The speciality chemicals sector reported a positive quarter at the beginning of FY25, breaking away from last year’s adverse results. The sector had a starry run lasting up to FY24, when everything from macro-economic tailwinds to policy shifts worked in favour. The companies also expanded capacities in a flurry of activity that attracted a lot of attention.
Then, several issues cropped up at the same time in FY24. Even as stock prices held on to previous highs driven by the strong outlook, the sector ratcheted up bad results. In the current fiscal when there is a promise of a revival, we analyse the high optimism in the sector along with persistently above-average valuations.
The story so far
Speciality chemicals was a sector in focus in 2023. If one constructed an index of chemical companies weighted by market capitalisation, the chemicals index with top 10 constituents would have returned 34 per cent CAGR for 10 years up to 2023 compared with 12 per cent CAGR for Nifty-50 or 8 per cent for Nifty Pharma (a related industry) in the same period.
Impacted by supply volatility from China during the Covid times, international and domestic clients diversified their supply chains and Indian companies were able to seize the opportunity initially. The strong capacity addition, leveraging their past relationships and forging new ones, also helped boost investor confidence in the sector. Gross block addition grew at 19 per cent CAGR from FY18-22 for top 10 companies, compared with 9 per cent CAGR from FY16-18.
From 2023 to now, the sector rally has fizzled out, underperforming the broader index, as seen in the graph. The sector returns are at 13 per cent CAGR since 2023, which is below the 20 per cent Nifty-50 CAGR or the 35 per cent CAGR in Nifty Pharma. Given the lacklusture financial performance in FY24, the underperformance can be termed as mild. The sector (84 companies reporting Q1FY25 results) reported a 7 per cent year-on-year revenue decline in FY24. The EBITDA margins also declined 230 basispoints (bps); this combined with the revenue decline delivered a 35 per cent decline in reported profits for the sector companies. This dented the sector momentum, which reported 17 per cent EPS CAGR in FY18-22, the period preceding the current meltdown. However, the capex momentum remains intact. The dip in operations, in the face of continuing asset build-up, has impacted the leverage ratios, as Net debt to EBITDA rose from 1.1 times in FY23 to 1.8 times by FY24-end.
The recent quarter performance at 7.3 per cent year-on-year revenue growth in Q1FY25, along with recovery of EBITDA and PAT margins as seen in the graph, is pointing to a recovery on a weak base. But considering the extent of impact in FY24, a sharp recovery cannot be pencilled in just yet.
2023-24: A perfect storm
During FY21-23, while recovering from Covid along with recovering end-user industries, the demand of speciality chemical companies rallied. Besides, facing a volatile geopolitical situation in Russia-Ukraine, clients of speciality chemicals stocked up in record quantities and pulled ahead a significant portion of future demand. In many instances, companies supplying chemicals were also arranging for warehouses for their clients owing to oversupply.
From Q1FY24, the high inventory started destocking, as situation returned to normalcy along with a huge cost of holding in a high-interest rate environment. The economic recovery in Europe and the US also flattened out, resulting in companies with above-average inventory holding turning into below-average holding ones in a short span of FY24.
The period also coincided with recovery in Chinese production and new facilities being set up in that country following the ban under the Blue-Sky policy of 2016 (introduced to curb pollution). The anti-dumping and tariff war on Chinese products also softened in the US, further heightening the competition from Chinese products when Europe and the US were destocking inventory. The weaker-than-expected economic recovery in China also pushed out the excess production, compounding the problem. The prices of many chemicals had declined in FY24 owing partly to this. The impact has been primarily felt on agro-chemicals and performance chemicals, which form a large part of speciality companies’ product portfolio.
Parallelly, FY24 also witnessed a sharp contraction in refrigerant gases, another large portfolio mix of companies. The US market was to implement bans and quotas on several HFC gases used in refrigeration, pulling ahead a large demand into FY23. As duty cuts on Chinese products were imposed and quotas allotted on deliveries of gases, the domestic supplies took a large hit in FY24.
While topline was impacted on several accounts, the bottom-line impact was compounded by negative play of operational and financial leverage. The capacity build-up, invested in FY21-23 and commercialised in FY24, could not be fully utilised. This added to the expenses of operations, with a sub-optimal cash flow from operating it. The financial implication was also sharp, as higher interest rates on lower profitability impacted bottomlines.
There were a few bright spots in the fiscal as well, which cushioned the impact. The India import substitution factor played out, especially in the base chemicals segment. For companies like Deepak Nitrite, the capacity built for import substitution was fully leveraged despite dumping from Chinese players. The domestic demand for chemicals in pharma, FMCG and other sectors cushioned the impact of decline in export demand. The new products introduced also played in restricting the decline.
