVE Genesis built around talent, culture and controlled capital allocation Berger’s current management team is nurturing the key factors that have defined its success since the 1970s: (a) hiring & retaining high-quality talent; (b) improving employee work culture by promoting freedom to innovate and make mistakes; and (c) driving impactful marketing. This is supported by the promoter’s focus solely on the paints industry, with controlled capital allocation and a hands-off approach which gives professionals complete control of ground-level execution. CEO Abhijit Roy has implemented meaningful changes over FY13-15… Over the past three years, significant changes have been made around: (a) aggressive marketing campaigns for the ‘Silk’ and ‘Express Painting’ service; (b) IT investments into supply chain management; (c) process-oriented approach towards hiring, retention and incentivisation of the sales team; (d) raw material procurement and manufacturing process efficiencies; and (e) improving the quality of hires at the management trainee level. … which should help improve market share and margins Through the initiatives highlighted above, we expect Berger to gain ~500bps market share from Kansai and Akzo Nobel over FY15-25. Whilst the firm’s gross margin differential against Asian Paints has already narrowed from >500bps until FY10 to <250bps in FY15, we expect EBITDA margins to expand by 300bps over FY15-20, as investments behind employees, marketing initiatives and operational efficiencies start yielding results. Change in stance from SELL to BUY; upgrade earnings & valuations We expect 17.6%/28.2% revenue/EPS CAGR over FY15-20, with RoCEs rising from 17% in FY15 to 29% in FY20E. Our revised DCF factors in longevity of Berger’s growth profile given market share gains amidst 13.5%/11.0% decorative paint industry revenue CAGR over FY15-25/FY25-35. This industry growth will be driven by decreasing repainting cycles (from 10.6 years currently to 8.5/7.5 years by FY25/35), and a rise in the share of pucca houses & the organized sector. Our upgraded fair value of `266 (previously ` 178) implies 14% upside and 40x FY17E P/E. We change our stance to BUY.

CHANGE IN STANCE BRGR IN EQUITY December 07, 2015

Berger PaintsBUY

Consumer

Recommendation Mcap (bn): `162/US$2.4 6M ADV (mn): `64.1/US$1.0 CMP: `233 TP (12 mths): `266 Upside (%): 14

Flags Accounting: GREEN Predictability: AMBER Earnings Momentum: GREEN

Catalysts

Strong sales growth in 3QFY16 due to delayed festive season

Contribution to revenue growth in 2HFY16 from pan-India rollout of Express Painting Service

Expectations of faster shift from unorganised to organised market following GST implementation

Performance (%)

Source: Bloomberg, Ambit Capital research

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Berger Paints Sensex

Analyst Details

Rakshit Ranjan, CFA

+91 22 3043 3201 [email protected]

Berger Paints


250 years in the making Little did Lewis Berger know in 1760 that two and a half centuries after he began a manufacturing company in Europe, his surname would live on as the second-largest paints company in India. The Berger Paints of today has a fascinating history of changing ownerships.

As per the British National Archives, Lewis Steingenberger came to London from Frankfurt in Germany in 1760 as a 19-year-old colour chemist to manufacture Prussian Blue, using the name of Lewis Berger. After Berger died in 1800, his sons took over the business and converted the paints firm into a limited company, Lewis Berger and Sons Limited. In 1960, the company merged with Jenson and Nicholson, a manufacturer of coach paints, to form Berger, Jenson and Nicholson (BJN). In 1969, BJN acquired British Paints, making BJN the world's second-largest paints producer, after ICI Paints Division. British Paints, a part of Celanese Corp (USA) at that time, had an Indian operation based out of Kolkata. This Indian operation was acquired in 1947 from Hadfield's, a small colonial venture set up in 1923. And so, the routes of Lewis Berger from Germany and British Paints from India intersected as BJN took over British Paints India.

In 1970, BJN was acquired by Hoechst AG, then the world's largest chemical company, based in Germany. In India, Hoechst was associated with liquor baron, Vittal Mallya. In 1956, Mallya and two other Indian partners had tied up with Hoechst AG, to promote Hoechst Pharmaceuticals where he held 48% of the company and was the Chairman of the company. In 1978, Mallya became the Chairman of British Paints India, and in 1983, British Paints was renamed as Berger Paints India Limited. Following Vittal Mallya's death, his son, Vijay Mallya, took over the Group's reins in the 1980s. In 1988, Hoechst AG sold BJN to Williams Holding. Fueled by his ambitions to build a global conglomerate, Vijay Mallya acquired Berger's overseas operations (except Australia, Europe and the UK) through a leveraged buyout. Thus, by the late 1980s, the UB Group emerged as the controlling shareholder in Berger Paints. Finally, in 1991, Vijay Mallya sold the UB Group’s stake to the current owners, the Dhingra Brothers – Kuldip Singh and Gurbachan Singh.

Even as ownership changed hands thrice – from British Paints to BJN (1969), from BJN to the Mallyas (1978) and finally from the Mallyas to the Dhingras in 1991 – Berger Paints moved up the rankings in the Indian paints industry. Berger moved up the ranks from #7 in 1980 (following a factory lock-out) to #4 by 1991 and up to #3 by 1998; Currently, Berger is the second-largest paints company in India, after Asian Paints.

We now break down this journey into three distinct phases across the past 45 years.

Phase I - 1972-1991: The Madhukar/Biji Kurien era – Transforming into a decorative paints company “The most difficult thing to change at a company is to change its people. For instance, when I joined Berger (erstwhile British Paints) as the head of sales and marketing, I was 31 years old, supervising ~13 branches at the company, and most branch managers reporting into me had more than 31 years of experience!”

- Biji Kurien, ex-Managing Director, Berger Paints (erstwhile British Paints).

In 1971 and 1972, two Asian Paints employees, Mr. Dongargaokar Madhukar and Mr. Biji K. Kurien joined Berger Paints as CEO and Head – Sales and Marketing, respectively. Mr. Madhukar was eventually succeeded by Mr. Kurien as MD in 1980. The biggest change that the new management brought about was in improving the work culture at the organisation. The management focused on hiring and retaining high-quality talent and giving its employees full autonomy within certain boundaries. The culture of the organisation improved, which in turn gave the employees a sense of togetherness. However, the company lacked a sizeable presence in the decorative paints segment, which accounted for only 15-20% of its revenues.

Berger Paints has a fascinating history of changing ownerships

During 1970s, management focused on hiring and retaining high quality talent

Berger Paints


At an operations level, Mr. Kurien/Madhukar started shifting the orientation of the company towards a consumer-facing home décor business, focusing on delivering products and services based on the requirements of retail customers. To begin with, several new products were launched in the decorative paints segment - ‘Butterfly enamel’ was launched during the mid-1970s and Luxol Silk was launched in 1979 as the company’s first acrylic emulsion. These product launches were then supported by highly innovative and successful advertising campaigns through a tie-up with the Lintas Media Group, one of India’s largest advertising agencies. The biggest of these marketing campaigns was around Luxol Silk, a brand that was launched at a premium price as compared to the then incumbents like Dulux Velvet Touch, Asian Paints Apcolite, Shalimar Paints Superlac, and Jenson & Nicholson’s Special Effects. Through these marketing campaigns, Luxol Silk was successfully established as a premium emulsion associated with households that own prestigious objects like Persian carpets and Waterford crystals. The firm also pioneered the concept of outsourced manufacturing in the paints industry to improve operating efficiencies. This shift towards decorative paints and the success of brands such as Luxol Silk drove Berger to rise up the ranks through the 1980s and 1990s. As a result of these initiatives, Berger Paints grew from the seventh-largest paints company in India in 1980 (smaller than peers like Asian Paints, Nerolac, Garware, Jenson & Nicholson, Shalimar Paints and ICI) to become the fourth-largest paints company in the country in the early 1990s, with a strong orientation towards decorative paints. As Mr. Anoop Hoon (National Sales Manager-Decoratives, of Asian Paints from 1991-1994) recalls, “Madhukar and Biji Kurien brought brilliance into British Paints. During their era, supply chain, productivity, operational excellence, brands and focus on the Decorative market was initiated- everything they had learnt, experienced & perfected at Asian Paints was carried forth. Berger had been transitioned.” Meanwhile, in Amritsar, Punjab, the Dhingra Brothers – Kuldip Singh and Gurbachan Singh – were on the lookout for a paints company to diversify their business of paint exports to Russia. The Dhingra brothers were one of the largest distributors of paints in Amritsar and Delhi from 1898 to 1967. In the mid-1960s, they started manufacturing paints under the brand name of Rajdoot and scaled up the business significantly in north India during the 1970s. Thereafter, during the 1980s, the Dhingras established a strong exports franchise in the paints industry and became one of the largest providers of paints to the Soviet Union. Berger Paints was the perfect fit for the Dhingras, and in 1991, Vijay Mallya sold his controlling stake in Berger Paints to the Dhingras. Cash flows generated from the Soviet Union exports business were eventually used to buyout Berger Paints, fortuitously, a few months before the USSR disintegrated.

Phase 2 – 1992-2010: The Dhingra/Subir Bose era – Rising up the ranks to the second spot By the time the Dhingras acquired the company in 1991, Berger Paints was reeling under capital constraints, following the aggressive expansion into the home décor segment. Thus, the transformation in Phase 2 of Berger Paints’ history was marked by the following events:

The entry of the Dhingras as the new promoter of Berger in 1991: This was a significant source of relief for the firm as the firm was reeling under capital constraints until 1991, which resulted in delayed payments of salaries to the professional management team, and supply chain issues given its single manufacturing location of Howrah (West Bengal). Mr. K.S. Dhingra was supportive of the management team and helped the firm expand its manufacturing capacities after raising fresh capital through a rights issue in mid-1990s.

The introduction of colour tinting machines at the dealers’ shop: Colour tinting machines tint basic white paint with different colourants to form different shades. This machine automatically tints the shade desired by the customer once the shade’s code is punched in. As a result, the number of colour shades offered by the dealer at his shop increased dramatically from 125 colours to more than 5,000 colours.

Orientation of the company shifted towards a consumer-facing home décor business backed by impactful marketing campaigns

Berger rose up the ranks through the 1980s and 1990s

Mr. K.S. Dhingra, owner of Rajdoot paints and one of the largest providers of paints to USSR, bought Berger Paints in 1991

During the 1990s, Berger expanded capacities and continued to focus on decorative paints

Berger Paints


Two other key shifts took place in the 1990s: (1) Continued focus towards the home décor segment and away from the industrial segment (launch of colour tinting machines and ramping up of the emulsion business); and (2) Expansion beyond Berger’s traditional market in the eastern region of India through new paint units in Pondicherry and Jammu. By the late 1990s, Berger was the #3 player in both the decorative segment (11% share after Asian Paints and Kansai Nerolac) and the industrial paints segment (14% share after Kansai Nerolac and Asian Paints).

