Is the specialty chemicals rally justified? : Nirmal Bang

Sharper R&D focus, rising salience of specialty products, strong client relationships with global giants and market opportunities on the back of themes like import substitution and ‘Plus One’ have led to this re-rating.

India Specialty Chemicals basket has significantly outperformed all the leading indices over the last one year. The entire sector got massively re-rated (current valuation ~30x PE on FY24E), banking on the market opportunity across select chemistries, import substitution and ‘Plus One’ theme. Apart from the future growth potential, which might be driving the stock price performance to a great extent, earnings delivery of Indian Specialty Chemicals companies has been far superior compared to any other sector indices.

These companies have more than doubled their capex in the block of every 5 years and the next 3-4 years’ guidance also remains very promising. This should create a very solid asset base for these companies and hence there is a strong case for ~25% earnings CAGR over the next 5 years.

Despite the rich valuations currently, we believe that there is still enough value in select pockets from a medium-term perspective. All our coverage companies are leading players globally in their respective chemistries. We assign high probability to these names winning new long-term contracts in future. Rising share of specialty chemicals revenue in these companies would reduce the risk associated with RM volatility & pricing to an extent and enable consistent earnings growth.

While structurally we are positive on all coverage companies, we prefer fluorination companies over others from a medium-term perspective as market opportunity in this space is very big in existing as well as new applications, in our view.

Specialty Chemicals rally backed by strong earnings delivery: The Indian Specialty Chemicals space has got re-rated massively over the last one year. Majority of the companies in this space have moved up the value chain and are channelizing efforts towards increasing revenue from the specialty chemicals segment. Apart from the future growth potential, which might be driving the stock price performance to a great extent, earnings delivery of specialty chemicals companies has been far superior compared to any other sector indices. Significant capex acceleration will drive future growth of these companies.

Capex acceleration makes a good case for ~25% earnings CAGR over next 5 years: Indian specialty chemicals companies have more than doubled their capex in the block of every 5 years and most of the managements have upped their capex guidance for future as well. From the 8 companies which we have considered for our analysis (market cap >USD2bn), companies have committed capex of 73%-152% of the cumulative capex incurred in the last 5 years for FY22-FY24E. Considering the capex announcements of key companies for the next 3 years, we believe that the sector is poised to deliver ~25% earnings CAGR over the next 5 years. A significant portion of this incremental capex is towards the value-added segments.

Rising share of specialty revenue to bring margin expansion and consistency: While majority of our coverage companies started off as commodity chemical companies, incremental thrust on R&D and capex towards specialty chemicals has led to robust earnings growth and valuation re-rating in the past few years. Rising share of specialty chemicals revenue will enable these companies to deliver consistent performance with margin expansion, irrespective of the RM fluctuations. We like areas such as complex fluorination or CRAMS, which can improve the future earnings trajectory of the respective companies in a material way. Also, companies incorporating sustainability measures in their operations can witness margin expansion by efficiently managing costs and resources.

Valuation and outlook: The entire sector has got massively re-rated and is trading at ~30x PE on FY24E earnings. All these names were trading at low single digit multiples 10 years back.

Sharper R&D focus, rising salience of specialty products, strong client relationships with global giants and market opportunities on the back of themes like import substitution and ‘Plus One’ have led to this re-rating. While we believe in their long-term earnings potential and are structurally positive on all the coverage names, from 1-year perspective, we maintain Accumulate on SRF, Aarti Industries (ARTO) and Vinati Organics (VO) and Buy on Navin Fluorine (NFIL). Within our coverage universe, we prefer fluorination companies over others.

Risks: Logistics issues, Covid-19 related supply and demand shocks, deterioration in growth outlook of end-user industries and rising competition etc.