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Is there more upside left in specialty chemical stocks?

The sector has been on a tear, especially due to the supply disruption in China

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Published 2 months ago on Sep 11, 2020 Read

Rohan Gupta
Associate director, Edelweiss Securities

The sector has seen robust growth momentum in the past three to four years due to several drivers — higher domestic consumption and exports as buyers looked to reduce their costs by outsourcing to markets such as India. Asian countries such as Vietnam, Taiwan, Thailand and Malaysia will also benefit from this transition, but India scores stronger due to the availability of raw materials. Most importantly, India itself is a large domestic market for these chemicals.

Stocks in the sector have been hitting the roof in terms of valuation — from 12-15x five years ago to 25-35x PE currently. We are also seeing fund-raising by leading players in the sector for the first time ever. In the past one and a half year, Aarti Industries raised Rs.7.5 billion through QIP, PI Industries raised Rs.20 billion and SRF recently approved fund-raising of Rs.7.5 billion. Though these companies are generating solid free cash flows, this is due to growing investment opportunity which is making them aggressive on their capex plans or even driving inorganic growth opportunity. Valuations may remain the same or rise further as long as the companies don’t falter on earnings growth.

Nav Bhardwaj
Senior research analyst-chemicals, Anand Rathi Share and Stock Brokers

The growth in the Indian specialty chemicals is a combination of volume, pricing, currency uptick, and a change in the product mix. Most of the specialty chemical companies derive close to 50% of the business from exports. Lately, a lot of external factors have supported the recent rally in stock prices of the listed specialty chemical companies, such as the souring trade relations with China globally, resulting in the China plus 1 procurement diversification strategies, the environmental restrictions on manufacturing units in China, the movement in Chinese companies to move upscale the product chemical product chain, etc. Besides this the anti dumping duties on the import of various chemicals in India has helped. Indian Specialty chemicals have grabbed the opportunity and have been investing their operating cash-flows into their gross block. This rolling trend on capacity expansion to the tune of 15% of gross block since FY 14 has given legs to the primary rally in specialty chemicals. 

The biggest trend driving this business currently is the import substitution theme with a focus on pharmaceutical and agro-chemical intermediates. Companies that are fully integrated in the value chain of chemicals tend to capture the entire profit contribution of each step and tend to have a smoother margin profile. Backward integration along with pass through contracts helps them protect their absolute EBITDAs. None the less the current run up in specialty chemical stock prices has been too fast too soon. Most of the companies are discounting earnings beyond FY23 and leave little room for error. While returns in the immediate financial year from current levels seem a little difficult barring a few good names, holding them for the long term can help investors participate in the structural growth momentum of this special sector.