The new promoters drove the management to pursue new product segments and new markets during 1994-1999 Exhibit 1:

Source: Bloomberg, Company, Ambit Capital research

Improved financials drove stock price performance during FY1999-2004 Exhibit 2:

Source: Bloomberg, Company, Ambit Capital research

During FY1999-2004, Berger continued its expansion by focusing on the ramping up products for its rural network (Jadoo Cem, Jadoo Emulsion and Jadoo Synthetic) and on the Colorbank Tinting System (1,000 outlets by end-FY01). In addition, Berger aggressively pursued acquisitions that allowed it to increase production (especially in Nepal and to increase its presence in new segments (ICI’s motoring paints plant in Rishra). Berger was also searching for acquisitions overseas in Russia and Sri Lanka. During this phase, Berger’s also tried to acquire Snowcem’s exterior paints business to give it a presence in the western region of India, where Snowcem had manufacturing facilities and a dealer network. However, the deal fell through in 2003 when Berger was due diligencing on the business.

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Mar-94 Sep-94 Mar-95 Sep-95 Mar-96 Sep-96 Mar-97 Sep-97 Mar-98 Sep-98 Mar-99

Commissioned paint manufacturing unit at Pondicherry

Berger turns down Korean firm offer to buy stake

In the decorative segment also, Berger enjoys thenumber three position with a market share of around 11per cent after Asian Paints and Goodlas Nerolac.In theindustrial paints segment, Berger Paints enjoys numberthree position with a market share of 14 per cent afterGoodlas Nerolac and Asian Paints.

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Apr-99 Sep-99 Mar-00 Sep-00 Mar-01 Sep-01 Mar-02 Sep-02 Mar-03 Sep-03 Mar-04

Berger in talks to acquire Snowcem’s entire paints busines

Berger Paints `open to acquisitions'

Berger Paints eyes takeovers in Russia, Lanka

Berger Paints acquires Jenson's Nepalese subsidiary with brands

Berger Paints deal to acquire Snowcem paints business called off

Berger Paints to set up plant in Jammu

Berger Paints acquired from ICI Ltd, its 50% shareholding in Berger Auto & Industrial Coatings Ltd, a 50:50 joint venture unit

Berger Paints


Berger expanded overseas and maintained its domestic market share during FY04-09 Exhibit 3:


During 1995-2010, Berger Paints recorded 17% revenue CAGR, average EBITDA margins of 14% and average RoCEs of 20.4%. Stock price returns were healthy at 17.6% CAGR, beating the Sensex’s returns of 10.4%.

Phase 3 – 2011-2015: The Abhijit Roy era – Catching up with the market leader In February 2011, Berger announced Mr. Abhijit Roy’s elevation from Senior Vice President, Sales and Marketing, to Director and Chief Operating officer of the company. In the same announcement, it was also stated that Mr. Roy will succeed Mr. Subir Bose as the CEO of the company from 1 July 2012 onwards. Mr. Roy started his career with Asian Paints and was associated with cosmetics major, L’Oreal, before joining Berger Paints in 1996. This change in the management team has also coincided with acceleration in Berger’s revenue growth relative to the market leader, Asian Paints (see the exhibit below).

Revenue growth rebased to 100 in FY06 – Asian Exhibit 4:Paints grew far ahead of Berger during FY06-11

Source: Ambit Capital research

Revenue growth rebased to 100 in FY11 – Berger Exhibit 5:matched pace with Asian Paints during FY11-15


The company’s improved performance was driven by a combination of several initiatives around the following aspects of the business:

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Berger bought out the Bolix (Polish company) giving an exit to private equity company, Advent International.

Berger launches eco-friendly paints

Berger Paints has entered into the do-it-yourself paints segment by launching the Galaxy paint kit

Berger Paints India Ltd (BPIL) has effected a re-branding exercise with a new logo, aiming to tap the top end of the Rs 8,000-crore paints market in India

Berger Paints plans overseas buyouts

Berger Paints has selected Oracle Applications to manage its operations across nine manufacturing units and its 10,000-strong dealer network across India

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Berger Paints Asian Paints

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Berger Paints Asian Paints

Berger Paints


Change in brand positioning: In order to build aspirational connect with the end consumer, over the past five years Berger’s advertising spend as a proportion of sales has increased consistently (see the exhibit below). The firm has invested in two key advertising campaigns over the past five years:

Appointing Bollywood star, Katrina Kaif, as the brand ambassador of Berger Silk, the firm’s premium luxury emulsion, since 2013, to improve the brand’s awareness amongst customers.

Advertising the launch of Express Painting Solutions in 2015, a faster painting service enabling painters to use advanced equipment to execute the paint project in almost half the usual time with increased convenience for occupants of the house.

Advertising spends to sales have increased whilst cash discounts to sales Exhibit 6:have decreased for Berger over the past decade


Improving supply chain management: Whilst Asian Paints took the lead in installing a technologically-advanced centralised supply chain management and ERP (Enterprise Resource Planning) system over 1999-2002, Berger implemented a similar technological advancement to its distribution channel in 2012 in collaboration with Oracle. Our discussions with the management suggest that this new ERP platform should improve the accuracy of demand forecasting for the group in the coming years. In a press interview in December 2012, Mr. Abhijit Roy said: “It is the supply side that we need to improve. We lose some amount of sales on account of our inability to supply the right kind of material on time. It’s one area which we are working on.”

Change in approach towards hiring, retention and incentivisation of the sales team: In order to improve the efficiency and scalability of Berger’s sales team, Mr. Abhijit Roy has standardised the process for hiring sales personnel across the country to bring about consistency in the quality of people being hired. The distribution network has also seen improvement due to these changes. Recruitment of management trainees has been changed to include graduates from the Indian Institute of Management (IIMs) and subsequently the quality of talent recruited has been improved along with the training quality of these recruits. Incentive structures of the sales team have also been changed to make them more aligned with the firm’s interests of network expansion.

Gross margin expansion driven by improved efficiencies around procurement and manufacturing processes: Berger has reported a 450bps increase in gross margin over FY10-15. This gross margin expansion has come despite no major input cost tailwind over this period and this margin expansion has come in a period in which Asian Paints has reported no gross margin improvement. Even more interestingly, this gross margin improvement for Berger has come despite premiumisation of its product portfolio accounting for only a small fraction of this gross margin expansion. As summarised in the firm’s FY14 annual report: “This has been possible through improvement in product mix, generating higher volumes with better economies of scale through wider reach and better servicing, reduction of

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FY03 FY04 FY05 FY06 FY07 FY08 FY09 FY10 FY11 FY12 FY13 FY14 FY15

Advt spending to Sales Cash discount to sales

Mr. Abhijit Roy has implemented several key initiatives over the past 3-4 years

During FY11-15, Berger has narrowed its gross margin differential against Asian Paints

Berger Paints


rebates on the back of improved brand equity and, structured and well monitored measures for reduction in cost. The last one includes strong management of working capital, improvement of productivity at all plants, continuous development of alternate raw materials, new sources for raw materials and improved formulations for better quality and lower costs and innovative procuring and application. A new Vendor Management System was implemented for the purpose of seamless co-ordination and quicker decisions.”

Reduction in discounts to dealers: Our channel checks suggest that Berger has historically been the most aggressive amongst the top-five players in the industry in terms of providing discounts and rebates especially to dealers. Also Berger provides longer credit option (28 days vs 15-17 days for Asian Paints) and higher cash discounts on advance payment (5% vs 4-5% for Asian Paints) to its dealers. As shown in Exhibit 3 above, cash discounts and rebates given to dealers as a proportion of sales have been declining consistently over the past five years.

Initiatives implemented during FY09-15 resulted in increase in market share and gross margins Exhibit 7:


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Berger Paints appoints COO Abhijit Roy as managing director

Asian Paints arm sells stake in Berger Paints China

Berger Paints to spend Rs100-crore on new plant in South India

Berger to expand resin unit at Kundaim in North Goa Berger Paints will set

up a water-based paint plant at Hindupur in Anantapur district of Andhra Pradesh at a cost of Rs.300 crore

Berger Paints India Limited (BPIL) recently deployed Microsoft Dynamics CRM solution to boost business productivity, deliver key insights and improve efficiency in operations

Berger paints a new premium line for bigger pie

Berger Paints enters in Construction Chemicals Business

In expansion mode, Berger Paints plans units for auto, industry segments

Berger Paints India acquires architectural business of of Sherwin Williams Paints India

Berger Paints suspends operations in restive Bahrain

Berger Paints


What is Berger Paints’ secret sauce? Section 1: Focusing on the core business “We have to focus on paint and grow only in paint. It is a very competitive business. One small mistake can take us back by 3-4 months or even more vs peers. We have to tread safely. Whilst competitors wait for Berger to make a mistake, we too wait for competitors to make a mistake, so that we can cover the gap against them, faster.”

- Mr. K. S. Dhingra, promoter, Berger Paints in our meeting with him in Apr’15.

Despite ownership changes almost every decade, Berger has never shifted focus from the paints industry. This alone counts as a significant achievement. What makes this achievement even more noteworthy is the fact that the paints industry in India is a tough, ruthless and complex business. Unlike other FMCG industries, the paints business faces the following unique challenges:

Limited scope for product differentiation;

Low involvement of end-customers in deciding which paint product to choose;

Voluminous nature of the paint product (in terms of price per unit volume); and

Large number of stock-keeping units (SKUs) given varied paint preferences across geographies in terms of colours, type of paints and size of the SKUs.

Hence, competitive pressures in the paints industry are high and have resulted in:

Reduced trade margins of only 3-6% in the distribution channel for the paints industry as compared to 13-20% for consumer staples categories (for example: food, beverages, etc.), and 20-30% for most other discretionary consumer categories (for example: automobiles, durables, leisure, etc.).

Increased bargaining power of the channel (dealers and painters) as compared to other consumption categories given their ability to push a particular paint product to the end consumers.

In such a tough business, with low margins for distributors, how does one gain leadership? What are the critical success factors to beat competition? The answers to these questions lie around building efficiency of supply chain to ensure high inventory turnover for a dealer whilst maintaining tight control of the working capital cycle (especially inventory management). Since such supply chain efficiencies and brand recall cannot be built overnight, the focus of the management team in steadily improving its demand forecasting capabilities and distribution network efficiencies is the key driver of success of a paint company.

We identify five drivers of competitive advantages in the industry and compare the four leading players on these drivers, as shown in the exhibit below.

Comparison of top-4 paint players across drivers of competitive advantages Exhibit 8:

Asian Paints Berger Paints Kansai Nerolac ICI/Akzo Nobel

Supply chain management Product range

Products with special characteristics

Marketing initiatives

Benefits to dealers/painters

Quality of management professionals

Overall

Source: Industry, Ambit Capital research; Note: is the strongest and is the weakest.

Mr. K.S. Dhingra has a clear focus on only paints businesses in order to avoid making any mistakes

Berger Paints


Berger has been one of the only two companies (alongside Asian Paints) in the industry which have focused consistently on building supply chain efficiencies, consistently widening the distribution network, and effectively investing in branding and marketing initiatives. Some of the points highlighted by Mr. KS Dhingra, Berger’s promoter, in our discussions with him around his focus on paints, include: “Paints is the only business I know and I also know how competitive it is. Hence I

have maintained a philosophy of not taking the risk of allocating capital towards any business which is not related to the paints industry”

“I feel that even if people in the senior management of my company are not home-grown, they should have come from within the paint industry. If I bring in a CEO from say the automotive industry or FMCG industry, it will take them years to understand about the paints industry. I cannot take that risk.”

