Verdict: Positive over short term

IPO Snapshot:

Chemcon Speciality is entering the primary market on Monday 21^st September 2020, with a Rs. 318 crore IPO, comprising fresh issue of up to Rs. 165 crore and an offer for sale (OFS) of up to 45 lakh equity shares of Rs. 10 each by the promoters, in the price band of Rs. 338-340 per share. Issue represents 25.5% of the post-issue share capital and will close on Wednesday 23^rd September, with listing likely on 1^st October.

Company Background:

Chemcon Speciality manufactures chemicals under 2 business divisions:

1. Pharma chemcials (accounts for 2/3^rd FY20 revenue): comprises (a) Hexamethyldisilazane/ Hexamethyldisilane (HMDS) being India’s only and world’s 3rd largest manufacturer, with an installed capacity of 4,800 MTPA, including hi-purity HMDS and (b) Chloromethyl Isopropyl Carbonate (CMIC) being India’s largest and world’s 2nd largest CMIC manufacturer (26% global capacity share) with installed capacity of 1,800 MTPA. Clients include Aurobindo Pharma, Laurus Labs, Ind-swift, Hetero among others.
2. Oilwell completion chemicals (accounts for 1/3^rd revenue): Installed capacity of 15,000 MTPA of inorganic bromides, such as calcium, zinc and sodium bromide. India’s sole manufacturer of zinc bromide and largest manufacturer of calcium bromide, based on CY2019 production.

As of 31-7-20, company’s manufacturing facilities located at Vadodara (Gujarat) have volumetric reactor capacity of 375 KL, of which, 125 KL of HMDS capacity was commissioned in March 2020 and 13 KL hi-purity HMDS (used in semi-conductor and rubber industry) was commissioned in July 2020. DRHP filed in Aug 2019 actually had an object to fund this expansion of 125 KL capacity, which has already been undertaken and commissioned in March 2020, highlighting company’s strong execution capabilities. But, client concentration risk do exists, as top 5 and top 10 customers contributed 59% and 72% of FY20 revenue respectively.

Industry Tailwinds Supportive for Pharma Chemicals:

Entry barriers in the business remain high, both on (i) manufacturing front due to hazardous nature of products and (ii) marketing front due to client relations built over the years.

Import substitution and export potential: India is a net importer of HMDS, with 40% of current demand being met via imports from China and Germany. HMDS has no alternate in the silylating process for manufacture of penicillin group pharma drugs. Thus, Chemcon being India’s sole manufacturer of HMDS enjoys a natural advantage amidst global anti-China sentiments as well as India’s push for self-reliance.

For CMIC too, India is a net importer, with 62% of current domestic demand met via imports from China, since India and China are the only 2 countries manufacturing CMIC. Chemcon’s share in global CMIC capacity rose from 7% in CY14 to 26% in CY19, implying huge buoyance for the pharma chemicals piece of the business.

Oilwell completion chemicals, however, have been severely impacted due to pandemic-induced fall in crude oil prices and that segment is not expected to contribute much to future growth.

Objects of Issue and Shareholding:

Company is looking at raising fresh issue proceeds worth Rs. 165 crore to fund:

• Rs. 41 crore capex to expand pharma chemicals manufacturing capacity next to present site, from current 375 KL to 625 KL by FY22-end.
• Rs. 90 crore for working capital needs

Promoter holding, consisting of 2 families, will shrink to 74.47% post IPO from current 100%. One of the promoter group member and selling shareholder Naresh Vijaykumar Goyal has an appeal pending against a criminal case settlement regards a tender in Rajasthan as also a complaint against SEBI. Any adverse outcome on these can raise potential corporate governance issues, although company is now trying to project that as a personal individual matter.

Healthy Financial Margins:

FY20 revenue fell 14% YoY from Rs. 303 crore in FY19 to Rs. 262 crore in FY20 due to fall in product prices, but EBITDA margins actually strengthened from 22% in FY19 to 28% in FY20, as company’s margin, charged on per kg basis, is insulated from price fluctuations of its finished goods. Thus, FY20 EBITDA grew 9% YoY to Rs. 74 crore, with PAT up 14% YoY to Rs. 49 crore, leading to an EPS of Rs. 15.37 for FY20, on tiny equity base of Rs. 32 crore.

Company’s FY20 revenue of Rs. 262 crore, of which, 40% from exports, was achieved an average reactor capacity of 250 KL for the year, which has now been ramped up by 50% to 375 KL as of July 2020. Due to the pandemic, global oilwell completion chemicals demand has been adversely affected, impacting company’s 1/3^rd revenue pie. Going forward, expansion in pharma chemicals capacity is likely to compensate the fall of oilwell chemicals revenue.

As of 31-3-20, company net worth stands at Rs. 146 crore, with a comfortable net debt-to-equity ratio of 0.2:1, on net debt of Rs. 30 crore. Due to covid-induced lockdown, debtors surged to Rs. 89 crore on 31-3-20, representing 4 months outstanding of sales, which has since then got back to normal level of 2.5 months. Return rations are also healthy at 34% and 38% for RoE and RoCE in FY20 respectively.

Valuation:

At Rs. 340 per share, company’s market cap will be Rs. 1,245 crore, leading to a PE multiple of 22x on FY20 historic basis. Following peer set of some listed specialty chemical companies shows that this is actually among the lowest, despite Chemcon’s superior RoE and high margin business: 

SRF, Atul and Aarti are among the larger chemical companies with diversified product profile. Vinati Organics and Fine Organics clocking among the highest margins in the industry command premium PE multiples of over 40x. While Chemcon’s topline is much smaller, its niche presence with negligible competition and expanding capacity are the key tailwinds. While on an absolute basis, given the size of the company, historic PE multiple of 22x appears high. However, on relative terms, it is not, as over the past few months, PE multiple for the entire specialty chemicals sector has inflated and share price are at life-time highs, due to increasing diversification of global producers away from China, ongoing trade war and covid-induced demand surge. Rossari Biotech, catering to personal care industry, saw a bumper listing this July, with share price doubling from IPO price in just 2 months, and is currently trading at FY20 PE of over 60x. Peer Paushak which also manufactures CMIC, is trading at a PE  of 38x, despite much lower topline of Rs. 140 crore vis-à-vis Chemcon. Such is the frenzy in the sector!

Over the long term, these abnormally high PE multiples across the sector are likely to cool down (which have been as low as single digits too historically). But over the short-to-medium term, they appear to be sustaining.

Share price is a function of EPS and PE multiple. While risk of PE contraction exists across the sector, company’s earnings growth is likely to be healthy over FY21 due to additional capacity being commissioned in March 2020, even off-setting the demand destruction in oilwell completion chemicals. Thus, short term prospects are bright as outlook for both earnings and PE multiple are optimistic. However, over the long term, PE contraction can be a huge concern. 

Conclusion:

Potential corporate governance issues with the promoter group is a red flag. On the other hand, market leader increasing capacity, high margin business, low equity, supported by healthy demand tailwinds in pharma chemicals make the issue attractive over short-to-medium term. However, long term may not be as attractive on valuation. Thus, one can apply with a short-to-medium term outlook, but it may not qualify as a portfolio pick.

Grey Market Premium (GMP) of Chemcon Speciality: Grey Market Premium of Chemcon Speciality is an unofficial figure, against guidelines of SEBI. We strongly recommend investors against following the grey market premium. To know more about grey market premium and how it operates, read our article on ‘grey market premium’ in Pathshala column.

Disclosure: No Interest.