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No, the rally is not over yet

During our discussions with investors, several questions were raised on the sustainability of growth of the sector. In this note, we have tried to address some key investor concerns on: a) near-term margin outlook; b) long-term growth visibility; and c) right to win in the Chemicals space. We believe that the recent corrections in some Indian chemical companies’ stocks are temporary in nature as despite several challenges in 1HFY22 most of them recorded robust sales growth while operating margins took a hit as expected. However, in our view, operating margins are likely to improve and revert to normalised levels over the next 1- 2 quarters on the back of: i) easing of supply chain constraints; ii) price hikes taken to offset the high input costs; and iii) correction in raw material prices.

As highlighted in our sector note, India Speciality Chemicals — Shaking Up The Status Quo, India’s specialty chemicals industry is a decadal growth opportunity and it is still not too late to participate in the value creation process. We prefer: a) Deepak Nitrite due to its strong entry barriers owing to its phenol capacity; and b) CRAMS/CSM players Navin Fluorine and PI Industries as they provide long-term earnings visibility.

* Indian chemical players saw operating margin pressure in 1HFY22: During 1HFY22, operating margins (EBITDA margins) of a majority of Indian chemical players came under pressure on account of a contraction in gross margins and jump in operating costs (Exhibit 1). Gross margin contraction was driven by i) a steep rise in raw material prices as Chinese chemical producers had to curtail production on account of power shortages; and ii) unavailability of major raw materials due to supply chain constraints. The jump in operating costs was led by a) higher freight costs, led by container unavailability; and b) higher power and fuel costs led by a sharp jump in coal and alternative fuels. However, sales growth remained robust across major producers despite delays in shipments.

* Operating margins likely to improve and revert to normalised levels over the next 1-2 quarters: Several Indian chemical players have indicated that their customers have accepted the price hikes needed to offset the higher input cost. Hence, we believe that major Indian players should be able to pass on the complete price increases over the next 1-2 quarters. Moreover, since prices of a majority of the basic chemicals have reached record highs, we believe these high prices are unlikely to sustain. Prices of some chemicals have started correcting from their recent peaks. (Exhibit 3-16). As a result, any further meaningful correction in raw material prices would mean that Indian chemical players could have windfall gains as the price cuts could also happen with a lag just like the price hikes. Further, gradual easing of supply chain constraints should also result in lower freight costs. Hence, in our view, operating margins of Indian chemicals players should improve in 2HFY22 due to likely rise in gross margins and moderation in operation costs.

* China+1 strategy adoption by MNCs likely to continue: Recently, there have been press reports (click here) suggesting that the US government is likely to put eight Chinese companies (including biotechnology, health care, and tech firms) under the black list. This would mean that investments in these companies would be banned, in addition to export sanctions. There is a possibility of more companies being added to this list. Though it remains unclear whether Chinese chemical companies could be added to this list, this move by the US government could still aid the China+1 strategy adoption by MNCs to avoid any further disruptions. We believe this is likely to benefit Indian specialty chemicals players, especially players such as Navin who supply certain intermediates to Wuxi biologics (a company potentially facing black listing) to make certain end-products.

* The right to win in chemicals is innovation, process improvement, and scale: Every chemical reaction is ultimately a transfer of mass, and mass balance in chemical reactions is, in most cases, standard. Hence, the right to win in Chemicals is to either a) innovate the process, which gives an entirely different set of end products or b) improve the process, which gives higher yield of the end-product or c) achieve certain scale of operations to lower the operating expenses. Indian chemical producers such as Clean Science have done process innovation while companies such as Deepak Nitrite, Navin Fluorine, Galaxy Surfactants, and Fine Organics have filed several patents to improve their processes. Moreover, major chemical players have been continuously increasing their scale of operations, which is visible from recent capex announcements by many of them. This has been improving Indian chemical players’ competitiveness vis-à-vis Chinese players. Hence, we continue to believe that Indian specialty chemicals industry is a decadal growth opportunity.

* Prefer Deepak > Navin Fluorine > PI Industries: Deepak Nitrite (BUY, TP: INR 2,800) is our top pick in the sector as we believe that despite its inherent cost advantages for its upcoming phenol derivative products and strong entry barriers, it is currently trading at a significant discount to its peers. (Exhibit 2). We also prefer CRAMS/CSM players Navin Fluorine (BUY, TP: INR 4,440) and PI Industries (BUY: TP: INR 3,675) as they provide longterm earnings visibility.

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