The Indian specialty chemicals industry has grown over the past two years, driven by two factors: supply chain diversification from China and increasing import substitution. As a result, the share prices of the top five companies in the space by market capitalization have increased by an average of 160% in 2021 and 2022, even as the average valuation has compressed from 30 times year-over-year expected earnings in early 2021 to 25 times now.
However, the industry appears to have reached an inflection point recently, with the top five companies reporting a 2% year-over-year revenue decline in the June 2023 quarter. This compares poorly to the 30% year-over-year growth seen over the past three quarters. EBITDA margins declined by an average of 375 basis points year-over-year in the first quarter of fiscal 2024. Despite the underperformance, shares have held up and valuations have expanded (see chart).
This suggests the market has yet to factor in the short-term headwinds facing the sector. Even if some headwinds dissipate within 2-3 quarters, the impact of other headwinds may persist, and depending on the company’s position in the value chain, their impact will be felt throughout the company.
Although pricing was not encouraging, sales in Q1FY24 led to lower revenue. Agricultural, pharmaceutical and industrial customers have increased inventories in the face of uncertainty from conflicts in Russia and Ukraine, supply chain issues related to the coronavirus pandemic and the partial shutdown of China’s economy over the past two years. As these three factors recede, the high interest costs of holding inventory and increasing inventory liquidation costs have recently begun to impact order books. Concerns about an economic slowdown in Europe and the United States are also adding to the woes.
The Chinese economy could have absorbed the increase in Chinese production, but due to poor domestic economic growth, the increase in Chinese production has led to an oversupply in the international market, thus driving down prices. From basic chemicals to value-added products, from SRF to Atul, the impact of China’s oversupply is evident across companies.
While lower input costs may be beneficial to the business, lower utilization and pricing more than offset the benefits from lower costs, resulting in EBITDA margin compression. As crude oil prices begin to recover, the current low raw material prices may not last either.
Inventory liquidation can be completed within 1-2 quarters. But until interest rates remain elevated, demand growth will likely continue to face global recession concerns. Slightly longer-term headwinds will come from Chinese supplies. Accelerating economic growth in China is critical to partially curbing international supply gluts and may be a longer-term headwind than destocking.
The transition of supply chains to India will remain a core support for the industry. The product/supplier relationships fostered over the past two years will remain in good shape. This will be more evident depending on the complexity of the product offered.Additionally, oversupply in China could be good for value addition
Producers will have access to lower-cost raw materials, but at the same time, basic chemical manufacturers will compete with them. As a result, lower-ranked players may feel the pressure.
While capex momentum remains strong, companies have planned to push capex from fiscal 2024 to fiscal 2025 and beyond, awaiting visibility on demand drivers.
In the long run, advanced intermediates, contract manufacturers and CDMO producers are likely to sustain higher growth compared to basic chemicals manufacturers. We have recently recommended SRF, Gujarat Fluorochem and Navin Fluorine in this area and reiterate this call. But investors can wait out the storm and factor in potential headwinds for the stock price before buying shares.