Chemcon Speciality Chemicals - Red herring or True Value

Chemcon Speciality Chemicals Ltd is in the process of listing right now, with IPO closing on 23rd Sep 2020. With Spec Chem being the flavor of the season, decided to have a in-depth look at this one to find if its a red herring just riding the wave, or if it can deliver true value over long term.

Company Background

• Incorporated as Gujarat Quinone Private Limited at Vadodara, Gujarat on 15 Dec 1988. Current promotors incorporated Chemcon Engineers Pvt Ltd in April 1996. They acquired 100% in Gujarat Quinone and merged the 2 companies and renamed entity as Chemcon Speciality Chemicals (CSCL)

• CSCL is engaged in the business of manufacturing, marketing and supplying of the Pharmaceutical Chemicals and the Oilwell Completion Chemicals.

• CSCL is an ISO 9001:2015 certified company. Its manufacturing plant is located in Manjusar, near Vadodara.

Products & Applications

• CSCL product portfolio consists of Pharmaceutical Chemicals, mainly HMDS & its ancillary chemicals and CMIC

• Oilwell Completion Chemicals, namely Calcium Bromide (solution and powder), Zinc Bromide (solution) and Sodium Bromide (solution and powder)

• HMDS is important intermediates for API of life saving Antiretroviral (ARV) drugs used to treat HIV / AIDS and Direct Antiviral Action (DAA) drugs for Hepatitis B & C

• HMDS is also an key intermediate for 2nd Gen Cephalosporin antibiotics which are used to treat variety of conditions in Bronchitis, Ear infections, Skin infections, bacterial infections, and infections of ear, lung, throat and urinary tract

• Similarly, CMIC too is an critical intermediate for API of HIV / Hepatitis B & C drugs

• Its Bromide family of Oil well chemicals are used preparation of Oil wells during oil & gas exploration

Business Analysis
Since the company is in listing process right now, financial data is available only for limited period of FY17, FY18 and FY19 in DRHP document.

• Although CSCL has a limited basket of products, it seems to be well positioned in the market for these products.

• In HMDC, it is the ONLY manufacturer in India, and the 8th largest producer in the world, as of FY18

• For CMIC, it is the LARGEST in India, and the 2nd LARGEST producer in the world

• Thus, it has been very successful establish itself within its niche, within a relatively short period of time

Industry-wise Revenue

• As of FY19, Pharma contributes almost 2/3 of the revenue and remaining 1/3 is contributed by Oil Well Completion Chemicals business

• A minuscule part of revenue comes from other industries such as semi-conductor and rubber. A very small amount of revenue comes from services

Product-wise Revenue

• As of FY 19, almost 40% of its revenue comes from its biggest product, HMDS

• Bromide family of products contribute about 35%

• CMIC contributes about 15.65% revenue

Domestic Vs Export Revenue

• Revenue from domestic sales in FY19 is 196 Cr (64.67%), up from 24.2 Cr in FY17 (26.95%)

• Revenue from exports in FY19 is seen at 98 Cr (32.22%), up from 58.5 Cr in Fy17 (65.08%)

• Between FY17 and FY19, CSCL has demonstrated a very strong growth in both domestic as well as exports sales

• While its total revenue has grown to almost 4 times in these 2 years, its export sales have grown to over 1.5 times, while the domestic sales have grown almost by a massive 8 times in this short period

Market Share

• CSCL is India’s only HMDS manufacturer, and 8th largest globally. It has a global market share of 5.61% in HMDS. Its India market share in HMDS is 47.9%

• It is also India’s top manufacturer of CMIC, and 2nd biggest globally. It has a global market share of 28% and domestic market share of 50.4%

• In Oil well chemicals (Bromides), its market share is very small, 2.66%, though it is 6th largest manufacturer of such chemicals in the world. What is commendable though, is that till year 2013, CSCL did not even make these products, so it has done relatively very well to get this market share in a short span of 7 years.

Capacity & Utilization

• CSCL has a total installed volumetric capacity of 236 KL. These are spread across 6 manufacturing plans at their single manufacturing site in Vadodara

• Of the 6 plans, 1 is dedicated to making HMDS, 2 are for CMIC, 2 are for Oil Well Chemicals. One plant for HMDS was damaged in fire accident in 2018, and they are rebuilding it.