Outlook
New products will be the driver for many companies in the medium term. Without pricing as a lever, companies had to rely on cost competitiveness in FY24; this will be an ongoing feature and deliver results in the long term. The drive to ascend on the supply value chain is also ongoing, a diversification from commodity chemicals.
We have covered the top five companies based on market capitalisation and under our coverage to detail their outlook individually.
SRF: Medium-term outlook is pinned on new capacities for the value-added portfolio, and expected to ramp up production. The recovery from the protracted destocking is unknown, as per the company.
The company has commercialised ₹3,000-crore worth facilities — ₹1,800 crore for speciality chemicals and ₹1,200 crore for fluorochemicals in FY24; it will ramp up production in this fiscal. The speciality chemicals will expand on advanced intermediaries in pharma and agro chemicals. One product has been launched and few more are in client qualifications. In fluorochemicals, the company has commercialised base-grade PTFE (common fluoropolymer) and higher grades for diverse applications are in the development stage. A domestic-focused refrigerant gas plant will also ramp up production in FY25. The company has also invested in technology and process efficiency for cost cutting in production.
Gujarat Fluorochemicals: It is carving out a new product line for medium-term growth in fluoropolymers and battery chemicals. The latter includes electrolyte salts, cathode active materials and binders. The plant for lithium ion material (LiPF6 Lithium hexafluorophosphate) and the product is under customer qualification and can ramp up sales gradually from FY25. The company states that reversal of destocking has started in fluoropolymers, as legacy players are exiting while speciality chemicals continue to face weak prospects from Chinese dumping in Q1FY25.
Deepak Nitrite: Its focus on import substitution has paid off, with the Phenolics segment reporting 37 per cent year-on-year growth in Q1FY25. The company set up dedicated facility for substituting the imports of the commodity in India and the sales ramp-up is expected to continue into FY25 as well. The company expects to commercialise a ₹2,000-crore facility for phenol downstream products by FY25-end. Further down, the company will start work on a ₹14,000-crore project (under an MoU with Gujarat government) to set up engineering polymers facility in Dahej, which also includes an offtake agreement with Petronet India for raw materials.
Clean Science: It has seen light on HALS (hindered amine light stabilisers) with two products ramping up and three more to start production in FY25. The capacity utilisation of the new dedicated facility should increase, improving the company’s profitability in FY25 along with sales growth.
Navin Fluorine: It expects a H2FY25-based recovery for agro chemicals and is currently focusing on improving capacity utilisation of its recently-established multi-purpose plants and cost management. Its dedicated high-performance plant for a client has ramped up production in FY24 and is expected to drive growth this year as well. Two more projects worth ₹540 crore are expected to commercialise this year.
Valuations, expectations
The sector’s premium valuation has remained intact despite the downturn, owing to the lofty expectations. The stock valuations have discounted the positives and without a margin for error. The five stocks discussed are currently trading at a one-year forward earnings multiple of average 42 times in a range of 36-48 times. Four of the stocks are trading at an average 65 per cent premium to the last 10-year multiples, except Clean Science that debuted in 2021 at 54 times and has since ‘contracted’ to 48 times.
The consensus expectations are also lofty with an average 22/35 CAGR revenue and profit growth expectations in FY24-26. But adjusting for the weak comparable in FY24 and using FY23 as base for comparison, Deepak Nitrite, Clean Science and Navin Fluorine are expected to grow earnings in high single-digit to low double-digit range.
But overall, investors have to watch for return of the capex cycle, turnaround in price competition and performance of new products before committing to the stocks. Even value-added products are prone to commodity-like cycles in the industry as the recent downturn has proved. Volume growth is a reliable driver and for that capex cycle must restart in earnest to support growth expectations. For instance, most companies have ‘fine-tuned’ their capex cycles from high ranges announced in FY22-23.
As can be observed, most companies are only hopeful of Chinese excess exports reversal in H2FY25. In Q1FY24 when the downturn started, this was supposed to close by H2FY24, but dragged along into Q1FY25 as well. While the Chinese producers cannot take a hit on lower prices for longer, the actual reversal is crucial to return to growth for the sector. A portion of the new product line in companies’ portfolio is aimed to new-age solutions: EV, battery and energy storage solutions. Any fall in demand from the end-user industry (as with the slowdown in EV industry globally) can impact the capex plans and growth momentum of companies.