Verdict: Aggressive pricing, avoid

IPO Snapshot:

Neogen Chemicals is entering the primary market on Wednesday 24^th April 2019, to raise Rs. 132 crore via an IPO, comprising fresh issue of equity shares of Rs.10 each worth Rs. 70 crore and an offer for sale (OFS) of up to 29 lakh equity shares by promoters, in the price band of Rs.212 to Rs. 215 per share. Issue represents 26.4% of the post issue paid-up share capital (at upper end) and Rs. 62 crore OFS portion makes up 47% of the total issue size. Issue is closing on Friday 26^th April with listing likely on 8^th May.

The BRLM to the issue, Inga Advisors Private Limited, says this is their first public issue, in the RHP. However, attention is drawn to the fact that Inga Capital (carrying the same corporate logo as Inga Advisors) and ITI Capital (formerly Inga Capital) have been merchant bankers to IPOs in the past such as Xelpmoc Design, Bharat Road Network, Sadbhav Infrastruture, MEP Infra. This leads one to the question - was a new name incorporated just to circumvent disclosure norms for past issues, stocks which are either very thinly traded or under-performing benchmark?

Company Background:

Neogen Chemicals makes specialty chemicals with an annual turnover of about Rs. 220 crore from:

1. Bromine-based organic chemicals (78% of 9MFY19 revenue): 2 manufacturing facilities in Mahape, Maharashtra and Vadodara, Gujarat with combined capacity of 1.3 lakh litre p.a. (65%-85% capacity utilization), to double capacity via brownfield expansion in Vadodara; product finds application in pharma and agro chemicals; focus-area for company going forward
2. Lithium-based inorganic chemicals: 1.2 lakh kg. p.a. capacity at Mahape, Maharashtra (74% capacity utilization), to double capacity via greenfield expansion in Dahej, Gujarat for which land acquired; product finds application in refrigeration, construction chemicals and pharma

Pharma is company’s key customer segment, accounting for 83%/65% of 9MFY19/FY18 revenue respectively. Geographically, 58% of 9MFY19 revenue was earned from exports, up from 38% of revenue in FY18. Company has also ventured into custom synthesis and contract manufacturing (9% of 9MFY19 revenue) which fetch it higher margin vis-à-vis chemicals.  

Key Business Risks:

1. Environmental clearances / waste disposal threats looming large on the chemicals industry due to their hazardous nature
2. US based food safety company USD 3 billion Neogen Corporation has filed a commercial intellectual property suit against the company for use of ‘Neogen’ mark to manufacture and sell products, which is pending in the High Court.

Objects of Issue and Shareholding:

Rs. 70 crore of fresh issue proceeds will be used towards:

1. Debt repayment of Rs. 20.5 crore, of total Rs. 100 crore
2. Redemption of preference shares issued to Karvy Capital of Rs. 11.5 crore
3. Long term working capital of Rs. 20 crore
4. Balance Rs. 18 crore for general corporate purposes and issue expenses.

Thus, fresh issue proceeds will be utilised to towards existing capacity (already on stream) and not the expansion of doubling capacity as stated above, for which further debt and internal accruals will be utilised. 

Promoter shareholding, currently at 95%, will decline to 70% post IPO, whereas 86 public shareholders own 4.21% stake (pre-IPO) in the company.

Financials – healthy growth but foundation weak: 

On account of a low base, between FY14-18, company’s revenue/EBITDA/PAT have posted healthy growth of 20%/26%/30% CAGR, to Rs. 164 crore/Rs. 30 crore/Rs. 10.5 crore respectively in FY18 from Rs. 80 crore/Rs. 12 crore/Rs.3.6 crore in FY14. For 9MFY19, this grew to Rs. 159 crore/Rs. 28 crore/Rs. 12 crore respectively, leading to an EPS of Rs. 6.09 for 9MFY19, against Rs. 5.25 for FY18. EBITDA margins however, slipped during this period from 18.1% in FY18 to 17.4% in 9MFY19, as input prices surged, although PAT margin improved to 7.7% (6.4% in FY18) due to lower corporate tax rate (25% w.e.f. FY19 against 30% earlier, as company’s turnover is below Rs. 250 crore). This lower tax rate may benefit the company maximum for another year (FY20), post-which, it will move to the full tax bracket, lowering net margins from FY21 onwards. On an absolute basis, however, 8% margin does not reflect any superior product quality/unique business strength, as most listed specialty chemicals players are netting double digit bottomlines – some even upwards of 20% (Vinati Organics and Paushak).

Poor working capital management:

Company’s outstanding debtor days have historically been over 3 months, while inventory turnover ratio is very low, as 4.4 months of outstanding inventory is held in the books (31-12-18). As against this, industry norm of about 2 months (infact Vinati Organics operates at less than a months’ inventory) indicates gross inefficiencies.

On an equity of Rs. 20 crore and net worth of Rs. 61 crore (BVPS Rs 31), current debt equity ratio (31-12-18) is extremely high, at 1.7:1, which will moderate to 0.6:1 post IPO, as equity expands due to fresh issue and some debt is repaid. However, to fund the Vadodara and Dahej expansion, company will increase the leverage, which may again shoot up to ~ 1:1, again elevated levels, in the backdrop of peers enjoying cash surplus balance sheets. Thus, the growth (which was hitherto on a low base) is being clocked on a weak foundation (in the form of a leveraged balance sheet – for both capex as well as working capital).

Valuation:

At Rs. 215 per share, company’s market cap will be Rs. 502 crore, which leads to a PE multiple of 26x, based on FY19E EPS of Rs. 8.25 and a PE multiple of 21x, factoring in a 40% earnings growth for FY20E. Discounting FY21 earnings may be futile at this point in time, as details of expansion are not shared currently.

Below is the peer comparison table, for the fiscal FY19E:

*adjusted for exceptional gain during the year

^post IPO

In relation to peers, following points go against the company, making the issue pricing stretched:

1. Small size of business ~Rs. 250 crore of annual turnover, vis-à-vis peers with 12 times the topline like Aarti and Atul ruling at lower PE multiples of 21x and 24x vs 26x for Neogen.
2. Single digit net margins of about 8% is also the lowest in the peer set. Even Paushak which earns 2.5 times the margins (i.e. 21% against 8%) is ruling at a lower PE multiple of 23x.
3. High leverage and working capital intensive nature of the business: most of the above peers (except Aarti Industries) are cash rich companies with nil debt, while Neogen will continue to have a leveraged balance sheet. Also, outstanding inventory at over 4 months shows poor working capital management, as against an average of below 2 months.  
4. Under-performance of small cap stocks in secondary market is making them an un-preferred choice among investors. Hence, interest for this issue may be limited to poor.

Thus, current pricing more than fully captures the future growth.

FY19 has been a good year for specialty chemical industry and most of the players have capitalized on the same, including Neogen. However, ‘small cap’ tag may be the biggest negative for the stock, with aggressive pricing not helping either.

Conclusion:

Other than planned doubling of capacity in the future, there is no attraction in the issue – small scale of operations, slim margins, high debt, poor working capital management, aggressive pricing and a ‘small cap’ tag. Given better opportunities in the listed space (even when market is at all-time high levels), this issue is best avoided.

Grey Market Premium (GMP) of Neogen Chemicals:

Grey Market Premium of Neogen Chemicals 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.