As a result, Berger has been able to rise up the ranks from the seventh-largest paint company in India in 1980 to becoming the second-largest decorative paints company by the year 2000. Since 2000, Berger has widened the gap against the #3 and #4 players (Kansai Nerolac and Akzo Nobel). Our discussions with former senior management personnel in the paints industry suggest that lack of focus has been a key reason for the significant reduction in market share of companies like Garware Paints, Jenson Nicholson, and Shalimar Paints during the 1980s and 1990s. Some examples include: Garware Paints started a policy where it would give elongated credit periods to its

dealers in order to grow its distribution network. So eventually, the balance sheet stress increased to a point where in the early 1980s, the firm went from being the third largest in the industry to becoming non-existent.

Jenson & Nicholson’s problems included capital misallocation in the early 1990s as it ventured into sectors like Financial Services, weigh bridges, weighing machines in Ranchi and hotels in Patna. There were few other incidents which were not related to each other but contributed to the downfall of the company between 1995 and 2000. These included: (a) the floods in 1998-99 affected their factories and depots when they did not have adequate insurance cover; (b) loss of their chief technical manager in an air crash; (c) poor implementation of strategy towards the launch of tinting machines in India; and (d) a failed public issue after which SEBI banned them from the capital markets for three years.

Mistakes made by some of the other larger paint players include: (a) frequent changes to their ownership and management teams which brought discontinuity to the focus on execution at the ground level; and (b) more focus on the industrial side of the paints business rather than the decorative side of the business. Thus, a manic, single-minded focus on the core business is among the key reasons behind both, Asian Paints and Berger Paints, maintaining their competitive positions in the Indian paints industry.

Section 2: Deepening the competitive moat Berger Paints has steadily built its competitive advantages across the four criteria of John Kay’s ‘IBAS’ framework, namely: Innovation, Brands and Reputation, Architecture and Strategic Assets (for more details of this framework, please refer to the Appendix). We discuss each aspect:

Innovation

(A) Promoters: Berger was acquired by the Dhingra Brothers (Kuldip Singh and Gurbachan Singh Dhingra) in 1991 who, until that point, were largely involved in the paints manufacturing and trading businesses in India and Russia. The promoters stand out in two ways:

Flying under the radar: They maintain a low profile and are rarely spotted in the press despite their high net worth; as per Forbes, they are among India’s richest families. For a family of their stature, the Dhingras’ office in Delhi is a sparsely furnished, back-of-the-shopping-precinct affair in a nondescript Delhi suburb. In our meetings over the past few years with the promoters, we have found them to be refreshingly grounded.

Businesses of peers like Garware and Jenson & Nicholson have been adversely affected by lack of focus

Berger rates highly on our IBAS framework

Berger Paints


Hands-off approach: With the promoters keeping a hands-off approach, Berger is run entirely by professionals. This tradition has continued through the years, despite change in ownerships. Headquartered in Kolkata, Berger runs its operations from a non-descript office building on the lower profile end of Park Street. The promoters have refrained from interfering in the day-to-day management of the company. In our discussions, Berger’s senior management points out that “One of the biggest contributions of the promoters is that they have always given us a lot of freedom and flexibility to operate. Beyond the support provided in strategic initiatives, and discussions on the annual business plan held in the beginning of the year, the promoters allow complete independence to the management based out of Kolkata to handle and deliver the budget that they have committed to.”

(B) Tinting machines: In 1996, when the emulsion category of paints in India was solely controlled by ICI (Dulux brand) and Asian Paints (Apcolite and Royale brands), Berger was one of the pioneers (second after Jenson & Nicholson) to launch colour tinting machines at dealer stores in India. The machines use three main bases (dark, medium and pastel) to recreate walls using Tintovision software, thereby reducing the number of SKUs in the supply chain for a dealer and manufacturer, and significantly increasing the number of SKUs that could be delivered to a customer based on the shade of his choice. However, the challenge for Berger was that the price of a tinting machine for a dealer was as high as `831,000 – a large outlay for a dealer in those days - and the ‘Berger’ brand was unheard of in the emulsions space. To overcome this challenge, Berger used innovative marketing and sales tactics to aggressively push tinting machines to their dealers as an efficient cost-saving and space-saving device. In less than four years, by September 1999, Berger had installed 400 tinting machines, out of a total of 1,200 machines in the industry, thereby establishing the firm’s presence in the emulsions category.

(C) Products: Berger has, in the past, focused significantly on introducing products with special characteristics which have allowed it to create a strong brand recall for such products. In the exhibit below, we list a few Berger products and their characteristics. These products have enabled Berger to sustain its competitive positioning in the industry.

Berger’s key products and their qualities Exhibit 9:Brand Name Characteristic

Luxol Silk Upmarket emulsion launched in 1979 with a prestigious feel of silk. This was launched at a price higher than that of the market leader ICI’s Dulux.

Breathe Easy Made from low volatile organic chemicals (VOC) and is suitable for schools and hospitals and for the elderly and those who suffer from breathing problems

WeatherCoat AllGuard Silicon-based exterior water based paint with enhanced water resistance

Easy Clean Most washable interior paint in India with pleasant sheen finish

Designer Finishes ‘Illusions’ Brand that provides metallic/marble type finishes to walls

Source: FY13 Annual Report, Ambit Capital research

Brands/Reputation:

Over the past 50 years, Berger has consistently invested in creating a strong brand recall in all categories of paints from the economy segment to the premium segment. Some of the examples of these investments include:

Biji Kurien, who joined the firm in 1973 as the head of sales and marketing, spearheaded Berger’s orientation towards brand creation. After the launch of brands such as Butterfly (1975) and Luxol Silk (1979), through its tie-up with Lintas Media Group, British Paints, as Berger was known then, became the first company that advertised on the cover page of a weekly English news magazine. One of the most-successful advertising campaigns around Luxol Silk, which helped position Berger in the premium paints category, emphasised the association of premium paint customers with prestigious objects. The taglines of the advert campaign included:

Over the past 50 years, Berger has consistently invested in creating a strong brand recall

Berger Paints


When the miniature is Moghul, the walls are Luxol Silk

When the furniture is Queen Anne, the walls are Luxol Silk

When the carpet is Persian, the walls are Luxol Silk

When the Piano is Steinway, the walls are Luxol Silk

When the bronze is Chola, the walls are Luxol Silk

When the vase is Satsuma, the walls are Luxol Silk

Luxol Silk – It is the only emulsion paint you can tell with your eyes closed

In the designer finish segment, Berger was the first off the block with the launch of the ‘Illusions’ brand in 2001. Since then most of its peers have introduced designer finish paints in their product portfolio.

Since Mr. Abhijit Roy has taken over as the MD and CEO of Berger, the firm has seen a significant increase in its brand salience thanks to two key initiatives in the premium segment: (a) launch of Berger Silk advert campaign featuring Bollywood star, Katrina Kaif; and (b) launch of the Berger Express Painting service and the aggressive advertising campaign backing it.

These product launches and marketing initiatives have helped strengthen Berger’s relationship with dealers and have enhanced brand recall among customers. Berger has aggressively raised its ad spend over the years (from 3% of sales in FY05 to ~5% in FY11 and 6.6% in FY15).

Advertising & promotion expense as percentage of sales Exhibit 10:

FY05 FY11 FY15

Asian Paints 3.7% 4.0% 5.2%

Berger Paints 3.3% 4.9% 6.6%

Kansai Nerolac 3.3% 3.8% 4.1%

Akzo Nobel 5.3% 9.2% 4.2%

Shalimar 1.9% 0.6% 0.3%


Architecture

Berger has well-entrenched relationships with its key stakeholders, namely, employees and distributors. These relationships have been built and strengthened over the years and are now part of its corporate culture.

Employees and the work culture: In this particular aspect, Berger has learnt from the industry leader, Asian Paints, which is well known for its top-of-the-line management. This learning began as early as the 1970s under the leadership of Mr. Madhukar and Mr. Biji Kurien. As a veteran of the paints industry put it: “Mr. Biji Kurien was a very fine brain and he had a knack for selecting people. He was the first leader at British Paints to put very young people in charge of very large portfolios. May be one criticism of him was that he delegated too much; but this delegation also meant that the people set the pace for the company to become what Subir Bose could leverage on from the 1990s onwards. So Berger had very capable people in key positions including R&D. R&D was a neglected area before him.”

Mr. Kurien stated in our recent discussions with him:

“Everywhere in the consumer industry there are only two things that make a company successful – its customers and its people. These are the only two areas where decision making and enthusiasm means something. When I was the CEO of British Paints, I ensured that two people in the whole organisation - the personnel manager and the marketing manager - had to get my clearance on everything that they do.”

Berger has strong relationships with its key stakeholders, namely, employees and distributors

Berger Paints


“The kind of salaries that we were paying, we couldn't afford the Asian Paints approach of hiring IIM graduates. My philosophy was that you need to give an opportunity to your employees to perform to their full potential. Two things that I used to tell my recruitment manger - don't recruit someone who is NOT able to do a job, just to fill a vacancy. Secondly, even if we don't have a job, but you come across the right person, you must recruit him. Most of the things that I did was essentially to stabilise the operations and decided to give full autonomy to the people within certain boundaries. “

Mr. Kurien’s successors and the current promoters have supported this approach of hiring and retaining high-quality talent, and providing freedom and accountability to its employees throughout the organisational hierarchy. In our recent discussions, Mr. Abhijit Roy, currently the Managing Director and Chief Executive Officer (CEO), stated that:

“One of the primary reasons for the better performance of Berger is the culture which has two parts to it. One, there is freedom to innovate and freedom to make mistakes. You are not berated or scolded; you are not told to follow a straitjacketed approach from the leaders. This culture helps cultivate an entrepreneurial feeling amongst our employees. The second part is that we have a very open culture. Like anybody from field level to sales manager can walk into my room without appointment and talk to me to either give information or ask for my views. I sometimes call branch managers into a conference room and ask them to present their success story which we put up on SharePoint (a team collaboration software tool) for everyone else to understand and share. This encourages people to think differently and innovate.”

“I have focused on improving the quality of manpower being hired in this organisation over the past five years. For instance, previously the recruitment of a sales officer used to be carried out by various branch managers. This led to a lack of consistency in the quality of people being hired across geographies and hence inter-branch transfers used to create problems. We have standardised that part now. In terms of management trainees, we have moved to IIMs and hence recruiting quality has been improved along with increased focus on training these people.”

This focus on employees is also a stated policy, which is implemented rigorously. Berger Paints’ Directors recognise the importance of fostering an enabling culture within the company. In the FY13 Directors Report, they stated, “Your Company recognises the fact that talent and skills are increasingly becoming scarce and it requires considerable effort to identify, engage and retain such talents. Your Company is paying increasing attention to these aspects and also to training. Per employee training hours in the year was 15. The Company recognises the fact that salary alone is not the criteria for satisfaction of deserving employees and offers a participative work environment and an open culture”.

