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Richer prospects to aid growth, but rich valuations to cap upside

* Clean Science (CSTL) reported revenue in line with our estimate; however, higher operating expenditure led to a miss on EBITDA (margin at 44.9% v/s 50.1% in 2QFY21 and 48.8% in 1QFY22). The Performance segment aided the quarter, while Pharma and FMCG Chemicals suffered on lower volumes and realization.

* The company took some amount of price increase (7–10%) at end-2QFY22, with the benefits likely to accrue in 3QFY22. Contracts are being renegotiated in 3QFY22 for the next CY, when the company expects prices to recover.

* The management highlighted that raw material costs would be ~30% of sales going forward; in line with the same, we build in EBITDA margin improvement of 49–50% over FY23–24E.

* Ongoing expansion at Unit III would increase the existing product capacity by 50% (project completion by Mar–Apr’22), while Unit IV would be completed by Jun’23. Considering the same and the robust demand outlook for CSTL (as it plans to capture higher market share for its products), we build in a revenue CAGR of ~25% over FY21–24E, with an EBITDA-EPS CAGR of ~24% over the same period.

* In view of its dominating product market share and ability to sustain the highest margins in the industry, we value the company at 50x FY24E EPS (as it commands ROIC of ~75%) to arrive at Target Price of INR1,800/share.

* The stock has posted a stellar price performance of 40% in the last three months (since our initiating coverage report) and trades at 70x FY23 EPS. Considering the rich valuations, we downgrade the stock to Neutral.

* The key risks to our recommendations are (a) continued product/technological innovations, which have helped CSTL differentiate itself from others, and (b) sharp price decline in key RMs such as Phenol, which could expand margins.

In-line revenue, miss on EBITDA – due to higher operating expenditure

* Revenue was in line with our estimate at INR1.5b (+9% YoY, +5% QoQ).

* Performance Chemicals revenue grew 17% YoY /7% QoQ to INR1.1b on the back of increased volume offtake and better QoQ realization for MEHQ.

* Pharma Chemicals revenue was down 12% YoY /10% QoQ to 197m on lower volumes and realization (except for improvement in volumes of DCC).

* FMCG Chemicals revenue stood at 171m (-10% YoY, +6% QoQ).

* The gross margin was in-line at 69% (-250bps QoQ), although higher conversion costs (+140bps QoQ) resulted in lower EBITDA. The margin shrank to 44.9% (v/s 50.1% in 2QFY21 and 48.8% in 1QFY22), with EBITDA at INR687m (-2% YoY / -4% QoQ).

* PAT came in at INR535m, translating to EPS of INR5 (v/s our est. of INR5.3).

* 1HFY22 revenue was up 18% YoY to INR3b (primarily driven by growth of 24% YoY in the Performance Chemicals segment), with EBITDA up 11% YoY to INR1.4b (margins contracted to 47% v/s 50% in 1HFY21). PAT stood at INR1.1b (+12% YoY).

Valuation and view

* Continuing its pursuit in R&D, CSTL forayed into the Hindered Amine Light Stabilizers (HALS) series (estimated global market size of USD1b) – the company has been the first to develop the HALS series in India.

* Unit III would also have the first line of production dedicated to the HALS series (expected to be commercialized by 2HFY23), while additional production lines would be installed at Unit IV. CSTL has also acquired land for Unit IV, which would focus on more (HALS) stabilizers and other downstream intermediates for Pharma and Agro.

* Additional capacity expansion would drive further growth for the company, accompanied by low margin volatility, due to:

* Challenges faced in competing on the cost and margins fronts, leading to likely consolidation or shutdowns at units globally

* Further downstream/forward integration by CSTL into high-value products, which would offset any potential threat to its current high margins

* CSTL being likely to generate FCF of INR6.6b over FY22–24E, with capex of INR3b planned over this period – thus, its capex would be funded purely via internal accruals and it would remain net cash going forward.

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