Atul Ltd: CD Equisearch retain 'Accumulate' with target revised upward

Dynamic Equities | May 31, 2017, midnight

According to  American Chemistry Council’s (ACC) “Year End 2016 Chemical Industry Situation and Outlook,”, despite a contraction this year, US chemical production (excluding pharmaceuticals) is expected to grow by 1.6% in 2016, followed by 3.6% growth next year and 4.8% in 2018. It reckons that US competitive advantage - access to sufficient supplies of natural gas - continues to offset major challenges, including a rebalancing in oil & gas sector, weak export markets and a strong dollar. It portends that advances in manufacturing and exports in 2017 would stoke demand for basic chemicals and improving manufacturing activity will aid growth for most specialty chemicals. It posits that production of specialty chemicals, which has been dampened by oilfield and mining chemicals, would pick up and rise to 3% in 2017 as demand from oil& gas sector recovers.

Much like other chemical manufacturers like Aarti Industries, Sudarshan Chemicals and Deepak Nitrite, Atul too has ramped up its capex in last few years - Rs 277 crs ($41.0m) on average in two years ending FY16 from Rs 110 crs ($16.3m/ on average) in preceding two years - though less than that of Aarti's (Rs 365 crs /$54.0m average for last two years). Deepak's ongoing asset splurge of some Rs 1200 crs for setting up world class capacities of phenol and acetone vastly belittles the combined fixed asset accretion of last ten years (Rs 632 crs/$93.5m). Atul completed expansion of five expansion projects (worth some Rs 213 crs/$31.5m) last fiscal - sales generating capacity of over  Rs 500 crs($74.0m) - mainly in all businesses. Plans are afoot to expand capacity of its API plant and add new capacities of epoxy resins and hardeners this fiscal.

Surprisingly, tumult in global crude oil markets did little to perturb most chemical manufacturers who have relied on motley of factors - increasing share of specialty chemicals; altering product mix; resorting to dynamic pricing mechanism (fixing absolute margins) - to guard themselves from menace of falling finished product realizations. Both Atul and Aarti for instance, bettered their operating profit growth (relative to sales growth) in last two years - the former by broadening its product mix and aggressively promoting its brand business and the latter shook off the jolt by exploiting the incessant fall in benzene prices to increase its specialty chemicals margins by over 700 bps in last two years.

Yet threat of demonetization of Indian currency - particularly on the rural economy – could neutralize beneficial impact of recent rise in crude oil prices and other margin stimulating initiatives. For Atul's crop protection business, increasing brand sales and expanding overseas presence (Africa/ South America) remain key priorities, while the pharmaceutical business would focus on increasing CRAMS business and developing new formulation business for patents. Its colors business which dealt a fatal blow last fiscal (sales down by some 23%) would strive to unveil new dyes, pigments and products for non-textile applications, while the aromatics business would expand its product portfolio in personal care and aroma ingredients, besides setting up state-of-the-art-kilo lab facility.

After faltering a bit in H2 revenues though are projected to briskly recover (+14.8%) by next fiscal but the estimates risks falling apart to demonetization precipitating a dreadful economic slowdown. Besides, time lag in price setting in aromatics business (finished product prices misaligned to monthly fluctuations in raw material prices), margin besetting impact of cheaper imports of epoxy resins and hardeners and restive competition from China in crop protection business are factors not to be languidly allayed. Estimates of notable rise in crop protection and aromatics volumes lend their fragility to aftershocks of demonetization on consumer spending and farm output. Yet dramatic loss in margins appears a lesser risk not least due to product diversification and propensity to introduce value added products.

The stock currently trades at 20.7x FY17e EPS of Rs 103.52 and 17x FY18e EPS of Rs 126.49. Average earnings growth of 17.9% (previous estimate: 11.9%) for two years ending FY18 somewhat undermines the ravaging impact of non-linear events - slowdown in consumer spending, increased volatility in crude oil markets - and their inter dependence. Little scope exists of limitless expansion of margins through cost control and product rationalization - the cornerstones of hefty swell in operating margins in last few years - from 11.4% in FY12 to 17.9% in FY16.Yet steady return on equity (five year average: 17.8%) and its eschewing of debt pile up doubtless make investors sanguine. Balancing odds, we retain our accumulate rating on the stock with revised target of Rs 2530 (previous target: Rs 2168) based on 20x FY18e earnings (PEG ratio: 1.1) over a period of 6-9 months.

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