Specialty chemicals valuations high but investors can play on growth curve of these stocks

Specialty chemicals

by 5paisa Research Team Last Updated: Dec 09, 2022 - 02:40 am 50.9k Views

Indian specialty chemicals sector has tagged along with the frothy surge in local stock market indices. While this may turn off investors given high valuations in the sector at large, the macro growth opportunities can be a reason why one can still look at stocks selectively in the space, according to analysts at Kotak Securities.

One-year forward earnings multiples for the sector have re-rated to 55x, over two times their historical level. This brings scepticism for investors but there are some strong factors that provide comfort.

This is driven by lower cost of equity led by lower risk-free rates and improved investor comfort on longevity of earnings.

“We believe investor comfort will sustain given the long growth runway and healthy sector RoCE along with high reinvestment rates; however, we note that sector valuations will be highly sensitive to CoE changes. Importantly, earnings growth is likely to sustain, especially for our scalability candidates,” according to Kotak Securities.

What’s behind the positive macro picture for specialty chemicals?

The brokerage house feels Indian specialty chemicals companies are poised to ride tailwinds from macro drivers including ‘China+1’ strategy of global consumers of the product, import substitution within the country, growing costs within China (capital, operational, compliances) and currency benefits.

It noted that India has just 4% share of the global chemicals market that is growing at 5-6% in dollar terms. Even a 15% CAGR in rupee terms over next 15 years would garner just 8% global market share.

This is modest given the expected and strategic lowering of chemical exports by China that represents 13-15% chunk of the global market.

But instead of a top-down approach one should look at a bottoms up picture to identity real beneficiaries of sector macros, one that can leverage innovation and create sustainable business models.

Which specialty chemical stocks to pick?

According to Kotak Securities, companies that are able to scale-up will be marked by their ability to build entry barriers based on novel chemical process and continuously expand into related fields, upgrade R&D talent and allocate capital prudently to leverage organic investments as well as drive strategic M&As and global partnerships.

In particular, while there is a long runway, investors should chase scalability not valuations, according to Kotak Securities that has initiated coverage on the sector.

It has picked stocks based on growth of outsourcing and supply chain diversification, which benefits contract manufacturers like PI Industries, SRF and Navin Fluorine; import substitution that propels manufacturers like Aarti and Atul and growth in niche applications, which drives opportunities for Clean Science and Vinati. But not all are a buy at current levels.

Aarti Industries (BUY: CMP 932.2: FV 1080, upside: 16%) The firm is a play on aggressive import substitution play and its move into downstream aromatics. After stagnant earnings over FY2019-21, it is now poised for a sharp trajectory along with RoCE improvement.

Vinati Organics (BUY: CMP 1888: FV 2200, upside: 16.5%) Its strong earnings growth has been led by revival of ATBS demand from Europe and the US, alongside growing new applications driving full absorption of higher capacity besides ramp up of butyl phenols, new IB derivatives and recent foray into antioxidants.

Atul Ltd (ADD: CMP 9387.45: FV 10,000, upside: 6.5%) The company differentiates itself through its vast infrastructure, presence across multiple verticals and calibrated capex leading to superior RoIC and healthy has strong free cash flow generation. But the company is likely to lag peers in terms of growth.

SRF Ltd (ADD: CMP 11027: FV 12,000, upside: 8.8%) SRF has effectively used cashflows from its legacy businesses to support growth investments driving 33% CAGR growth in earnings and expansion of RoE to 20% from 8% over FY2014-21. Its chemicals business that contributes 45% of revenue can grow at 20% CAGR over next 10 years while refrigerants emerge as its next growth engine.

PI Inds (ADD: CMP 3144.25: FV 3500, upside: 11.3%) The company boasts of a strong track record of growth (23% EPS CAGR over FY2018-21, 28% over the past decade) and RoCE (20%+ over past decade) and differentiated R&D investment (4% of sales) driving success in innovator partnerships.

Clean Science (REDUCECMP 2058: FV 1950), The company outshines peers on high RoCE (~74%) along with healthy growth, driving healthy fresh cash flow generation but the run-up in valuations leaves limited room for gains at the current price.

Navin Fluorine (REDUCECMP 3752: FV 3750) It is uniquely placed among contract manufacturers given its niche expertise in a growing but complex chemistry – fluorination and presence in multiple industry verticals. But its rich valuations are not cognizant of risks of delay in commissioning current projects. There is also a lag between new project announcements and the brisk pace of re-rating.

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