• Total installed capacity is at 2400 MT for HMDS, 1800 MT for CMIC and 14,400 MT for Bromides solution and 600 MT for Bromides powder.

• Current utilization (FY19) for HMDS is 93%, for CMIC is at 95% and for Bromides is at 57%

• As per plan, IPO proceeds (fresh sale of 165 Cr) will be utilised for CAPEX for 3 new plants (46 Cr), shared infrastructure and Working capital (90 Cr)

• All the 3 new plants will be dedicated to making of pharma chemicals i.e. HMDS & CMIC

• The new plants will add new volumetric capacity of 376 KL. Along with restoration of plant lost in fire incident, the total capacity will rise to about 625 KL, more than doubling from current installed capacity.

Growth Runway

• As per Frost & sullivan report, HMDS demand in India is projected to grow at CAGR of 5.6% in next 3 years. India is currently net importer of HMDS, with 52% of its demand in 2018 met by imports, mainly from China. Chemcon is the only HMDS manufacturer in India. Hence, by substituting imports and catering to India’s HMDS market, Chemcon has an opportunity to grow at a CAGR of ~20% between 2018 and 2023 in the HMDS Segment.

• India and China are the ONLY 2 countries in the world to make CMIC. India has 45% market share, and China has 55% market share of global production.

• India has the largest demand for CMIC, with 65% of global consumption. This demand is growing very fast. CMIC is critical input for HIV / Hepatitis B life-saving drugs. Demand for these drugs has been rising due to lowing prices and rising demand for better healthcare.

• As per Frost & Sullivan report, global demand for CMIC is predicted to grow at CAGR of 12.5% between 2018 and 2023, with demand in India expected to grow at 14% CAGR in the same period. Currently, India is a net importer of CMIC, with 50% of its demand being met through imports from China.

• Chemcon being leading producer of CMIC in India, is well positioned to substitute imports from China and hence has an opportunity to grow at a CAGR of more than 25% in CMIC segment between 2018 and 2023.

• With planned CAPEX will double the capacity in lucrative pharma chemicals (HMDS, CMIC). Thus, post-expansion, CSCL will be in great position to grow its revenue by meeting the rising demand of HMDS and CMIC

• If CSCL is able to achieve its expected growth CAGR of ~20% over next 3 years in HMDS & CMIC segment (currently 62%+ of its revenue ~200 Cr), it can easily double its revenue from the pharma segment in this period, to about 400 Cr

Competitors

• In HMDS, its leading competitors are Dow Chemicals (18.19% global market share), Xingyaqian Silicon (China, 20.68% market share), Zheijiang Sorbo (China, 10.22% share), Shin-Etsu (Japan, 10.44% share).

• In CMIC segment, Shanghai Twisun leads with a global market share of 33.46%, followed by Chemcon, trailed by Anshul Speciality (India, 11.26% global share) and Inner Mongolia Saintchem at 14.8% share.

• In Oil Well Chemicals segment, its biggest competitors are Israel Chemicals Limited, Albermarle, LANEXESS, TETRA and PPC.

• However, since it has no competition from any of the global majors in India, it maintains massive market share in domestic markets (HMDS 47%, CMIC 50%), while rest of demand is met through imports.

• With domestic demand expected to grow at healthy pace in both HMDS and CMIC, CSCL can continue to expand at a much faster pace by substituting imports

Competitive Moat

• Substantial market presence in HMDS segment. India’s only producer of HMDS and 8th largest in the world

• India’s largest and 2nd largest globally, with a dominant global market share of 28%

• Speciality Chemicals industry has high barrier to entry due to several reasons

1. a. Involvement of complex chemistry in manufacture of products, which are difficult to commercialize on a large scale

2. b. Long gestation period to be enlisted as a supplier with the reputed customers of Pharma industry and Global chemical groups

3. Industry is highly knowledge intensive

4. Given the nature of the end application of products, the processes and products are subject to and measured against high quality standards and very stringent impurity specifications. These are extremely difficult to achieve for new entrants

5. Since the intermediates are used in API manufacturing, reworking of regulatory approvals required by them on change of suppliers is very time consuming and costly, resulting in customer sticking to proven suppliers, thus making it very difficult for new players to enter

6. Some of the products used in manufacturing of Speciality chemicals are corrosive and toxic, and handing these materials requires a very high degree of technical skill and expertise, the operations involving these have to be undertaken by well trained and experienced personnel, which is not easy to obtain.

