Saturday, June 18, 2022

Indian Chemicals Sector Update Report

The rich multiples in India’s specialty chemicals space has been a topic of constant discussion with
investors. We find that several factors have led to the re-rating of specialty chemicals companies
under our coverage – 1) increase in FCF generation since FY16 despite a strong jump in capex, 2)
improvement in RoCEs and RoICs for a majority of them, and 3) strong tailwinds from disruptions in
China. As capex intensity rises, we believe these multiples should sustain for contracted players
(barring inflation) as we expect – a) no earnings cut, especially for contracted players, b)
continuation of economies of scale benefits, and c) strong FCF generation. Keeping in mind the
current volatility in crude prices, we recommend backing contracted players with high earnings
growth visibility. Our top picks – SRF (large cap), and Navin (mid cap).

Increase in FCF generation since FY16: Over FY12-15, most specialty chemical companies posted a
low FCF (negative in some cases). However, since FY16, Chinese chemical companies started facing
production challenges due to a) breach of pollution norms, b) US-China trade war, c) Covid
disruptions, and d) power rationing. As a result, Indian companies started getting more orders,
which resulted in higher utilisation and, in turn, better EBITDA margins (led by operating scale
benefits) (see Exhibit 5). Hence, despite increase in capex intensity, they posted higher FCF. This
trend has been clearly visible over FY16-22 (see Exhibit 3).

– Improvement in RoCEs and RoICs: Over FY16-22, most specialty chemical companies
deleveraged their balance sheets partly on account of equity raise and partly on account of
increase in FCFs (see Exhibit 8). Further, a majority of them saw their RoCEs and RoICs
improve over the same period (see Exhibit 9-10) despite a jump in investments into newer
business segments/products.
– Strong FCF generation to continue over FY23-24E: Most of the specialty chemical companies
have announced huge capex plans over FY23-24E. Some of this capex is for honouring recent
contract wins (case in point Navin, Anupam, SRF, and PI). Moreover, even the non-
contracted capex will see good conversion to revenue partly due to import substitution and
partly due to adoption of a China+1 strategy by MNCs, in our view. Further, we expect
EBITDA margins of most companies to improve due to economies of scale. This should result
in higher OCF generation (considering similar working capital requirements). Hence, despite
rising capex intensity, we expect strong FCF generation to continue over FY23-24E in India’s
specialty chemicals space (see Exhibit 3).
– Rich multiples of contracted players should sustain: There is high volume growth visibility for
contracted players. Further, since contracted players have a cost pass-through mechanism,
margin contraction (if any) due to the increment in raw material prices can be reversed in
subsequent quarters. Hence, we don’t expect any earnings cut in case of contracted players.
By contrast, for non-contracted players, earnings cut is likely to be the factor of margin
contraction. Hence, multiple corrections for them would depend on their ability to manage
their margins