India - Chemicals Key takeaways from

expert call
05 May 2020

Feeling the pinch, and gains are no cinch! Dr Deepak Palekar is a chemical industry
DD MMM YYYY
veteran with nearly 30 years of experience in
We hosted chemical expert Dr Deepak Palekar on a conference the fields of chemistry and chemical
call, to discuss the impact of Covid-19 on India’s chemical engineering. Dr Palekar in 2014 stepped
industry. Dr Palekar highlighted that industry operations are down as President (Pharmaceuticals &
severely disrupted by manpower shortages and logistical Intermediates) of Atul., one of India’s
constraints; these may last 1-2 months. Demand pressures will leading chemical companies. Prior to Atul, he
also probably weigh on FY21 earnings. Longer-term, there are worked in senior roles at Rhodia (one of the
definite opportunities, given a desire among multinationals to world’s leading chemical companies) for ten
shift sourcing away from China. However, India’s gains may be years and at Hindustan Lever’s research
limited, owing to the country’s poor infrastructure, high centre. His professional qualifications include a PhD (Tech)
corruption levels, restrictive labour laws and environmental from the Department of Chemical Technology (UDCT),
activism. University of Mumbai. Dr Palekar is now Executive Director at
Sustainable Technosolutions for Environmental Protection
Severe near-term disruption: Manpower levels at chemical (STEP), an independent consulting firm founded by his wife,
companies are currently capped at 30-40% of normal (except in the who is also a chemical industry expert. Simultaneously, he is
pharma/food sectors), and a shortage of skilled personnel and contract also engaged in various consulting assignments related to the
labour (often migrants) is the key constraint on production. Logistics is chemical industry, including identifying Indian contract
another key hurdle, with ports operating at 25-30% of normal levels manufacturers for Japanese companies. He currently consults
and tankers in short supply for effluent discharge. Transport costs have with around ten companies and helps them with
spiked by up to 40%. Nevertheless, companies are focussed primarily customer/supplier acquisition as well as technology
on resuming production; profitability concerns have taken a back seat. development.

Very limited visibility: Companies typically do have a couple of Figure 1: Valuation summary
months’ worth of orders in hand, but production constraints are forcing Mkt Cap FY21ii FY22ii FY20-22ii
them to prioritise manufacturing of key products. While customer Company name CMP (Rs) TP (Rs)
(US$ m) P/E P/E EPS Cagr
enquiries continue, there is no visibility on prices. Meanwhile, Chinese SRF (ADD) 3,641 3,275 2,764 25.6 19.3 3.5
competitors have resumed production and are cutting prices. Some raw Aarti Industries (ADD) 1,095 960 2,520 31.9 22.8 21.4
material suppliers are demanding advance payment, and cash flow
Atul (REDUCE) 4,632 4,480 1,814 27.3 19.6 2.5
management has become a key priority.
Navin Fluorine Intl (ADD) 1,518 1,620 991 37.3 28.1 18.5
Tata Chemicals (BUY) 281 440 946 9.1 7.0 0.9
Definite opportunities in the long term: There is a visible knee-jerk
Deepak Nitrite (BUY) 485 570 874 13.2 11.8 NM
reaction among global customers to shift sourcing away from China, but
a key question is the speed at which Indian companies can respond. Sudarshan Chemical (BUY) 402 480 368 28.0 16.4 15.8
Larger Indian companies are relatively better-placed. However, China is Source: Bloomberg, IIFL Research
too large to be ignored for the next few years, and the Indian
government needs to get its act together to offer a credible alternative.

Abhijit R. Akella, CFA | abhijit.akella@iiflcap.com Akul Broachwala | akul.broachwala@iiflcap.com Vidit Shah | vidit.shah@iiflcap.com
91 22 4646 4654 91 22 4646 4665 91 22 4646 4657