• Obtaining environmental clearances from government agencies to set up and expand capacities for manufacturing these chemicals is time-consuming and difficult process. Even for established players, obtaining permission often proves to be elusive. New players thus find it very difficult to get a foot-hold

Financials

• Revenue is growing at a break-neck pace, rising almost 4x between 2017 and FY2019, at a CAGR of 83.95%, up from 89.8 Cr in Fy17 to 304 Cr in Fy19. DRHP document does not contain financials of FY20, but from unconfirmed data available on various sites, the revenue for Fy20 has fallen by about 10% to 266 Cr, even though PAT has improved to 48.8 Cr in FY20, compared to 43.08 Cr in Fy 19.

• EBIDTA in the same period (FY17 - FY19) has grown from 86.6 million to 679.21 million at a CAGR of 180.06%. PAT has jumped from 28.24 million in FY17 to 430.41 million in FY19, growing at CAGR of 290.39%

• Decent balance sheet, with negligible debt and leverage. Inventory levels have shot up, but given the explosive growth in sales in last 2 years, its in line. Similarly receivables have shot up almost doubling over last 1 year, but given that revenue has doubled too.

• RoE and RoCE for FY19 are seen at 44.94% and 43.37%

• Receivable days are pretty high at 106 days, almost doubling from 56 days seen in previous year. This is clearly a concern.

• Cash flow from operations has declined slightly to 113.71 million, down from 139.97 in FY18. Decline has mainly been due to steep rise in Inventories and trade receivables

Promotors

• Promoters of the CSCL are Kamalkumar Rajendra Aggarwal, Navdeep Naresh Goyal and Shubharangana Goyal. Promotor group consists of another 15+ names in what looks like extended family / associates

• The promotors have a stake in another listed company in India - Overseas Synthetics Ltd, and several other unlisted ventures, 3 of which qualify by SEBI’s definition as Group companies.

• All the 3 unlisted companies have very ordinary performance. One (dealing in industrial linings) has a revenue of 19 Cr and meagre PAT of 0.5 Cr, another one (dealing in technical textiles) has a revenue of 6 cr with a profit of 0.8 Cr. Third one (dealing in real estate), has zero sales and a small loss of 0.3 Cr. The listed entity Overseas Synthetics, has had zero sales for the last 4 years, and practically nothing for past 10 years!!

• There are some negative observations relating to these companies. In SILPL, it has granted unsecured loans to another promoter venture without clarity of interest rate and repayment terms. In case of Supertech Fabrics, there is dispute / law suit contending the purchase of a land parcel. In Kana Real Estate, the networth of the company has been fully eroded.

There are couple of additional significant Red Flags about the promotors

• Kamalkumar Rajendra Aggarwal, Shubharangana Goyal and Navdeep Naresh Goyal and certain members of the Promoter Group, namely, Naresh Vijaykumar Goyal and Minal Kamal Aggarwal (collectively, the “PG OSL Shareholders”), have filed a settlement application dated March 10, 2019 with SEBI in relation to their inadvertent failure to make certain disclosures required under the Takeover Regulations and the SEBI Insider Trading Regulations in relation to their holdings in Overseas Synthetics Limited (“OSL”), a company listed on BSE Limited, which is a member of the Promoter Group.