Distributors: As mentioned previously, the lack of active involvement of the end consumer (especially in the mid-tier and economy segments) enhances the role of dealers/painters in the decorative paint selection process. Consequently, paint manufacturers offer performance-based incentives to painters/dealers including:

Rebates per litre are offered to dealers depending on the volume of sales for each dealer.

Favourable credit terms or higher cash discounts are offered to dealers.

Rewards/gifts including international holiday trips are offered to painters based on their performance.

Berger beats its competitors on this metric by offering the most attractive benefits to both the dealers as well as the painters. Moreover, distribution expansion over the past five years has significantly improved under the leadership of Mr. Abhijit Roy mainly due to a change in the approach towards hiring, training and incentivisation of the sales team, by giving them reasonably stretched targets to deliver.

One of the primary reasons for the better performance of Berger is its strong work culture

Berger Paints


Strategic assets

In the paints industry rolling out an all-India network of plants, manufacturing facilities and dealer/distribution network is a key strategic asset which serves as a strong entry barrier. This is because the need to stock surplus inventory in depots and the time to supply products to the dealers are both reduced if there is a manufacturing plant closer to the area of product demand.

Berger’s manufacturing facilities are its key strategic assets. Starting from the Eastern region, Berger has expanded rapidly over the years. The exhibit below highlights the network size of Berger’s manufacturing plants compared to its peers.

Factory location of paint companies Exhibit 11:

Company No. of factory

Location North South East West

Asian Paints 8 Kasna (UP), Rohtak (Haryana)

Patancheru (AP), Sriperumbudur (TN)

Ankleshwar (Gujarat) Sarigam (Gujarat)

Khandala (Maharashtra) Taloja (Maharashtra)

Berger Paints 9 Sikandrabad (UP),

Jammu (J&K), Surajpur (Noida)

Hindupur (AP), Puducherry

Howrah (WB), Rishra (WB)

Jejuri (Pune), Goa

Akzo Nobel 6 Kanpur (UP), Mohali (Punjab) Hyderabad (AP) Rishra (WB) Thane (Maharashtra),

Gwalior (MP) Kansai Nerolac 5 Bawal (Haryana),

Jainpur (UP) Hosur (TN) Ratnagiri (Maharashtra), Ahmedabad (Gujarat)

Shalimar 4 Sikandrabad (UP) Chennai (TN) Howrah (WB) Nashik (Maharashtra)

Source: Company; Ambit Capital research

Section 3: Controlled capital allocation “We are clear that whatever capital is available with us we will use it for our paint business and not anywhere else. This is clear. We will not go for diversification.”

- Mr. KS Dhingra, promoter, Berger Paints in our meeting with him in Oct’15

Our discussions with Mr. Dhingra suggest that one of the key areas of change that Mr. Dhingra brought about at Berger after he bought the business from Mr. Mallya was the removal of capital constraints which were hampering both expansion as well as incurring recurring operating expenditure. He has said, “When I bought this business in 1991, the situation was so bad that the management was not even getting paid salaries on time.”

Besides paying the operating expenses, Mr.Dhingra also contributed significantly towards setting up of manufacturing plants across the country. In our discussions, the management team of Berger stated that “Supply chain in paint industry is very important. Until the early 1990s, we used to suffer because our factory in Howrah was at one end of India and we had to supply products across the country from there. Moreover, paint demand was very seasonal around festivities, which used to further complicate supply chain issues for us. From 1996 onwards we started expanding our factories, first in Pondicherry, then in Jammu then Gujarat, all coming in at regular intervals.”

As articulated by Mr. Anoop Hoon (National Sales Manager – Decoratives, of Asian Paints from 1991-1994), “The problem faced by Berger during a major portion of the Biji Kurien era, particularily in the 80's, was that the owners were not giving enough capital for capacity expansion. Dhingras understood that what Berger needed was capacity expansion or being able to set up new plants, and to be fully supportive of the professional management team.”

As highlighted in the exhibit below, Berger’s RoCEs have been consistently between 16% and 28% over the past few years. The firm has consistently maintained a dividend payout ratio of 35-40% over the past 20 years. This controlled capital allocation by Berger is a result of Mr. Dhingra’s view about allocating capital only to businesses in the paints industry, without diluting the firm’s focus on the core domestic decorative business. Some views shared by Mr. Dhingra in our discussions with him on this subject include:

Berger’s well spread-out network of manufacturing facilities are its key strategic assets

Mr. K.S. Dhingra has followed a conservative approach towards capital allocation

Berger Paints


“My philosophy on capital allocation is similar to what happens in Golf – focus on your stance and keep your eye on the ball (which for me is my business). Don’t look at the direction in which you want to hit; instead look at the ball. Then it will certainly go in the right direction.”

“We bought the biggest specialist exterior insulation finishing systems, i.e. EIFS company in Poland in 2008 where we have a technology related edge. Although we want to bring it to India at some point of time in future, the right time has not come yet. If I do it now then for a long time I will disturb the Balance Sheet of Berger. Hence, I will wait for the right time”

Berger’s dividend payout ratio and RoCE have remained fairly steady over Exhibit 12:the past two decades


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Berger Paints


Understanding the sustainability of growth We expect 13.5%/11% sales CAGR for decorative paints industry over FY15-25/FY25-35

Decorative paints industry’s revenue CAGR and its growth drivers Exhibit 13:

FY05-15 FY15-25E FY25-35E

Growth drivers CAGR CAGR CAGR

Population Increase - increase in # of HHs 1.6% 1.1% 1.1%

More nuclear families - increase in # of HHs 1.2% 1.2% 0.8%

Decrease in Repainting Cycle 3.3% 3.1% 2.3%

‘Kaccha to Pucca’ shift in houses 1.9% 1.5% 1.5%

Like for like product price hikes 2.9% 2.9% 2.9%

Premiumisation of product portfolio 1.5% 1.5% 1.5%

Shift from Unorganised to Organised Market 2.9% 1.4% 0.5%

Total CAGR 16.3% 13.5% 11.0%

Source: Ambit Capital research; Industry

Despite being one of the oldest and one of the largest categories in the home building sector, the Indian paints industry is far away from saturation point for most of its growth drivers. Our analysis suggests that revenue growth of the decorative paints industry in India is likely to moderate from 16.3% CAGR over FY05-15 to 13.5% CAGR over FY15-25 and 11.0% CAGR over FY25-35. This can be sub-divided into various growth drivers:

Growth driver #1: Increase in total number of households (2.1% CAGR over FY15-35)

Increase in the number of households across the country is driven by two factors:

Increase in India’s overall population: Based on demographic forecasts provided by United Nations and Census, we assume that India’s population will expand at a CAGR of 1.1% over the next decade (from 1.21bn in 2011 to 1.41bn by 2025). This compares against 1.6% CAGR in overall population over 2001-2011.

Reduction in average number of individuals per households: Census data on the number of households suggests that the average number of individuals per household in India reduced from 5.5 in 2001 to 4.9 in 2011. This reduction is driven largely by the increase in the number of nuclear families across the country (demonstrated in the exhibit below by increase in households with 3-4 members). Since households with over 5 individuals still account for ~50% of the country’s overall households (down from 57% in 2011), we expect a reduction in the average number of individuals per household to ~4.1 by 2025.

Average number of individuals per households (%) Exhibit 14:

Source: Ambit Capital research, Census of India

4.1%

9.7%

36.7%

31.1%

18.4%

3.9%8.2%

30.9%32.2%

24.8%

0%

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25%

30%

35%

40%

1 2 3-4 5-6 7+

2011 2001

We expect industry revenue growth of 13.5% CAGR over FY15-25 and 11.0% CAGR over FY25-35

Berger Paints


These two factors together will result in 3.5% CAGR in the total number of households across the country over FY15-25. We expect this growth rate to moderate to 1.9% CAGR over FY25-35, due to a moderation in the pace of reduction of the number of individuals per household beyond FY25.

Growth driver #2: Shift from unorganised to organised (1.0% CAGR over FY15-35)

As highlighted in the exhibit below, the proportion of organised sales in the decorative paints industry has increased significantly from 58% in 2010 to 65% in 2014, contributing to 2.9% CAGR in industry revenues. Given the likely changes around implementation of GST and continued rise in propensity amongst consumers to use branded products, we expect the organised share of the industry to rise to ~75% by FY25 (implied industry revenue CAGR of 1.4% over FY15-25) and to 80% by FY35 (implied industry revenue CAGR of 0.5% over FY25-35).

Shift from unorganised to organised segment in decorative paints industry Exhibit 15:

2010 2015 2010-15 CAGR 2025 2015-25

CAGR 2035 2025-35 CAGR

Organised 58% 65% 2.9% 75% 1.4% 80% 0.6%

Unorganised 42% 35% 25% 20% Total 100% 100% 100% 100% Source: Industry, Ambit Capital research

Growth driver #3: Reduction in repainting cycles (2.7% CAGR over FY15-35)

As highlighted in the exhibit below, we estimate that the repainting cycle of organised and ‘pucca’ houses currently stands at 10.6 years. With rising disposable household incomes, we expect this repainting cycle to reduce to an average of 8.5 years by 2025, contributing 3.1% CAGR to the decorative paint industry revenues over FY15-25. We expect this CAGR to moderate to 2.3% over FY25-35, as repainting cycles reduce further to ~7.5 years by 2035.

Computation of repainting cycle across the industry Exhibit 16:

Sanity check on cost of painting per household in 2011

Cost psf (`) (A) 12

Floor area (sft) (B) 500

Paint area multiplier (C) 4

Paint area (sft) (D)=(B * C) 2000

Cost of paint project (`) (E)=(D / A) 24000

Cost of paint material (`) (F)=(E * 35%) 8400

Computation of Repainting cycle across the Industry

Decorative Revenue (cr) (G) 12000

House Painting p.a. (cr) (H)=(G / F) 1.43

Number of HH (cr) (I) 25

Painting Cycle (J)=(I / H) 17

Pucca Houses in 2011 (K) 61%

Painting Cycle of Pucca Houses (K * J) 10.6

Source: Industry, Ambit Capital research

Growth driver #4: Conversion from ‘kaccha’ to ‘pucca’ houses (1.5% CAGR over FY15-35)

Data from the National Sample Survey Organisation (NSSO) suggests that the proportion of pucca houses (which contribute to the overall painting industry) increased from 41% in 1991 to ~50% in 2001 and to ~61% in 2011, contributing 1.9% CAGR to the number of pucca houses across the country over 2001-2011. We expect this CAGR to moderate to 1.5% in the future.

Berger Paints


Growth driver #5: Like-for-like product price hikes (2.9% CAGR over FY15-35)

Like-for-like product price hikes in the decorative paint industry over the past decade have been only 2.9% CAGR. This is a low growth rate because in the midst of weak product differentiation, the larger paint companies like Asian Paints and Berger have kept their product pricing competitive whilst gaining market share from peers on the back of better supply chain efficiencies.

