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Margin continues to decline; demand remains strong

* DN reported a miss on our estimates. EBITDA came in 8% lower than our estimate at INR3.5b, while EBITDA margin, at 20.4%, was lower than our estimate of 25.1%, the lowest since 4QFY19. Phenolics continued its strong growth, with Basic Intermediates and the Performance Products segment performing well in 3QFY22. EBIT margin in the Fine and Specialty Chemicals fell for the fifth consecutive quarter. However, the same in Basic Intermediates and Phenolics normalized in 3QFY22.

* EBIT mix for Basic Intermediates and Fine and Specialty Chemicals remains largely similar to 2QFY22 levels, with the contribution from Phenolics at 52% (down from an average of 64% in 1HFY22). However, the contribution from Performance Products increased significantly to 13% in 3Q from 3% in 2QFY22 on the back of higher realizations and strong demand.

* With the tailwinds of demand-supply mismatch, force majeure (as seen in the Basic Intermediates segment in 3QFY22), elevated raw material costs, and logistics and container availability issues being gradually resolved, the price of Phenol appears to be peaking around current levels, while Acetone prices having normalized from its peak in 3Q v/s 2QFY22.

* Our FY23E/FY24E EPS estimate reflects a growth of 5%/6% YoY. The company has maintained its highest ever utilization rate of 120% in the Phenolics business in 3QFY22, leaving limited growth in this segment from volume accretion. Commissioning of the additional IPA plant of 30ktpa capacity was also completed in 3QFY22.

* The company, at its 50th AGM on 30th Jul’21, announced an incremental capex of INR7b in phenol downstream products (Solvents) and reiterated its focus on advancing towards Specialty/Intermediate Chemicals (with a capex of INR3b in fluorination in DN).

* The stock trades at 28x/26x FY23E/FY24E EPS. With the pricing environment remaining volatile and limited earnings growth opportunities till the time greenfield expansions get commissioned (phenol downstream products would result in captive phenol consumption of 35-40%), we maintain our Neutral rating. Valuing the stock at 28x FY24E EPS, we arrive at a TP of INR2,365.

Performance Products segment springs a surprise in 3QFY22

* Revenue came in 13% higher than our estimate at INR17.2b (+39% YoY, +2% QoQ), driven by Basic Chemicals and the Performance Products segment. EBITDA was 8% lower than our estimate. EBITDA margin, at 20.4% (v/s 23% in 2QFY22), was the lowest since 4QFY19. Gross margin was flat sequentially at 37%, while the conversion cost was higher at 17% (v/s 14% in 2QFY22). Reported PAT stood 4% lower than our estimate at INR2.4b (+12% YoY), translating in an EPS of INR17.8 (est. INR18.5).

* Phenolics accounted for59% of total revenues in 3QFY22, with Basic/Fine and Specialty Chemicals’ mix at 20%/12%. Performance Products segment’s contribution to EBIT improved to 13% QoQ in 3Q from 3% in 2QFY22, with the contribution from Phenolics at 52% v/s 63% in 2QFY22. Basic/Fine and Specialty Chemicals’ mix stood at 19%/15%.

Valuation and view – neutral

* The management’s vision is to become the largest player in Solvents, with a play on import substitution. It will continue to focus on bringing additional products under the Fine and Specialty Chemicals segment and keep closing the value chain gaps by manufacturing these products. DN has been investing in its market intelligence team, which studies opportunities in new and existing markets.

* The management’s increased focus on advanced/high value products would aid margin expansion and sustainability of the company, which investors are most wary of. It could also result in a multiple re-rating for the stock as the mix of Specialty/Complex Chemistry products increase.

* Despite a capex of INR18b over the next three years, it is expected to turn net cash positive by FY23E, with FCF generation of INR18.4b over FY22-24E.

* We value DN at 28x FY24 EPS and reiterate a Neutral rating with target price of INR2,365

* Risk to our call: Sharp improvement in Fine and Specialty Chemicals segment margin, sustainability of higher Phenolics margin, and continuity of better results in the Performance Products segment in coming quarters would drive product prices higher.

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