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Prefer contracted players amid disruptions and rising capex

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.

 We recommend backing contracted players (SRF, and Navin): In the wake of heightened supply chain issues, and elevated crude prices, a certain degree of risk of further margin contraction remains for non-contracted players. Hence, in large caps, we prefer SRF, which has a bright outlook for its fluoro chemicals business as highlighted here; in midcaps, we prefer Navin, which has several capacities coming on stream starting 1QFY23 till FY25. In the contracted space, we also like PI and Anupam. However, PI continues to have a pharma acquisition overhang; in Anupam’s case, its fluorination capex announcement is awaited. In the non-contracted space, we like Deepak and Clean. However, due to elevated crude prices, Deepak’s phenol spreads have been under pressure while Clean’s successful execution of HALS is a monitorable.

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