We expect a similar low price hike CAGR of 2.9% to prevail over the next two decades in this industry.

Growth driver #6: Premiumisation (1.5% CAGR over FY15-35)

Based on our discussions with market participants, we understand that the product mix of premium/mid/economy by volumes in the decorative paints industry has changed from 7%/52%/41% in FY06 to 12%/53%/35% in FY12. Current average prices per litre of premium/mid/economy products are at ~`220/`135/`45.

We estimate this volume-wise product mix to change to 30%/46%/24% by 2025, contributing 1.5% CAGR to industry revenues over FY15-25. Since the product mix will be nowhere close to being saturated even in 2025, we expect a similar CAGR of 1.5% to be contributed by product premiumisation over FY25-35 as well.

We expect Berger to gain 500bps market share over FY15-25, and no change to its market share thereafter As highlighted previously, under the leadership of Mr. Abhijit Roy, over the past three years Berger has implemented several initiatives around: (a) brand building, with its advertising spends to sales rising from 5% in FY12 to ~6.5% currently; (b) launch of Berger’s express painting service; (c) improvements in hiring, training and incentivisation of sales staff in the organisation; and (d) improvement in the quality of hires made by the firm at the middle management level. Through these initiatives, we expect the firm to gain ~500bps market share over FY15-20 (from ~20% currently to ~25% in FY20). These market share gains are likely to come from peers like Kansai Nerolac and Akzo Nobel, given a relative lack of focus from these peers in improving their sales, supply chain, and marketing capabilities at the ground level.

However, given the limited visibility around sustainability of such initiatives by the firm thereafter, we assume the firm’s revenues will increase only in line with the overall market beyond FY20.

Berger’s revenue growth vs paints industry over FY05-35E Exhibit 17:

FY05-15 CAGR FY15-25 CAGR FY25-35 CAGR

Berger’s total market share gain over the period ~50 bps ~500 bps 0 bps

Industry revenue growth 16.3% 13.5% 11.0%

Berger’s revenue growth 16.5% 16.6% 10.5%


We expect ~300bps EBITDA margin expansion over FY15-20 and none thereafter Over FY1995-2010, Berger’s gross margins have lagged behind those of Asian Paints by ~500-1,150bps. As highlighted in the exhibit below, Berger has reported a 450bps increase in gross margin over FY10-15. This gross margin expansion has come despite no major input cost tailwind over this period and despite its largest competitor, Asian Paints, reporting no gross margin expansion over the same period. Moreover, only a small fraction of this gross margin expansion is explained by the extent of premiumisation of Berger’s product portfolio mix.

We expect 500bps market share gains for Berger from Kansai Nerolac and Akzo Nobel over FY15-25

450bps gross margin expansion over FY10-15 will translate into 300bps EBITDA margin expansion over FY15-20

Berger Paints


Gross margin of Berger and Asian Paints over Exhibit 18:FY06-15


WTI Crude prices over FY06-15 (USD per barrel) Exhibit 19:


As summarised in the firm’s FY14 annual report, we believe that the key reasons for this gross margin expansion are – “structured and well monitored measures for reduction in costs” like:

A new Vendor Management System was implemented in FY14 for the purpose of seamless coordination and quicker decisions

Continuous development of alternate raw materials

New sources of for raw materials

Improved formulations for better quality and lower costs

Innovative procuring and application

Strong management of working capital

Improvement of productivity at all plants

Although FY16 is likely to see a 160bps gross margin expansion due to crude-related tailwinds from a softer input cost environment, we expect a reversal of these benefits over the next 12-18 months through an absence of product price hikes.

However, given the nature of the changes implemented over FY10-15 (highlighted in the bullets above), we do NOT expect the firm’s gross margins to move below ~41.5% in the future, even as recent tailwinds related to crude prices reverse over the next 12-18 months.

Gross margin and EBITDA margin profiles for Berger Exhibit 20:


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Berger has implemented significant changes around management of raw materials and manufacturing processes

Berger Paints


Whilst we forecast steady gross margins of ~41.5%, we expect Berger’s EBITDA margins to expand by ~300bps over FY15-20 due to a combination of the following factors:

100bps reduction in advert spends to sales ratio: Out of the 450bps gross margin expansion reported by Berger over FY10-15, as much as 210bps was invested into increased advert spends. Whilst we expect the firm’s focus on advertising spends to continue, we forecast a 100bps reduction in advert spends to sales ratio for the firm over FY15-20, as the benefits of these higher marketing investments start coming through in the form of market share gains.

Efficiencies around salaries and wages (80bps): We expect an 80bps reduction in salaries and wages to sales ratio due to combination of two factors: (a) the firm will reap rewards of having upgraded the quality of middle management talent that it hired over the past three years; and (b) as the firm becomes a process-oriented organisation incrementally, there will be scale efficiencies on this cost item – for example, benefits of standardising the process for hiring its sales team

Operating efficiencies (120bps): Due to scale-related benefits and also gains from increased use of IT, data analytics and process-driven operations, we expect operating efficiencies of 20-30bps each across various cost items like freight handling charges and other operating expenses.

Berger Paints


Valuations – Upgrade to BUY, factoring in longevity of growth We expect ~17.6% revenue CAGR and ~28.2% EPS CAGR over FY15-20E, with RoCEs rising from 17% in FY15 to 29% in FY20E. Our revised DCF factors in a greater longevity of Berger’s healthy growth profiles, as the current management team further improves the key values around: (a) quality talent hiring; (b) strong organisational culture; (c) increasingly process-oriented operations; (d) impactful marketing; and (e) controlled capital allocation. As a result, we use terminal growth in our DCF from FY36 onwards (vs FY30 onwards in our previous model). Our three-stage DCF gives a fair value of `266 (14% upside), implying an FY17E P/E of 40x. We change our recommendation from SELL to BUY.

We prefer DCF over a multiples-based approach Given the steady and cash-generative nature of the business, we use a DCF approach to arrive at a fair value for Berger. Moreover, we believe that a relative valuation based approach around say P/E or EV/EBITDA multiples does NOT adequately capture the fair value of Berger. This is because, given the way Berger has cemented its second rank position in the industry over the past decade, and given the various initiatives implemented around personnel management, marketing and operational efficiencies by Mr. Abhijit Roy over the past three years, Berger’s historical relative valuation band-charts (see the exhibits below) are incorrect benchmarks for the current implied P/E multiple. Berger’s P/E and EV/EBITDA multiples have justifiably re-rated upwards over the past three years.

EV/EBITDA Exhibit 21:


P/E band-chart Exhibit 22:


Our DCF valuation model on Berger includes the following three stages:

Stage 1: Five-year growth phase – FY15-20 We forecast 17.6% revenue CAGR for Berger, led by an industry growth rate of ~14% and market share gains of ~250bps. As highlighted above, we expect EBITDA margin expansion of 300bps over FY15-20E and hence we forecast 28.2% EPS CAGR over this period.

Through improving efficiency of working capital cycle management and incremental investments around improved data analytics for finished goods inventory management and the Vendor Management System for improved raw material procurement efficiencies, we expect a reduction in inventory days from 60 days in FY15 to 52 days in FY20E, and hence a reduction in working capital cycle days from 47 days in FY15 to 37 days in FY20E. This is likely to lead to an improvement in asset turnover from 2.2x in FY15 to 2.8x in FY20E.

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We change our recommendation from SELL to BUY.

Berger Paints


As a result of the margin expansion and improved asset turns, RoEs are likely to improve from 22% in FY15 to ~31% in FY20E.

Berger’s earnings profile over FY11-20 Exhibit 23:


Asset turnover and RoCE Exhibit 24:


Stage 2: Fade period over FY21-36 This stage of our DCF model forecasts a gradual moderation in revenue growth rates from 19.3% in FY20 to 7.0% in FY35 (an overall CAGR of ~16.6%/10.5% over FY15-25/FY25-35, as highlighted in Exhibit 17 on page 19). PBIT margins in this stage are likely to remain steady, as the firm sustains its market dominance as the second-largest player with ~25% market share.

Our assumption on operating metrics in the fade period of our DCF-based Exhibit 25:valuation (` mn)


Stage 3: Growth to perpetuity From FY36 onwards, we forecast a growth in revenues, earnings and cash flows at 5%, broadly in line with the long-term GDP growth forecasts for India.

WACC used for discounting of cash flows Our DCF model uses a WACC of 13% for the company which is based on the computation shown in the table on the right.

10%

15%

20%

25%

30%

35%

0%

10%

20%

30%

40%

FY11

FY12

FY13

FY14

FY15

FY16

E

FY17

E

FY18

E

FY19

E

FY20

ERevenue growth EPS growthRoCE (RHS) EBITDA Margin (RHS)

15%

17%

19%

21%

23%

25%

27%

29%

31%

1.50

1.70

1.90

2.10

2.30

2.50

2.70

2.90

FY11

FY12

FY13

FY14

FY15

FY16

E

FY17

E

FY18

E

FY19

E

FY20

E

Asset turnover ROCE (RHS)

0%

5%

10%

15%

20%

0

10,000

20,000

30,000

40,000

50,000

60,000

FY21

FY22

FY23

FY24

FY25

FY26

FY27

FY28

FY29

FY30

FY31

FY32

FY33

FY34

FY35

FY36

FCFF (LHS) Revenue growth PBIT Margin

WACC Computation

Item %

Risk free rate of return 8.2

Beta (2 Year monthly) 0.85

Risk Premium 7

Cost of Equity 14.2

Cost of Debt 12

Debt/Equity 20

Corporate Tax Rate 30

WACC 13.0

Source: Ambit Capital Research

Berger Paints


Relative valuation – Deserves a rich P/E Despite paints companies being classified as chemicals companies globally, and despite paints being linked to the home building sector, we believe that the business models and growth prospects of paints companies in India are akin to the consumer staples/ entry-level consumer discretionary companies because the paint companies are highly cash-generative B2C businesses in India with drivers of competitive advantages including supply chain efficiencies, quality of distribution and strength of their brand recall.

Berger Paints is currently trading at a 10% premium to peers like Kansai Nerolac, and at a 15% discount to the market leader, Asian Paints. We believe that the premium against Kansai and Akzo is clearly justified due to the superior competitive advantages that were highlighted in Exhibit 8 on page 10. We believe the firm deserves to trade at a slight discount of 5-10% as against Asian Paints, since the market leader continues to demonstrate superior capabilities around velocity of its supply chain, efficient working capital cycles and greater capital efficiency, underpinned by a high-quality talent pool at the middle and senior management level.

