Highlights:– Strong topline growth in Q1, aided by crop protection business
– Net profit increased in spite of weaker margins due to lower interest expense
– Focused on therapeutic areas of CNS and diabetes
– New API products to contribute one-third of revenue in pharma segment in next three years
– In crop protection chemicals, company should benefit from industry consolidation
Hikal Ltd (Market cap: Rs 1,769 crore) is an emerging chemical company selling to two promising end-markets – pharmaceuticals and crop protection chemicals. Its long term contracts with pharma and agro-chemical majors such as Merck, Bayer, Syngenta, BASF and Pfizer are paying dividends. A growing API (active pharmaceutical ingredient) portfolio backs up growth prospects. We believe that the company could be benefit if global majors in chemicals and pharmaceuticals increase their sourcing requirements from India.
The stock has corrected by about 24 percent from its 52-week high levels and is testing important technical levels. We believe investors may look at the stock at current levels.
Table: Q1 financials
A key positive
In Q1 FY20, revenues increased by 24 percent year-on-year (YoY) mainly driven by 34 percent sales growth in crop protection business (41 percent of FY19 sales). A 15 percent sales growth in pharma business (59 percent of FY19 sales) aided sales growth as well.
A key negative
Company’s gross margin was affected by about 600 bps on YoY basis. As a result, earnings before interest, tax, depreciation and amortization (EBITDA) contracted by around 160 bps, partially offset by lower other expenses. However, despite a weaker operating margin, net profit grew by 58 percent YoY since its interest costs declined.
APIs – new products to aid diversification: Hikal mainly focuses on therapeutic areas of central nervous system (CNS) and anti-diabetic segments. Its key product is gabapentin (35 percent of pharma sales). It is a global leader in production of gabapentin, which targets CNS ailments. Going forward, gabapentin’s share in sales is expected to moderate as company focuses on new products such as pregabalin, venlafaxine, quetiapine and valacyclovir. New products are expected to contribute one-third of revenue from the pharma vertical in next three years. Hikal aims to file 5-6 DMFs (Drug Master File) every year.
Table: New APIs on roll
Backward integration: Due to slowdown in Chinese supplies, the company expects shortages and pricing pressures for APIs to continue in the near term. However, the company is taking efforts to offset the adverse impact by making operational improvements and developing alternate raw material sources. It has developed alternate raw material sources for two major products – an anti-convulsant drugand a cholesterol-lowering drug.
Capex plan: HIkal’s is investing Rs 350crore in capital expenditure projects, of which Rs 150 crore investment has been spent in FY19 and the rest to be spent in the next 1.5 years. The management expects an asset turnover of 1.5x with focus on pharma and crop protection. With project debt to equity ratio of 0.5x and expected EBITDA margins of around 20 percent, financial metrics are moderately better than the existing business. The company’s current leverage ratio (debt/equity ratio: 0.75x) is bit elevated though not alarming.
Risk factors: About 30 percent of the raw materials are sourced from China, which makes the company vulnerable to volatility in prices due to reforms in China. Secondly, concentration risk of products needs a close watch. Both pharma and crop protection segments have a product each with high share of revenue, at about 15%-40% of segmental revenue. Thirdly, regulatory risk remains a constant risk as 85 percent of pharma revenues come from regulated markets (for instance, US and UK).
Hikal’s Q1 FY20 performance, particularly sales growth, was ahead of our expectations. It is likely to meet its mid-teen sales growth guidance for FY20. Going forward, we expect a large part of double-digit sales growth in medium term to be contributed by volumes.
Source: Moneycontrol Research
But in Q1 its operating margin was affected by product mix and higher plant related expenses. We expect its operating margin to improve in future, due to contribution from high margin new products and its foray into specialty chemicals.
We believe that structural trends such as India becoming a preferred choice for contract manufacturing in APIs and chemicals remain intact. This scenario is supported by multiple factors, such as an enabling environment, technical knowhow available in India and higher cost pressures for global pharma and agro-chem majors. The cost of manufacturing in China has become higher due to stricter environmental and regulatory compliance norms. We believe HIkal’s ongoing capex program could help it capitalize on existing opportunities
Coming to valuations, Hikal is trading at an FY21 EV/EBITDA of 6.1x which makes it an attractive stock in the sector, given double-digit earnings growth expected in next two years. It is currently trading close to its long term technical support price levels and hence presents an opportunity to accumulate, in our opinion.