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Indian Specialty Chemicals to benefit from China+1 strategy

* The Indian Specialty Chemicals sector has not benefited from the China+1 strategy, with none of our coverage companies (DN, NOCIL, VO, GALSURF, NFIL, FINEORG, AACL, and ATLP) showing any significant rise in exports (as a percentage of revenue) in the past decade (Exhibit 1).

* On a consolidated basis, while exports from India have risen by ~50% over the past decade, other countries like Vietnam have shown a significant rise in exports (Exhibit 2). Indian Specialty Companies will stand to benefit only when India takes concrete steps towards capitalizing this new opportunity.

* The consolidation in Chemical companies still continues in China and is expected to result in a growing call for alternate suppliers of key chemicals.

China+1: The climax is far away

* Although several initiatives had been taken in China before, the most critical ones began in CY16, culminating in 80,000 companies being charged with violation of emission standards in CY17, almost double of that in CY16. Estimates suggest that almost 40% of China’s total manufacturing capacity was temporarily shut in CY17, with closures of 2-4 weeks.

* This culminated in the following: a) all toxic MSMEs to relocate to designated chemical industry parks away from urban areas by CY20-end, b) all larger toxic plants to relocate by CY25-end, and c) plants must re-engineer to produce nontoxic products or close permanently if re-engineering/relocation is not possible.

* Several other provinces also have stated goals to close/shift Chemical companies and industrial parks. It is important to note that it is relatively easy for larger companies to relocate/re-engineer; cost becomes prohibitive for MSMEs, which also have restricted availability of capital. A slew of tax measures have also been levied on various polluting chemicals (Exhibit 3).

India is trying to exploit the opportunity: bright future for Specialty Chemicals

* As highlighted in our recent sector initiation – Genie is out, India’s exports have climbed a meager ~50% during the past decade, while a few countries like Vietnam been able to quadruple their exports in the same period through aggressive policies.

* Although India started late, under Atmanirbhar Bharat, 13 sectors have been approved for production linked incentives (PLI) of INR1.97t, which is expected to result in an incremental USD500b of production over the next five years.

* A slew of petrochemical expansions are also underway by major players like Indian Oil, Hindustan Petroleum, GAIL, Nayara Energy, Haldia Petrochemicals, and HMEL, which would drive demand for Chemicals and Specialty Chemicals in the country.

Valuation and recommendations

* Since the past few quarters, the euphoria due to: a) consolidation of polluting Chemical companies in China, b) COVID-related supply chain disruptions, and c) supportive margins have led to multiples expanding for the Indian Specialty Chemical companies. Annexure I suggest that the story of consolidation is not yet over in China, which may emerge as a strong growth driver for Indian Specialty Chemical companies.

* Indian companies are progressively increasing the contribution of Specialty Chemicals in their portfolio. For example, DN is expected to come up with INR7b of investments in downstream products of phenol. Additionally, Deepak Clean Tech is expected to be more towards Specialty Chemicals. VO is expected to commence production of anti-oxidants and downstream of butyl alcohol. The NOCIL’s management said that some customers are conducting advanced precommercial studies on “certain Specialty Chemicals and high Value Chemicals,” which may raise the contribution of Specialty Chemicals in their portfolio.

* Companies with higher contribution of Specialty Chemicals in their mix command higher multiples. We recommend a buy on VO and GALSURF, which are trading at 42x and 29x FY23 EPS. We value VO and GALSURF at 43x and 33x Sep’23E EPS and reiterate our Buy rating on the stocks with a TP of INR2,220 and INR3,620, respectively.

* We value DN and NOCIL at 28x and 22x Sep’23E EPS and recommend a Buy with a TP of INR2,350 and INR340, respectively. DN and NOCIL are currently trading at 27x and 17x FY23E EPS.

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