Relative valuations for Berger and its peers Exhibit 26:

Company name CMP Mcap

(US$mn)

EPS CAGR FY15-

17

P/E EBITDA CAGR EV/EBITDA Sales

CAGR FY15-17

EV/SALES ROE (FY17) (LC) FY16E FY17E FY15-17 FY16E FY17E FY16E FY17E

Indian companies

Asian Paints 835 11,990 24% 47.0 40.2 21% 28.2 24.1 14% 5.2 4.4 34.0

Berger Paints 234 2,430 31% 41.4 35.6 22% 23.4 19.6 14% 3.3 2.8 27.4

Kansai Nerolac 240 1,937 27% 37.4 31.5 22% 22.5 19.2 15% 3.3 2.8 19.2

Pidilite Industries Ltd 553 4,246 27% 42.8 38.8 26% 27.7 24.6 12% 5.2 4.4 26.9

Hindustan Unilever Ltd 815 26,408 18% 41.7 33.7 18% 30.0 24.9 11% 5.3 4.6 105.3

Mean 25% 42.1 36.0 22% 26.4 22.5 13% 4.4 3.8 42.6

Median 27% 41.7 35.6 22% 27.7 24.1 14% 5.2 4.4 27.4

Global paint companies Akzo Nobel 63 17053 37% 16.6 15.6 18% 8.7 8.3 3% 1.2 1.2 15.4

Ppg Industries Inc 104 28085 -8% 18.5 16.4 12% 11.8 11.0 2% 2.0 2.0 31.2

Du Pont (E.I.) De Nemours 66 58044 -9% 24.1 20.5 -3% 12.6 12.2 -14% 2.4 2.5 29.4

Kansai Paint Co Ltd 1889 4189 18% 20.6 18.2 14% 10.1 9.1 6% 1.4 1.3 9.8

Nippon Paint Holdings Co Ltd 2918 7724 -58% 29.7 26.0 56% 10.9 10.0 47% 1.8 1.7 7.1

Duluxgroup Ltd 6 1781 9% 18.8 17.9 10% 11.6 11.0 4% 1.6 1.5 33.7

Sherwin-Williams Co/The 266 24766 20% 25.0 21.4 15% 15.6 13.7 4% 2.4 2.3 134.0

Mean 1% 21.9 19.4 17% 11.6 10.8 8% 1.8 1.8 37.2

Median 9% 20.6 18.2 14% 11.6 11.0 4% 1.8 1.7 29.4


Berger Paints


Ambit vs consensus; changes to estimates; and forensic accounting scores Ambit vs consensus: In line with consensus on FY16/17

Ambit vs consensus (` mn) Exhibit 27:

Ambit Consensus Divergence from Consensus

FY16E Sales 48,345 48,609 -1%

EBITDA 6,459 6,434 0%

PAT 3,627 3,655 -1%

FY17E Sales 57,298 56,358 2%

EBITDA 7,821 7,759 1%

PAT 4,585 4,556 1%

Source: Ambit capital research

Changes to our estimates and valuations Whilst we have not changed our forecasts for revenues for Berger, we have upgraded our forecasts for the margins for the firm due to a combination of the following factors: (a) improved efficiencies around raw material procurement, implementation of Vendor Management Systems and development of alternative raw materials and formulations have led to an increase in our gross margin forecasts; and (b) our understanding of the initiatives implemented by the management over the past three years around talent hiring, training and incentivisation at both the sales team level as well as at the middle management level, has led to an increase in our EBITDA margin forecasts around operating efficiencies in the future.

Although our earnings forecasts have been upgraded by 8-9%, as highlighted in the exhibit below, our fair value for Berger has been upgraded from `178 previously to `266 now. Note that besides the upgrade to our forecasts for the next 2-3 years (as highlighted in the exhibit below), we factor in a greater sustainability of healthy earnings profile over the long term, following our understanding of how the current management team is nurturing the core values of the business around quality of talent hiring, impactful marketing, increasingly process-oriented operations and controlled capital allocation.

Change in our estimates (` mn) Exhibit 28:

New Estimates Old Estimates Divergence

Particulars FY16E FY17E FY16E FY17E FY16E FY17E

Revenue 48,345 57,298 48,345 57,298 0% 0%

EBITDA 6,459 7,821 6,043 7,134 7% 10%

EBITDA margin 13.4% 13.7% 12.5% 12.5% 7% 10%

PAT 3,627 4,585 3,345 4,117 8% 11%

EPS 5.2 6.6 4.8 5.9 8% 11%

Source Ambit capital research

Berger Paints


Risks and catalysts Risks to our BUY stance Sluggish economic growth for a prolonged period of time can result in a

moderation in our FY17 revenue growth forecasts for Berger vs our current expectation of a revival in YoY revenue growth rates from 11.9% in FY16E to 18.5% in FY17E.

Capital misallocation in future? As highlighted previously, one of the biggest factors driving consistency of returns for Berger in the past has been the firm’s prudent approach towards capital allocation. Any changes to this approach, especially outside the paints business for the firm could result in a reduction in focus and financial return profiles for the firm thereafter.

Catalysts Revenue growth revival in 3QFY16: Due to a delayed festival season in FY16

vs FY15, the demand for paint products during October and November this year has been significantly superior to that during the same period last year. As a result, although we do NOT expect an overall revival in consumer sentiment to be visible in the 3QFY16 results, we expect paints companies including Berger, to report a strong revival in revenue growth rates (towards mid-teens as compared to 6% YoY sales growth reported in 1HFY16).

Contribution to sales from Berger’s Express Painting Service: Having successfully completed pilot tests in Kerala and West Bengal, Berger has started a pan-India rollout of its Express Painting Service over the past three months. A meaningful contribution from this to the firm’s overall revenues is likely to act as a positive catalyst.

Expectations from GST rollout: Any clarity around timelines and effectiveness of GST rollout from the Government is likely to result in increased expectations around accelerated shift from the unorganised to organised market.

Berger Paints


Balance Sheet

Year to March (̀ mn) FY13 FY14 FY15 FY16E FY17E FY18E

Shareholders' equity 693 693 693 693 693 693

Reserves & surpluses 8,839 10,514 11,913 14,242 17,205 20,910

Total networth 9,532 11,207 12,606 14,935 17,898 21,603

Minority Interest 0 0 0 0 0 0

Preference share capital 0 0 0 0 0 0

Debt 5,497 6,235 6,089 6,089 5,089 4,089

Deferred tax liability 408 538 579 579 579 579

Total liabilities 15,436 17,981 19,273 21,603 23,565 26,271

Gross block 9,795 13,220 14,613 16,613 18,113 19,613

Net block 6,040 8,638 9,307 10,075 10,509 10,902

CWIP 1,674 1,333 1,004 1,004 1,004 1,004

Investments 108 907 1,345 1,345 1,345 1,345

Cash & equivalents 2,270 1,841 1,698 2,675 3,355 4,655

Debtors 4,114 4,857 5,352 5,854 6,781 7,914

Inventory 6,364 6,957 7,195 7,915 9,224 10,832

Loans & advances 1,194 1,301 1,070 1,197 1,419 1,695

Other current assets 108 116 188 132 157 188

Total current assets 14,050 15,071 15,503 17,774 20,937 25,284

Current liabilities 5,514 6,887 7,121 7,965 9,440 11,278

Provisions 922 1,081 765 856 1,014 1,212

Total current liabilities 6,436 7,968 7,886 8,821 10,454 12,490

Net current assets 7,614 7,103 7,617 8,953 10,483 12,794

Miscellaneous 0 0 0 0 0 0

Total assets 15,436 17,980 19,273 21,378 23,340 26,046


Income statement Year to March (̀ mn) FY13 FY14 FY15 FY16E FY17E FY18E

Operating income 33,464 38,697 43,221 48,345 57,298 68,454

% growth 13.5% 15.6% 11.7% 11.9% 18.5% 19.5%

Operating expenditure 29,752 34,384 38,113 41,886 49,477 59,041

Operating profit 3,712 4,314 5,107 6,459 7,821 9,412

% growth 22.3% 16.2% 18.4% 26.5% 21.1% 20.3%

Depreciation 567 707 925 1,007 1,067 1,106

EBIT 3,145 3,607 4,182 5,451 6,755 8,306

Interest expenditure 377 466 501 505 464 381

Non-operating income 314 360 360 403 452 506

Adjusted PBT 3,082 3,500 4,041 5,350 6,743 8,431

Tax 898 1,006 1,394 1,723 2,158 2,698

Adjusted PAT/ Net profit 2,184 2,494 2,647 3,627 4,585 5,733

% growth 21% 14% 6% 37% 26% 25%

Prior Period Items - - - - - -

Reported PAT / Net profit 2,184 2,494 2,647 3,627 4,585 5,733

Minority Interest 0 0 0 0 0 0

Share of associates 0 0 0 0 0 0

Adj Consolidated net profit 2,184 2,494 2,647 3,627 4,585 5,733 Reported Consolidated net profit 2,184 2,494 2,647 3,627 4,585 5,733


Berger Paints


Cash flow statement

Year to March (̀ mn) FY13 FY14 FY15 FY16E FY17E FY18E

EBIT 3,459 3,966 4,542 5,855 7,206 8,812

Depreciation 567 707 925 1,007 1,067 1,106

Others (379) (292) (142) (0) - 0

Tax (843) (1,022) (1,437) (1,723) (2,158) (2,698)

(Incr) / decr in net working capital (1,599) (275) (434) (359) (849) (1,013)

Cash flow from operations 1,206 3,084 3,454 4,780 5,267 6,208

Capex (2,179) (2,431) (1,615) (2,000) (1,500) (1,500)

(Incr) / decr in investments (92) (803) (361) - - -

Other income (expenditure) 199 209 148 - - -

Others 30 11 - - - -

Cash flow from investments (2,041) (3,014) (1,829) (2,000) (1,500) (1,500)

Net borrowings 2,080 525 (149) - (1,000) (1,000)

Issuance of equity 12 20 - - - -

Interest paid (327) (424) (451) (505) (464) (381)

Dividend paid (484) (619) (1,169) (1,298) (1,622) (2,028)

Others - - - - - -

Cash flow from financing 1,281 (499) (1,769) (1,803) (3,086) (3,409)

Net change in cash 446 (429) (144) 977 681 1,299

Closing cash balance 2,270 1,841 1,697 2,675 3,355 4,655

Free cash flow (974) 653 1,839 2,780 3,767 4,708


Ratio analysis

Year to March (%) FY13 FY14 FY15 FY16E FY17E FY18E

EBITDA margin (%) 11.1% 11.1% 11.8% 13.4% 13.7% 13.8%

EBIT margin (%) 10.3% 10.2% 10.5% 12.1% 12.6% 12.9%

Net profit margin (%) 6.5% 6.4% 6.1% 7.5% 8.0% 8.4%

Dividend payout ratio (%) 33.4% 35.8% 36.2% 35.8% 35.4% 35.4%

Net debt: equity (x) 0.3 0.4 0.3 0.2 0.1 (0.0)

Working capital turnover (x) 4.4 5.4 5.7 5.4 5.5 5.4

Gross block turnover (x) 3.4 2.9 3.0 2.9 3.2 3.5

RoCE (%) 18.6% 17.4% 16.5% 20.0% 22.3% 24.6%

RoIC (%) 23.9% 21.5% 19.0% 23.2% 26.7% 30.4%

RoE (%) 25.0% 24.1% 22.2% 26.3% 27.9% 29.0%


Berger Paints


Appendix: John Kay’s IBAS framework “I don’t want an easy business for competitors. I want a business with a moat around it. I want a very valuable castle in the middle and I want the duke who is in charge of that castle to be very honest and hardworking and able. Then I want a moat around that castle. The moat can be various things. The moat around our auto insurance business, GEICO, is low cost.” – Warren Buffett

“I always try and spend the last few minutes… to touch on a competitor, or a company they do business with, such as a supplier or a customer. Although not all managements will talk about other companies, when they do, it can be very revealing. The ultimate commendation is when a company talks positively about a competitor. I always put a strong weight on such a view.”

