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Contraction in Phenol margin, but recovery expected

* Deepak Nitrite (DN) reported a miss on our estimate. EBITDA came in 9% lower than our estimate at INR2.7b, while EBITDA margin – at 13.8% – was also below our estimate of 16.3%, the lowest since 1QFY19. The miss was largely due to the Phenolic segment. EBIT margin contracted to 8% in Deepak Phenolics, the lowest since 4QFY20.

* Management announced that it has commissioned a project (for an agrochemical product) in Oct’22 for which the entire volumes are tied up for the next five years – it expects another project to be commissioned in Nov’22, which would be margin accretive.

* A product for the EU market (developed in-house) was also launched and DN is only the second manufacturer of the same globally. This would be replacing a product recently banned for being carcinogenic. The performance of DN was also adversely affected by the fire incident in its Nandesari site but the plant is running at full capacity since Oct’22.

* We raise our FY23/24 revenue estimates by 8%/7% primarily due to the commissioning of new products, Nandesari plant running at full capacity and the company being successful in passing on the cost increases with demand remaining robust. However, given the contraction in Phenol margins in 2QFY23 and the underperformance of the Phenolic segment in 1HFY23 v/s last year, we cut our EBITDA/EPS estimates by 8%/9% for FY23E, respectively.

* The stock trades at 24x/23x FY23E/FY24E EPS. With pricing environment remaining volatile and limited earnings growth opportunities until the time Greenfield expansions get commissioned (phenol downstream products would result in captive phenol consumption of 35-40%), we maintain our Neutral rating. We value the stock at 22x FY24E EPS, to arrive at our TP of INR1,890.

Miss on EBITDA as margin remains suppressed

* DN’s revenue was above our estimate at INR19.6b, up 17% YoY, but down 5% QoQ. EBITDA declined 30% YoY and 24% QoQ to INR2.7b (est. INR3b). EBITDAM stood at 13.8% (v/s 17.3% in 1QFY23) – the lowest since 1QFY19. Gross margin contracted 370bp QoQ to 30.2%. PAT dipped 31% YoY and 26% QoQ to INR1.7b (est. INR1.9b,), translating into an EPS of INR12.8.

* The EBIT margin in Phenolics stood at 8% (the lowest since 4QFY20), with EBIT at INR1b. The EBIT margin in Advanced Intermediates stood at 20% (v/s 18% in 1QFY23), with EBIT at INR1.4b. Revenue mix in Phenolics/Advanced Intermediates stood at 65%/35% in 2QFY23, respectively. EBIT mix in Advanced Intermediates/ Phenolics stood at 57%/43% v/s 41%/59% in 1QFY23, respectively.

* The Nandesari plant, which was adversely impacted by a fire incident in Jun’22, turned fully operational in Oct’22.

* DN has incorporated a company in the Sultanate of Oman – Deepak Oman Industries FZC – to set up a chemical manufacturing plant.

Valuation and view

* The management aims to become the largest player in Solvents, with a play on import substitution. It has already announced its foray into MIBK (40ktpa), MIBC (8ktpa) and Polycarbonate. Note that MIBC is a forward integration of MIBK.

* Despite a capex of INR15b over the next two years, DN is likely to turn net cash positive by FY24, with an FCF generation of INR9.6b over FY23-24. Return ratios are forecasted to be at 4-27%, significantly lower than that of FY22.

* However, the management’s focus remains on commodities, rather than specialty products or complex commodities, as of now. We maintain our Neutral rating, valuing DN at 22x FY24E EPS to arrive at our TP of INR1,890.

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