what is happening in the speciality chemical industry
The chemical sector, including speciality chemical companies, was one of the best-performing sectors in the last decade. Many chemical companies have generated multifold returns in the same time period. As a developing country, India has a huge demand for all types of chemicals. Historically, most of this demand was met by China until 2017, and to some extent, it still is, as we import many chemicals from China. However, China's pollution-related issues opened up significant opportunities for Indian companies after 2017.
In recent years, though, a noticeable shift has occurred, with speciality chemical companies finding themselves lagging behind in the market. This leads to a compelling question: Was this a mere bubble, or is it part of a broader structural transformation? Let's delve deeper to uncover the truth.
You may wonder what kind of chemicals comes under the umbrella of speciality chemicals. Speciality chemicals encompass a diverse range of categories, including surfactants, polymer additives, flavors and fragrances, electronic chemicals, and agrochemicals and intermediates.
These chemicals demand a higher level of expertise due to their specialized nature, and not every company possesses the capabilities required for their production. The complexity of manufacturing and the need for expertise enables these companies to charge premium rates to their customers. As a result, many of these firms enjoy exceptionally high-profit margins and impressive return ratios (ROE and ROCE), setting them apart from their commodity chemical counterparts. Furthermore, they have greatly benefited from the China+1 strategy and the import substitution trend.
India is home to over 100 listed companies in the speciality chemical industry, with market capitalizations ranging from Rs. 19 Cr. to Rs. 1,20,697 Cr. Notable names include SRF, Gujarat Fluorochemicals, Deepak Nitrite, Aarti Industries, Navin Fluorine, Clean Science, Galaxy Surfactants, and many others.
Even though this industry has generated massive wealth for its investors in the past decade, for the past couple of years it has been struggling. And not every company is of high quality in this space. Just look at the below image to understand the current scenario.
Most of the companies have negative 1-year returns compared to positive returns of Nifty. But if you look at the 3-year CAGR of the companies, almost all names have outperformed the Nifty in that time frame. There is one important observation. Even after the significant price drop in many names, they are still trading at very high P/E.
As speciality chemicals companies enjoy high profit margins and return ratios, they also command higher valuations. So even after the price corrections, relative valuations remain high (have a look at the P/E ratio). And when companies are priced to perfection, negative news has a bigger impact on the stock price.
The speciality chemicals industry in India has been facing some challenges in the past couple of years, such as:
The global slowdown after the COVID-19 pandemic has impacted the demand for speciality chemicals from various end-user industries, such as automotive, textiles, paints, and cosmetics. Many of the Indian speciality chemical companies export a large percentage of their output to the international market, especially to the US and Europe, where the demand has been weak.
China is a major producer and exporter of speciality chemicals and has been lowering its prices to gain market share. China has also been investing in environmental compliance and technological upgradation, which has improved its product quality and reliability. This has posed a threat to the Indian speciality chemical companies, which have to compete on both price and quality.
The Indian specialty chemical industry depends on imported raw materials, such as crude oil, natural gas, and benzene, which are subject to price fluctuations and supply disruptions. The rising prices of these raw materials have squeezed the margins of the Indian speciality chemical companies, while the supply disruptions have affected their production and delivery schedules.
Even the current situation is not very encouraging. The outlook for the chemical industry remains bleak as India's exports of organic and inorganic chemicals experienced a decline in September 2023, along with falling imports. In the US, chemical production decreased both on a monthly and yearly basis and chemical railcar holdings, a volume indicator, were down year-on-year. Soft demand conditions persist, influenced by China's economic weakness, ongoing European challenges, and uncertainty surrounding a potential US recession in 2024. Additionally, China is expected to introduce new production capacities, even as it continues to export aggressively, further pressuring chemical prices.
We believe that the whole chemical industry is going through headwinds at the moment and even next quarter will also remain soft for most of the companies. Multiple factors are affecting Indian companies negatively like high raw material prices and dumping by China. But the size of the opportunity is still big. Some companies like Aarti Industries are planning to build a whole ecosystem and they will have a presence in each step of the chemical supply chain. The company is doubling its fixed assets and will play a solid part in the import substitution going forward.
The critical question is whether the speciality chemical industry will be able to replicate the impressive returns (over 20-30% CAGR) it achieved in the past five years. We believe that the probability is very low. We feel that the chemical sector is transitioning from being a high-growth industry to becoming a consistent compounder. Our advice is to focus on companies that are poised for significant volume growth in the years to come, given that pricing in this industry is heavily influenced by the dynamics of supply and demand.
The speciality chemical industry is going through headwinds at the moment. Fluctuating raw material prices, sluggish demand, and dumping from China have contributed to the pain. However, demand for speciality chemicals will remain strong with increasing use cases. In the stock market, good prices and good news do not come together. So investors planning to invest in this sector should focus on the companies that are sitting on the high operating leverage and will have a solid volume growth.