– Anthony Bolton, the legendary fund manager who ran the Fidelity Special Situations fund

Sustainable competitive advantages allow firms to add more value than their rivals and to continue doing so over long periods of time. But where do these competitive advantages come from? And why is it that certain firms seem to have more of these advantages than others?

In his 1993 book, ‘Foundations of Corporate Success’, John Kay, the British economist and Financial Times columnist, wrote more comprehensibly and clearly about this than any other business guru. John states that “sustainable competitive advantage is what helps a firm ensure that the value that it adds cannot be competed away by its rivals”. He goes on to state that sustainable competitive advantages can come from two sources: distinctive capabilities or strategic assets. Whilst strategic assets can be in the form of intellectual property (patents and proprietary know-how), legal rights (licenses and concessions) or a natural monopoly, the distinctive capabilities are more intangible in nature.

Distinctive capabilities, says Kay, are those relationships that a firm has with its customers, suppliers or employees, which cannot be replicated by other competing firms and which allow the firm to generate more value additions than its competitors. He further divides distinctive capabilities into three categories:

Brands and reputation

Architecture

Innovation

Let us delve into these in more detail, as understanding them is at the core of understanding the strength of a company’s franchise.

Brands and reputation

"A product can be quickly outdated, but a successful brand is timeless." – Stephen King, American novelist, author & TV Producer

In many markets, product quality, in spite of being an important driver of the purchase decision, can only be ascertained by a long-term experience of using that product. Examples of such products are insurance policies and healthcare. In many other markets, the ticket price of the product is high; hence, consumers are only able to assess the quality of the product only after they have parted with their cash. A few examples of such products would be cars and high-end TVs.

In both these markets, customers use the strength of the company’s reputation as a proxy for the quality of the product or the service. For example, we gravitate towards the best hospital in town for critical surgery and we tend to prefer world-class brands whilst buying expensive home entertainment equipment. Since the reputation for such high-end services or expensive electronics takes many years to build, reputation tends to be difficult and costly to create. This in turn makes it a very powerful source for a competitive advantage.

Sustainable competitive advantages allow firms to add value and continue doing so over long periods

John Kay’s framework focusses on ‘Innovation’, ‘Brands’, ‘Architecture’ and ‘Strategic Assets’ as sources of sustainable competitive advantage

“A product can be quickly outdated, but a successful brand is timeless”

Berger Paints


For products that we use daily, we tend to be generally aware of the strength of a firm’s brand. In more niche products or B2B products (eg. industrial cables, mining equipment, municipal water purification, and semiconductors), investors often do not have first-hand knowledge of the key brands in the relevant market. In such instances, to assess the strength of the brand, they turn to:

Brand recognition surveys conducted by the trade press. The length of the warranties offered by the firm (the longer the warranties, the

more unequivocal the statement it makes about the firm’s brand). The amount of time the firm has been in that market (eg. “Established 1905” is a

fairly credible way of telling the world that since you have been in business for over a century, your product must have something distinctive about it).

How much the firm spends on its marketing and publicity (a large marketing spend figure, relative to the firm’s revenues, is usually a reassuring sign).

How much of a price premium the firm is able to charge vis-a-vis its peers.

One way to appreciate the power of brands and reputation to generate sustained profits and hence, shareholder returns, is to look at how India’s most-trusted brands, according to an annual Economic Times survey, have fared over the last decade. As can be seen in the table below, over the past decade, the listed companies with the most powerful brands have comfortably beaten the most widely acknowledged frontline stockmarket index by a comfortable margin on revenues, earnings and share price movement.

Performance of listed companies with the most-trusted brands Exhibit 29:# Company Trusted Brands* 10-year Growth (FY04-14) (% CAGR)**

Revenues EPS Share price***

1 Colgate-Palmolive Colgate (1) 14 17 27

2 Hindustan Unilever

Clinic Plus (4), Lifebuoy (10), Rin (12), Surf (13), Lux (14), Ponds, etc

10 8 15

3 Nestle Maggi (9), Nestle Milk Chocolate (62), etc 15 16 23

4 GSK Consumer Horlicks (16) 15 21 33

5 Bharti Airtel Airtel (18) 33 18 15

Average for the listed companies with the top 5 brands 18 16 22

For the index, Nifty 12 13 14

Source: Economic Times and Ambit Capital analysis using Bloomberg data. Note: * Figures in brackets indicate the rank in the 2012 Economic Times ‘brand equity’ survey to find the 100 most-trusted brands in India. ** The FY14 data is based on Bloomberg consensus as on 7 April 2014. *** Share price performance has been measured from Mar-04 to Mar-14

Architecture “A dream you dream alone is only a dream. A dream you dream together is reality.”

– John Lennon

‘Architecture’ refers to the network of contracts, formal and informal, that a firm has with its employees, suppliers and customers. Thus, architecture would include the formal employment contracts that a firm has with its employees and it would also include the more informal obligation it has to provide ongoing training to its employees. Similarly, architecture would include the firm’s legal obligation to pay its suppliers on time and its more informal obligation to warn its suppliers in advance if it were planning to cut production in three months.

Such architecture is most often found in firms with a distinctive organisational style or ethos, because such firms tend to have a well-organised and long-established set of processes or routines for doing business. So, for example, if you have ever taken a home loan in India, you will find a marked difference in the speed and professionalism with which HDFC processes a home loan application as compared to other lenders. The HDFC branch manager asks the applicant more specific questions than other lenders do and this home loan provider’s due diligence on the applicant and the property appears to be done more swiftly and thoroughly than most other lenders in India.

Listed companies with the most-trusted brands have beaten the benchmark index on revenues, earnings and share price performance

‘Architecture’ refers to the network of contracts, formal and informal, that a firm has with its employees, suppliers and customers

Berger Paints


So, how can an investor assess whether the firm they are scrutinising has architecture or not? In fact, whilst investors will often not know the exact processes or procedures of the firm in question, they can assess whether a firm has such processes and procedures by gauging the:

extent to which the employees of the firm co-operate with each other across various departments and locations.

rate of staff attrition (sometimes given in the Annual Report).

extent to which the staff in different parts of the firm give the same message when asked the same question.

extent to which the firm is able to generate innovations in its products or services or production processes on an ongoing basis.

At the core of successful architecture is co-operation (within teams, across various teams in a firm and between a firm and its suppliers) and sharing (of ideas, information, customer insights and, ultimately, rewards). Built properly, architecture allows a firm with ordinary people to produce extraordinary results.

Perhaps the most striking demonstration of architecture in India is the unlisted non-profit agricultural co-operative, Gujarat Cooperative Milk Marketing Federation Ltd (GCMMF), better known to millions of Indians as ‘Amul’.

With its roots stretching back to India’s freedom movement, GCMMF was founded by the legendary Verghese Kurien in 1973. This farmer’s co-operative generated revenues of `137bn (around US$2.1bn) in FY13, thus making it significantly larger than its main private sector competitor, Nestle (FY13 revenues of `91bn or around US$1.5bn). Furthermore, GCMMF’s revenues have grown over the past five years by 21% as opposed to Nestle’s 16% over the same period. In fact, GCMMF’s revenue growth is markedly superior to the vast majority of the top Indian brands shown in Exhibit 6.

GCMMF’s daily milk procurement of 13 million litres from over 16,000 village milk co-operative societies (which include 3.2 million milk producer members) has become legendary. The way GCMMF aggregates the milk produced by over 3 million families into the village co-operative dairy and then further aggregates that into the district co-operative which in turn feeds into the mother dairy has been studied by numerous management experts.

Not only does the GCMMF possess impressive logistical skills, its marketing acumen is comparable to that of the multinational giants cited in the table shown above: In key FMCG product categories such as butter, cheese and packaged milk, Amul has been the longstanding market leader in the face of sustained efforts by the multinationals to break its dominance. GCMMF is also India’s largest exporter of dairy products.

So how does GCMMF do it? How does it give a fair deal to farmers, its management team (which includes the alumnus from India’s best business schools), its 5,000 dealers, its 1 million retailers and its hundreds of millions of customers? Although numerous case studies have been written on GCMMF, at the core of this co-operative’s success appears to be: (a) its 50-year old brand with its distinctive imagery of the little girl in the polka red dotted dress; (b) the idea of a fair deal for the small farmer and the linked idea of the disintermediation of the unfair middle man; and (c) the spirit of Indian nationalism in an industry dominated by globe girdling for-profit corporates.

Innovation

“Learning is not compulsory … neither is survival.” – W Edwards Deming, American statistician, professor, author. The world’s most

famous prize for manufacturing excellence is named after him. "Innovation distinguishes between a leader and a follower."

– Steve Jobs

HDFC and GCMMF are the most striking demonstrations of architecture in India

Berger Paints


Whilst innovation is often talked about as a source of competitive advantage, especially in the Technology and Pharmaceutical sectors, it is actually the most tenuous source of sustainable competitive advantage as:

Innovation is expensive.

Innovation is uncertain - the innovation process tends to be a ‘hit or miss’.

Innovation is hard to manage due to the random nature of the process.

Furthermore, even when the expensive innovation process yields a commercially useful result, the benefits can be competed away, as other firms replicate the innovator and/or employees who have driven the innovation process tend to extract the benefits of innovation through higher compensation.

In fact, innovation is more powerful when it is twinned with the two other distinctive capabilities we have described above – reputation and architecture. Apple is the most celebrated example of a contemporary firm which has clearly built a reputation for innovation (think of the slew of products from Apple over the past decade which first changed how we access music, then changed how we perceive our phones and finally, how we use our personal computers).

Strategic assets In contrast to the three distinctive capabilities discussed above, strategic assets are easier to identify as sources of competitive advantages. Such assets can come in different guises:

Intellectual property i.e. patents or proprietary know-how (eg. the recipe for Coke’s famous syrup which is a closely held secret and kept in the company’s museum in Atlanta, Georgia);

Licences and regulatory permissions to provide a certain service to the public, eg., telecom, power, gas or public transport;

Access to natural resources such as coal or iron-ore mines;

Political contacts either at the national, state or city level; Sunk costs incurred by the first mover which result in other potential competitors

deciding to stay away from that market eg. given that there already is a Mumbai-Pune highway operated by IRB, it does not make sense for anyone else to set up a competing road; and

Natural monopolies i.e. sectors or markets which accommodate only one or two firms; for example, the market for supplying power in Mumbai is restricted to one firm, Tata Power.