Key takeaways from the call
Dr Palekar shared his perspective on the impact of Covid-19 across
two time horizons: the short-term (i.e. the next couple of months
until Jun-2020) and the medium-to-longer term (Jul-2020 to Mar-
2021). In the short-term, there are severe disruptions in production,
caused by the location of manufacturing units (those in red zones
are more affected), manpower shortages and logistical bottlenecks.
Plants in major cities are more severely impacted
Major cities such as Mumbai, Pune and Vadodara are all classified as
red zone areas, leading to relatively more severe disruption. For
example, migrant workers have found it difficult to rejoin workplaces
in these cities. In contrast, smaller towns that have a high
concentration of chemical units, such as Lote-Parshuram, Roha and
Mahad (all in Maharashtra), have seen a relatively more limited
impact on operations, since it has been possible to transport workers
from nearby towns. Dr Palekar also cited the example of Solapur
(Maharashtra), which has been recategorised from orange zone to
red zone, making it more difficult for chemical companies located
there to bring manpower into commercial zones.
Manpower availability is the biggest constraint
Companies with continuous manufacturing processes tend to have
relatively lower manpower needs. However, most specialty chemical
companies tend to operate on batch processes, which are often
manned by specialists. Government restrictions currently cap
headcount at 30-40% of normal levels, except in the case of
manufacturing units catering to the pharma/food sectors
(agrochemicals are not exempt: industry contacts indicate that
headcount here is capped at 40% of normal). This cap covers the
total headcount at the unit, including employees operating the
utilities. Consequently, the factory may be unable to source all the
relevant specialists it needs for a batch process, potentially leading
to challenges in terms of process safety and efficiency.
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India - Chemicals
Dr Palekar cited the recent examples of tragic accidents at Galaxy
Surfactants and Tagros Chemicals: these may well have owed their
genesis to the absence of skilled specialists. Consequently,
companies have been inclined to focus on plant safety in the initial
couple of weeks post restart.
Larger companies are better-placed
Dr Palekar mentioned that larger companies such as Atul and
Deepak Nitrite (DNL) are better-organised, and that their human
resource departments have planned well in advance. Atul has
ramped up its production in the past 2-3 weeks, and expects to
reach significantly high capacity utilisation within another 2 weeks.
Similarly, Privi Organics (a part of Fairchem Speciality) had
anticipated constraints and restarted operations with reduced
manpower, and is now operating at 70-75% utilisation rates. In
contrast, smaller manufacturers have been facing greater
challenges. The scarcity of contract labour (often comprising
migrants) is a key constraint. Such labour performs tasks such as
moving material within the factory, packaging of products and
operating utilities. Some of these tasks are frowned upon by the
unionised workforce. Shortages of such contract labour are felt
particularly acutely by smaller organisations. Such organisations also
typically do not have proper effluent treatment facilities and,
therefore, needed to use tankers to send effluent for treatment or
discharge. But tankers are now in short supply, so these smaller
units are unable to adequately dispose of their effluent, leading to
fears of a crackdown by the pollution control authorities. In the
longer-term, given these challenges, smaller companies may
struggle to survive.
Industry is likely to rationalise headcount
Certain companies have already started using reduced manpower
(e.g., Privi), and Dr Palekar expects this trend to continue,
potentially backed by greater automation. Even after capacity
utilisation ramps up, there will be a need to practice social distancing
in the workplace, necessitating headcount reductions. Dr Palekar’s
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conversations with certain large companies indicated that their
managements are indeed thinking along these lines.
Visibility is limited to the next few weeks
For the next 3-4 weeks, raw material availability is assured, but
logistical hurdles are a risk. Most trucks are either stranded on the
roads (due to lack of clearances) or at ports (if they have not
discharged their containers), or simply do not have available drivers.
This has led to a spike in transport costs, ranging over 10-15% to as
much as 30-40%; bearing this cost is a challenge for manufacturers.
Ports are operating at only 25-30% of normal levels, and so
companies with sizeable exports are likely to be significantly
impacted. (A similar risk applies to imports as well.) Cash flow
management is a major issue, as either collections from customers
may take longer or, in some cases, suppliers are demanding
advance payment. Companies do have orders in hand for a couple of
months and customer enquiries are ongoing, but customers are not
committing on price. Meanwhile, Chinese producers have resumed
production and are cutting prices, leading to further uncertainty
around pricing. Given all these pressures, Dr Palekar expects a
negative impact on revenues and profits, at least in 1QFY21.
Fear of infection from Chinese imports!
Dr Palekar narrated an anecdote related to Jubilant Lifesciences’ unit
in Nanjangod near Mysore, which recently imported azithromycin
from China but then found that ~15 of its employees were infected
with Covid-19. Subsequently, it was found that the infection was not
related to the shipment, but incidents such as these have created
some apprehensions about importing from China.
Definite opportunities emerging in the medium-term
Beyond Jul-2020, there are definite chances that the global chemical
industry begins to shift its sourcing away from China. However,
China is too important to be side-lined, for at least the next few
years, since there are unlikely to be large capacities available with
competing countries in the short-term. Nevertheless, global
customers may explore the possibility of additional contract
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India - Chemicals
manufacturing or outsourcing from India. The key question is how
fast Indian companies can respond; larger companies are better-
placed to capitalise on the opportunity, since smaller ones may not
have the resources. Dr Palekar cited the example of his Japanese
clients, who have been exploring the possibility of shifting away from
China; all of them are considering sourcing either from Japan itself
or from India/Thailand. One of his Japanese clients has identified
two Indian manufacturers for specialty polymer additives. However,
India’s long lockdown has hurt the country’s prospects of gaining
market share and damaged the country’s credibility as a reliable
supplier.
However, India’s track record is not impressive
Dr Palekar expressed his doubts over how far India can benefit from
such opportunities, given its poor infrastructure, high corruption
levels, restrictive labour laws and environmental activism. He cited
the recent example of 56 global companies that recently exited
China, of which only 3 came to India. Indian companies also do not
have some of the high-end specialty chemicals (e.g. amino acids
used in nutraceuticals) that are required by certain global clients
such as the Japanese. The Ranbaxy-Dai-ichi fiasco is another turn-
off, since the Japanese prize business ethics above commercial
considerations. Nevertheless, Dr Palekar believes that some Indian
companies could indeed benefit from the emerging opportunities.
Southeast Asia has become a formidable alternative
In the past decade, countries like Vietnam, Thailand, Indonesia and
Malaysia have made rapid strides. Originally, the plants set up there
were by multi-nationals for basic products. However, since then,
these countries have improved their competitiveness, chiefly by
building infrastructure that is far ahead of India’s. Therefore, they
have a significant logistical advantage over India, offsetting their
disadvantage in terms of availability of skilled personnel. Besides,
unlike in the pharma industry, specialty chemical plants set up by
the Japanese and Koreans are heavily automated and manned by
people from the home-country: this reduces the need for local
skilled personnel, cancelling out India’s advantage in this regard.
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 India - Chemicals

