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Lackluster R&D expenses…

…put sustainability of rich valuations at risk

* In this report, we delve into the R&D expenditure of 52 Indian Chemical companies. Our research shows that Indian companies spend significantly less on R&D (0.5-0.6% of revenue) vis-à-vis their global peers (3-4% of revenue).

* Our numerous interactions with industry experts have highlighted this lacuna, which may challenge the terminal growth of 5-6% that the current stock prices of most companies are commanding, even after assuming a high growth trajectory of 15 years in our three-stage reverse DCF.

* The absence of sufficient R&D spend is likely to challenge the sustainability of rich valuations that the companies are commanding. Of the nine companies under coverage, we have a Buy rating on only three: NOCIL, GALSURF, and VO.

R&D has a high gestation period

* According to a McKinsey study, the average commercialization time for new products in a familiar market and with familiar technology is about four years. It can be as high as 14 years for product launches in new markets, with a low degree of technology familiarity.

* The success rate can vary by 15-50%, depending upon the degree of market and technology familiarity.

* However, new products can produce an incremental IRR as high as 60% over existing products, indicating that payoffs can be worth the risk.

Indian companies lag behind global peers in R&D spends

* Companies under our coverage (except NFIL) spend less than 1% of their revenue on R&D. The larger spectrum of 52 Indian Chemical companies spend 0.5-0.6% of sales as against 3-4% for their global peers, that too on a much lower base.

* Global companies like DuPont or Ashland, which spend 3-4% of their revenue on R&D, show a minimal variation in their gross margin. This phenomenon is not visible in any of the 52 Indian companies listed in our report.

* Commodity players like AACL and DN spend 0.2-0.5% of their revenue on R&D. INEOS, the largest phenol producer globally, spends 0.25% of its revenue on R&D. NOCIL spends 0.5% on R&D, while China Sunshine, a much larger Chinese player, spends 2.7%. FINEORG spends just 0.3% vis-à-vis 2.8% for Arkema, which is one of its global peers.

Valuation and view

* Lackluster R&D spends raise concerns about the sustainability of the rich valuations that these companies are commanding. As a result, we have a Buy rating on only three companies – VO, GALSURF and NOCIL – in our Coverage Universe.

* VO: The demand outlook for the ATBS segment remains positive going forward, after a temporary blip in FY22. Veeral Organics Pvt. (a wholly-owned subsidiary of VO) is set to commence production of MEHQ, guaiacol, and isoamylene in 1HFY24, which should drive the next-level of growth for VO. We value the stock at 45x FY24E EPS and reiterate our Buy rating.

* GALSURF: The continued focus on R&D (with an annual expenditure of INR400- 500m) and increased wallet share from existing customers is likely to drive volume growth and expand EBITDA margin. Volumes registered ~6% CAGR over the last five years. We build in a similar growth over FY22-24 and reiterate our Buy rating on the stock.

* NOCIL: In volume terms, the Indian Tyre industry is likely to grow by 7-9% in FY23. Domestic Tyre companies are planning to ramp up production, with a planned capex of INR200b over the next three years. Valuing NOCIL at 22x FY24E EPS, we reiterate our Buy rating.

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