Whilst strategic assets can come in different forms, all of them result in a lower per unit cost of production for the firm owning the asset relative to its competitors. For example, Tata Steel’s decades-old access to coal and iron-ore from its captive mines allows it to make more money per tonne of steel produced than any other steel manufacturer in India. According to Ambit Capital’s analysts, on a tonne of steel produced, Tata Steel earns `45,000 vs `39,000 for SAIL and `38,000 for JSW Steel.

Unsurprisingly therefore among the top-50 companies by market cap in India since the Nifty was launched in 1995, there is only one conglomerate – Tata Sons - which has had three companies which have been in the index more or less throughout this period i.e., Tata Power, Tata Steel and Tata Motors.

Upon closer examination, the Tatas are an almost text book case of how to build businesses which, without being the most innovative players in town, combine architecture and brands to great effect, thereby creating robust sources of sustainable competitive advantages. The group seems to have created at least three specific mechanisms to ensure that these sources of competitive advantage endure:

Firstly, Tata Sons, an unlisted company (owned by several philanthropic trusts endowed by members of the Tata family), is the promoter of the major operating Tata companies and holds significant shareholdings in these companies. Tata Sons’ patient, long-term orientation in terms of building large and robust businesses gradually has played a major role in the stability of the listed Tata businesses.

Whilst most talked about, ‘Innovation’ is also the most tenuous source of sustainable competitive advantage…

…’strategic assets’ on the other hand are easier to identify

Access to captive coal and iron ore results in more money per tonne of steel for Tata Steel vs its competitors due to lower cost of production

The Tatas have combined architecture with brand to create robust sources of sustainable competitive advantages

Berger Paints


Secondly, Tata Quality Management Services (TQMS), a division of Tata Sons, assists Tata companies in their business excellence initiatives through the Tata Business Excellence Model, Management of Business Ethics and the Tata Code of Conduct. TQMS, quite literally, provides the architecture to harmonise practices in various parts of the Tata empire.

Thirdly, Tata Sons is also the owner of the Tata name and several Tata trademarks, which are registered in India and around the world. These are used by various Tata companies under a license from Tata Sons as part of their corporate name and/or in relation to their products and services. The terms of use of the group mark and logo by Tata companies are governed by the Brand Equity and Business Promotion Agreement entered into between Tata Sons and Tata companies.

Berger Paints


Institutional Equities Team Saurabh Mukherjea, CFA CEO, Institutional Equities (022) 30433174 [email protected]

Research

Analysts Industry Sectors Desk-Phone E-mail

Nitin Bhasin - Head of Research E&C / Infra / Cement / Industrials (022) 30433241 [email protected]

Aadesh Mehta, CFA Banking / Financial Services (022) 30433239 [email protected]

Abhishek Ranganathan, CFA Retail / Mid-caps (022) 30433085 [email protected]

Achint Bhagat, CFA Cement / Roads / Home Building (022) 30433178 [email protected]

Ashvin Shetty, CFA Automobile (022) 30433285 [email protected]

Bhargav Buddhadev Power Utilities / Capital Goods (022) 30433252 [email protected]

Deepesh Agarwal Power Utilities / Capital Goods (022) 30433275 [email protected] Dhiraj Mistry, CFA Consumer (022) 30433264 [email protected]

Gaurav Khandelwal Automobile (022) 30433132 [email protected] Gaurav Mehta, CFA Strategy / Derivatives Research (022) 30433255 [email protected]

Girisha Saraf Mid-caps / Small-caps (022) 30433211 [email protected]

Karan Khanna Strategy (022) 30433251 [email protected]

Kushank Poddar Technology (022) 30433203 [email protected] Pankaj Agarwal, CFA Banking / Financial Services (022) 30433206 [email protected]

Paresh Dave, CFA Healthcare (022) 30433212 [email protected]

Parita Ashar, CFA Metals & Mining (022) 30433223 [email protected]

Prashant Mittal, CFA Derivatives (022) 30433218 [email protected]

Rakshit Ranjan, CFA Consumer (022) 30433201 [email protected]

Ravi Singh Banking / Financial Services (022) 30433181 [email protected]

Ritesh Gupta, CFA Oil & Gas / Chemicals / Agri Inputs (022) 30433242 [email protected]

Ritesh Vaidya, CFA Consumer (022) 30433246 [email protected] Ritika Mankar Mukherjee, CFA Economy / Strategy (022) 30433175 [email protected]

Ritu Modi Automobile (022) 30433292 [email protected]

Sagar Rastogi Technology (022) 30433291 [email protected]

Sumit Shekhar Economy / Strategy (022) 30433229 [email protected]

Utsav Mehta, CFA E&C / Industrials (022) 30433209 [email protected]

Vivekanand Subbaraman, CFA Media (022) 30433261 [email protected]

Sales

Name Regions Desk-Phone E-mail

Sarojini Ramachandran - Head of Sales UK +44 (0) 20 7614 8374 [email protected]

Dharmen Shah India / Asia (022) 30433289 [email protected]

Dipti Mehta India / USA (022) 30433053 [email protected]

Hitakshi Mehra India (022) 30433204 [email protected]

Krishnan V India / Asia (022) 30433295 [email protected]

Nityam Shah, CFA USA / Europe (022) 30433259 [email protected]

Parees Purohit, CFA UK / USA (022) 30433169 [email protected]

Praveena Pattabiraman India / Asia (022) 30433268 [email protected]

Shaleen Silori India (022) 30433256 [email protected]

Singapore

Pramod Gubbi, CFA – Director Singapore +65 8606 6476 [email protected]

Shashank Abhisheik Singapore +65 6536 1935 [email protected]

USA / Canada

Ravilochan Pola - CEO Americas +1(646) 361 3107 [email protected]

Production

Sajid Merchant Production (022) 30433247 [email protected]

Sharoz G Hussain Production (022) 30433183 [email protected]

Joel Pereira Editor (022) 30433284 [email protected]

Nikhil Pillai Database (022) 30433265 [email protected]

E&C = Engineering & Construction

Berger Paints


Berger Paints India Ltd (BRGR IN, BUY)


0

50

100

150

200

250

300

Nov

-12

Jan-

13

Mar

-13

May

-13

Jul-

13

Sep-

13

Nov

-13

Jan-

14

Mar

-14

May

-14

Jul-

14

Sep-

14

Nov

-14

Jan-

15

Mar

-15

May

-15

Jul-

15

Sep-

15

Nov

-15

BERGER PAINTS INDIA LTD

Berger Paints


Explanation of Investment Rating

Investment Rating Expected return (over 12-month)

BUY >10%

SELL <10%

NO STANCE We have forward looking estimates for the stock but we refrain from assigning valuation and recommendation

UNDER REVIEW We will revisit our recommendation, valuation and estimates on the stock following recent events

NOT RATED We do not have any forward looking estimates, valuation or recommendation for the stock Disclaimer

This report or any portion hereof may not be reprinted, sold or redistributed without the written consent of Ambit Capital. AMBIT Capital Research is disseminated and available primarily electronically, and, in some cases, in printed form.

Additional information on recommended securities is available on request.

Disclaimer

1. AMBIT Capital Private Limited (“AMBIT Capital”) and its affiliates are a full service, integrated investment banking, investment advisory and brokerage group. AMBIT Capital is a Stock Broker, Portfolio Manager and Depository Participant registered with Securities and Exchange Board of India Limited (SEBI) and is regulated by SEBI

2. AMBIT Capital makes best endeavours to ensure that the research analyst(s) use current, reliable, comprehensive information and obtain such information from sources which the analyst(s) believes to be reliable. However, such information has not been independently verified by AMBIT Capital and/or the analyst(s) and no representation or warranty, express or implied, is made as to the accuracy or completeness of any information obtained from third parties. The information, opinions, views expressed in this Research Report are those of the research analyst as at the date of this Research Report which are subject to change and do not represent to be an authority on the subject. AMBIT Capital may or may not subscribe to any and/ or all the views expressed herein.

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Additional Disclaimer for U.S. Persons

10. The research report is solely a product of AMBIT Capital 11. AMBIT Capital is the employer of the research analyst(s) who has prepared the research report 12. Any subsequent transactions in securities discussed in the research reports should be effected through Enclave Capital LLC. (“Enclave”). 13. Enclave does not accept or receive any compensation of any kind for the dissemination of the AMBIT Capital research reports. 14. The research analyst(s) preparing the email / Research Report/ attachment is resident outside the United States and is/are not associated persons of any U.S. regulated broker-dealer and that

therefore the analyst(s) is/are not subject to supervision by a U.S. broker-dealer, and is/are not required to satisfy the regulatory licensing requirements of FINRA or required to otherwise comply with U.S. rules or regulations regarding, among other things, communications with a subject company, public appearances and trading securities held by a research analyst account.

15. This report is prepared, approved, published and distributed by the Ambit Capital located outside of the United States (a non-US Group Company”). This report is distributed in the U.S.by Enclave Capital LLC, a U.S. registered broker dealer, on behalf of Ambit Capital only to major U.S. institutional investors (as defined in Rule 15a-6 under the U.S. Securities Exchange Act of 1934 (the “Exchange Act”)) pursuant to the exemption in Rule 15a-6 and any transaction effected by a U.S. customer in the securities described in this report must be effected through Enclave Capital LLC (19 West 44th Street, suite 1700, New York, NY 10036).

16. As of the publication of this report Enclave Capital LLC, does not make a market in the subject securities. 17. This document does not constitute an offer of, or an invitation by or on behalf of Ambit Capital or its affiliates or any other company to any person, to buy or sell any security. The information

contained herein has been obtained from published information and other sources, which Ambit Capital or its Affiliates consider to be reliable. None of Ambit Capital accepts any liability or responsibility whatsoever for the accuracy or completeness of any such information. All estimates, expressions of opinion and other subjective judgments contained herein are made as of the date of this document. Emerging securities markets may be subject to risks significantly higher than more established markets. In particular, the political and economic environment, company practices and market prices and volumes may be subject to significant variations. The ability to assess such risks may also be limited due to significantly lower information quantity and quality. By accepting this document, you agree to be bound by all the foregoing provisions.

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289) and Paragraph 11 of the First Schedule to the Financial Advisors Act (CAP 110) provided to Ambit Singapore Pte. Limited by Monetary Authority of Singapore. 25. This Report is only available to persons in Singapore who are institutional investors (as defined in section 4A of the Securities and Futures Act (Cap. 289) of Singapore (the “SFA”).” Accordingly, if a

Singapore Person is not or ceases to be such an institutional investor, such Singapore Person must immediately discontinue any use of this Report and inform Ambit Singapore Pte. Limited.

Disclosure 26. Ambit and/or its associates have financial interest in Pidilite Industries.

Analyst Certification Each of the analysts identified in this report certifies, with respect to the companies or securities that the individual analyses, that (1) the views expressed in this report reflect his or her personal views about all of the subject companies and securities and (2) no part of his or her compensation was, is or will be directly or indirectly dependent on the specific recommendations or views expressed in this report. © Copyright 2015 AMBIT Capital Private Limited. All rights reserved.

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