Expensive valuations may cap near-term upside in chemical stocks: Analysts

The breathtaking rally in chemical stocks may be heading towards a short-term breather as valuations turn expensive and financial performance plateaus, caution analysts. However, they remain positive on the sector’s long-term growth story on the back of ramp-up in China’s environmental inspections and specialty chemical players having a healthy margin of safety.

An analysis of March quarter results of leading chemical companies such as Tata Chemicals, Navin Fluorine, and SRF show contraction in margins, “possibly reflecting full/partial exhaustion of low cost inventories and influx of high priced raw material”, say analysts.

“During earlier quarters, operating costs remained low aided by sizable reduction in admin expenses, sales promotion costs, travelling costs, advertising expenses, utilities, etc. These, we believe, have started to come back in Q4 due to normalcy returning during the large part of the quarter,” notes Rohit Nagraj of Sunidhi Securities.

He adds: These are alarming signs for the sector as we infer that an increase in input costs will hit financial performance in Q1FY22 (April-June quarter of FY22) along with elevated freight rates, and container availability issues. 

In Q4FY21, Tata Chemicals reported 17.7 per cent/9 per cent year-on-year (YoY) decline in Ebitda margin as US/UK EBITDA margin crashed due to a steep increase in operating expenses. Overall, Ebitda margin fell by 610bps YoY. As regards SRF, Ebit margins moderated further sequentially (-420bp QoQ) in the Packaging segment. Navin Fluorine's gross margins contracted by ~230bps YoY on account of an unfavorable product mix primarily in the Refrigerant business and marginal impact of supply chain issues in industrial molecule exports (specialty chemicals).

Deepak Nitrite, however, reported 22 per cent YoY growth in Ebitda and 600bps rise in Ebitda maetgn on accretive performance by Deepak Phenolics, strong growth in Fine and Specialty Chemicals segment, and recovery in Basic Chemicals segment.

“However, further growth in Deepak Phenolics Ltd is capped as the Phenol plant is already running at 115 per cent utilisation since Q2FY21 and IPA prices would fall as demand normalcy returns,” said a report by HDFC Securities that believes Deepak Nitrite is entering into challenging chemistries vis-a-vis chemistries it is currently operating in.

“The fluorination and photochlorination chemistries will pave the way to tap agrochemical and pharmaceutical customers for DNL. However, the company needs to demonstrate its competencies well over the period in these chemistries to seize business opportunities,” it added.

Return expectation

Post their March 2021 quarter results, most analysts have lowered their expectation from chemical stocks given the sharp run-up in prices and the resultant expensive valuations. Some, however, still maintain their 'buy/hold' recommendation from a medium-to-long term perspective.

At the bourses, Deepak Nitrite, for instance, has seen a stellar performance. The stock has moved up over 400 per cent since March 2020 when the market hit its lows. In comparison, the S&P BSE Sensex has gained 85 per cent. (See table)

HDFC Securities has downgraded Deepak Nitrite from ‘Add’ to ‘Sell’ with a revised target price of Rs 1,550. Nirmal Bang, on the other hand, has maintained a ‘Sell’ call on Tata Chemicals.

“Our ‘Sell’ is based on 22.8 per cent downside from CMP, rich valuation at 18.1x on FY23E ~ 79.2% premium to 5-year median PE of 10.1x, lack of fresh catalysts over the next 1-2 years, and single digit ROCE/RoE,” Nirmal Bang said in a post-result report.

Chemical stocks

SRF, too, has been downgraded by Kotak Institutional Equities to ‘Sell’ from ‘Add’ as rich valuations make the risk-reward balance unfavorable. Motilal Oswal Financial Services, meanwhile, has downgraded the stock from ‘Buy’ to ‘Neutral’.

“We downgrade the stock to SELL from ADD as the recent sharp rally has made the risk-reward balance unfavorable. We find valuations expensive at 23X FY2023E EPS given around 50 per cent of the business is either cyclical or ex-growth. Our FY2023 estimate already factors in ongoing capacity expansions and healthy margins across segments,” KIE observed.

Sharekhan has fine-tuned its FY22 earnings estimate for SRF given near-term uncertainties due to rising Covid-19 cases but believes that the large capex plan would drive sustained high long-term growth. The brokerage, however, has a ‘Buy’ call with a target price of Rs 8,100.

Emkay Global, meanwhile, has downgraded Navin Fluorine to 'Hold' as fair valuations cap near-term upside.  

From the long-term perspective, the brokerage expects SRF and Navin Fluorine’s margins to remain strong in the specialty business on complex chemistry molecules while higher phenol prices may affect Camlin Fine (in Q4), which could partially be mitigated by operating benefits from the Dahej facility. "In sector, we remain overweight on SRF, Vinati Organics and Camlin Fine," their analysts wrote in a recent report.