Facts and figures: China is too large to completely bypass

The global chemical industry is worth ~US$4 trillion, of which China
holds 38% share, while India is only at US$160bn. Similarly, in the
specialty chemicals industry, China is several-fold larger than India.
Certain basic chemicals required for downstream applications are
still not produced in India and are imported, e.g. methanol, styrene,
and acetic acid. Hence, the world will continue to buy from China for
at least the next few years.

IIFL view: Promise exists, but so does near-term pain!

Dr Palekar’s insights are consistent with our view that opportunities
are emerging for Indian chemical companies. However, we also
believe that given the likely deep economic recession ahead, the
industry faces a weak near-term demand outlook. Given the likely
pressure on earnings, valuations seem too high for most leading
companies. We would be cautious on richly-valued names and would
instead favour those with relatively attractive valuations, such as
DNL, UPL and Tata Chemicals.

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 India - Chemicals

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Key to our recommendation structure

BUY - Stock expected to give a return 10%+ more than average return on a debt instrument over a 1-year horizon.

SELL - Stock expected to give a return 10%+ below the average return on a debt instrument over a 1-year horizon.

Add - Stock expected to give a return 0-10% over the average return on a debt instrument over a 1-year horizon.

Reduce - Stock expected to give a return 0-10% below the average return on a debt instrument over a 1-year horizon.

Distribution of Ratings: Out of 230 stocks rated in the IIFL coverage universe, 111 have BUY ratings, 10 have SELL ratings, 85 have ADD ratings and 23 have REDUCE ratings

Price Target: Unless otherwise stated in the text of this report, target prices in this report are based on either a discounted cash flow valuation or comparison of valuation ratios with companies seen by the analyst as
comparable or a combination of the two methods. The result of this fundamental valuation is adjusted to reflect the analyst’s views on the likely course of investor sentiment. Whichever valuation method is used there
is a significant risk that the target price will not be achieved within the expected timeframe. Risk factors include unforeseen changes in competitive pressures or in the level of demand for the company’s products. Such
demand variations may result from changes in technology, in the overall level of economic activity or, in some cases, in fashion. Valuations may also be affected by changes in taxation, in exchange rates and, in
certain industries, in regulations. Investment in overseas markets and instruments such as ADRs can result in increased risk from factors such as exchange rates, exchange controls, taxation, and political and social
conditions. This discussion of valuation methods and risk factors is not comprehensive – further information is available upon request.

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