• Further, pursuant to a criminal complaint (“Complaint”) filed by the Central Bureau of Investigation (Jaipur) (“CBI”), the CBI Special Court, Jaipur (“CBI Court”), vide an order dated December 24, 2018 (“CBI Court Order”), has convicted and sentenced inter alia a member of the Promoter Group, Naresh Vijaykumar Goyal (in his capacity as a director of Super Scientific Works Private Limited) to (i) rigorous imprisonment for two years with a fine of ₹10,000 for commission of offences under Section 120-B of the Indian Penal Code, 1860; and (ii) rigorous imprisonment for three years and fine of ₹ 20,000 each for commission of offences under Section 13(1)(d)(ii) of the Prevention of Corruption Act, 1988

• So, other than the success of CSCL itself, the track record of the promoters across their other ventures is not too flattering, and can be termed as moderate at best. Probably, the presence of 2 non-promoter, whole-time Directors contributes immensely to the success of CSCL over last 20 years. Mr Himanshu Purohit, who holds a master’s degree in inorganic chemistry, has been with the company for last 20 years, and is currently Director – Production, taking care of critical functions such as Product Development, Production, and Material management. Similarly, Mr Rajesh Gandhi, CFO and Whole-time director, has been with the company for 20 years, and is in charge of key functions such as Finance & accounting, Export-Import, Compliance etc. Together, they seem to have played a key role in the success of CSCL.

Risks

• Promotor Risk - With the red flags noted above, it remains to be seen whether the promotors are clean and also given the performance of other group companies, CSCL remains the only exception which is successful.

• Raw material import risk: CSCL is heavily dependent on imports for its raw materials. As of FY19, 50.89% of company’s raw materials were imported. This exposes it to cost escalations due to currency exchange fluctuations. Also, a large part of its raw materials are sourced from china. Given the recent escalations in border dispute between India and China, any trade relationship breakdown / embargo between the two countries will have a big material impact on revenue and profitability of CSCL.

• Product Concentration Risk : As of now, 40% of CSCL’s revenue comes from one product – HMDS, used mainly for its applications in pharmaceutical industry. Revenue of CSCL depends on success of its customers end-products. Any change in that will have a very big impact on CSCL’s revenue and profitability.

• Industry Concentration Risk : CSCL relies on Pharma and Oil and Gas Exploration industry for almost all of its revenue. Any down-cycle or headwinds experienced by these industries will have a very massive impact on CSCL’s revenue and profitability.

• Customer Concentration Risk: As we have already seen earlier in this analysis, CSCL has massive dependence on its top 5 and top 10 customers. Any negative turn in relationship with any of these customers will have an immediate large impact on revenue and profit of CSCL.

• Regulatory / Environmental Clearance Risk : Obtaining environmental clearance in India is difficult. Any delays / problems in getting clearance for capacity expansion can have a direct and material impact on the growth and financial performance of CSCL.

• Execution Risk : If CSCL fails to execute on its strategy, failing to utilise the growth potential, it may have a big impact on its financials.

• Market Risk : If the growth in demand for CSCL’s customer’s end products does not rise as expected, it would have a significant impact on financial performance of CSCL.

Conclusion

• Just looking at the business in isolation, CSCL has found itself a very profitable and unique niche. With critical end-use of its products and rising demand, it looks to be on a unhindered growth path for the next 2-3 years. It has got itself in leadership position in its product segment within India and has made an impact globally as well.

• Growth Opportunity – With projections from Frost & Sullivan report indicating strong growth for its products in next 3 years, CSCL finds itself in an exciting space. Barring some extreme internal mismanagement or an external black swan event, it looks to be on track to achieve significant growth and leverage on the growth opportunity available to it.

• Promotor / Management Quality : CSCL Promotor quality is not top-notch, with several of their side ventures not being successful. Presence of couple of red flags (indicated in this report earlier) does not inspire confidence either. Though they have been in this domain for many years, they have not demonstrated innovation. Hopefully, the professional executives in the management team continue to drive the company to success, as they have done in recent past.

• Drop in Fy20 revenue, though small (about 10%), rising inventory days, rising receivable days etc are concerns, so those have to be closely monitored.

• Basis of current valuation assigned for IPO, at Rs 340, the stock is fairly valued at PE of 22.15 on trailing FY20 earnings. Given that other peers in Spec Chem space are commanding richer multiples in excess of 30, and also given the current IPO frenzy, this is likely to see good listing gains.

• I plan to take a very small tracking position, and will watch it closely to see how its plays out, especially given the growth potential of the products and the less than inspiring management.

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