After delivering many multibagger stocks, will this sector continue to impress?

Chemical companies high in specialty may continue to command a premium valuation as they may have pricing power to offset any inflation in input cost, with a lag, analysts said. While largely remaining positive on the sector’s medium term outlook, their price targets, however suggest muted returns ahead for the stocks. Analysts find specialty stocks a medium-term play.

“The buzzword last year was specialty chemicals. Anything and everything which had chemical in its name went up and people lapped it up overpaying and we have seen a heavy correction recently. We have to be careful as this is a year when you will probably see the differentiation coming in companies, which manage inventories better, manage raw material inflation better, hedge themselves better and have the pricing power,” said Gurmeet Chadha, Complete Circle Consultants.

Crisil in its FY23 outlook projected a revenue growth of 14-15 per cent and Ebitda margin of 17-18 per cent for the sector. Resurgence in demand owing to thrust on import substitution and increased export demand will support cash generation, it said, even as raw material prices are expected to remain high in the near term due to the ongoing Russia-Ukraine war.

“The ability to pass on cost increases to end users and strong balance sheet strength augur well for a positive credit quality outlook for this sector,” it said.

Navin Fluorine, Clean Science, Aarti Industries, Atul, PI Industries, SRF, Vinati Organics and are some of the specialty chemicals stocks that Kotak Institutional Equities track. Among these stocks, Kotak sees double-digit returns in none. It has upside targets of 20-44 per cent for Castrol and SH Kelkar & Company.

Motilal Oswal has ‘neutral’ rating on Alkyl Amines, Atul, Clean Science, Deepak Nitrite and Fine Organic, with only Alkyl Amines indicating a double-digit upside. Galaxy Surfactants, NOCIL and Vinati Organics are its three of its ‘buy’ calls with 10-20 per cent potential upside.

Nirmal Bang Institutional Equities said earnings delivery of Indian specialty chemicals companies has been far superior compared to any other sector. Specialty companies have more than doubled their capex every five years and the next 3-4 years’ guidance also remains very promising, it said.

“The R&D-centric growth approach has enabled select specialty companies to compete with China in terms of pricing as well as quality without having a matching scale. This approach makes select companies strong contenders as substitutes when the western world aggressively looks to reduce its dependence on China. Process innovation is a mega theme in our view,” it said on Thursday while initiating coverage on Clean Science & Technology with an ‘accumulate’ rating and Neogen Chemicals and Tatva Chintan Pharma with a ‘buy’ rating.

The brokerage said these stocks should trade at a valuation above the industry average, led by above-average earnings visibility, ongoing benefits of process improvement & innovation, opening up of new opportunities and improved client engagements.

“Despite their rich valuations currently, we believe that there is still enough value in select pockets from a medium-term perspective. We assign high probability to the three names winning new long-term contracts in future. Rising share of specialty chemicals revenue in these companies would reduce the risk associated with RM volatility & pricing to an extent and enable consistent earnings growth,” it said.

A median target of analysts suggests a 6 per cent upside for Clean Science, 3 per cent upside for Neogen and 24 per cent upside for Tatva Chintan Pharma. Nirmal Bang’s own targets suggest no upside for Clean Science and 15-20 per cent upside for the other two stocks.

In a note last month, Kotak Institutional Equities said the Russia-Ukraine conflict resulted in higher crude prices. But during FY2013-14 when crude traded at about $120 a barrel, its impact on gross profit of specialty chemicals makers was negligible.

“Companies with low dependence on crude (Navine Flourine, SRF) and ability to pass higher input costs will be least impacted. Our analysis indicates that while the correlation between gross margin and crude oil prices is high but correlation between absolute gross profit and crude oil prices is very low. This indicates that companies like Aarti and contract manufacturers like PI, SRF and Navin are able to transfer raw material increases with some delay,” it said.

JM Financial says Deepak Nitrite is its top bet in the chemicals sector as despite its inherent cost advantages for its upcoming phenol derivative products and strong entry barriers, it is currently trading at a significant discount to its peers.

The brokerage says it prefers CRAMS (contract research and manufacturing services) / CSM (custom synthesis and manufacturing) players PI Industries and Navin Fluorine as they provide long-term earnings visibility.

“Within our coverage, Fine, UPL, Deepak, and PI (in that order) are likely to post a robust sequential Ebitda jump in Q4. We continue to back: Deepak Nitrite due to its strong entry barriers owing to its phenol capacity and CRAMS/CSM players PI Industries and Navin Fluorine as they provide long-term earnings visibility. In large caps, we like SRF. However, the recent run-up in the stock price leaves limited upside,” JM Financial said.