– Flat top line; chemicals maintain strong momentum
– Operating margins rise in Q although they can soften in near term
– Capex of at least Rs 1,800 crore over next two years
– Leverage under prudent limits- Capital allocation remains a key watch
While the quarterly results of SRF appear uninspiring due to the marginal contraction in revenues, they conceal within a strong show in the specialty chemicals space. Strong operating margins across divisions adds to the shine. The company is in the thick of executing multiple projects which build a base for credible medium-term growth.
Q2 sales contracted by 1 percent YoY. The strong chemicals (39 percent of Q2 FY20 sales) segment sales growth of 25 percent was offset by declines in packaging film (38.1 percent) and technical textiles (18.6 percent) segments.
Within chemicals, specialty chemicals did well led by external markets for its user segments – agrichemicals and pharma. The management sees a revival in agrichemical demand, particularly in emerging markets, although the US was impacted by adverse weather conditions. In the case of fluorochemicals, sales were helped by domestic volume growth; SRF saw market share gains in this segment. There was also improved contribution from the chloromethane plant which was partially offset by the auto sector slowdown and decline in global refrigerant gases prices.
In the packaging films segment, sales fell 4.8 percent YoY in Q2. Despite this, segment sales for the first half of this fiscal year were relatively steadier with 2.8 percent growth. Steady demand helped both BoPET films (biaxially-oriented polyethylene terephthalate) and BoPP films (biaxially-oriented polypropylene) businesses.
Technical textiles sales declined 29 percent YoY. This segment faces a subdued near-term outlook for its key product, tyre cord fabric, because of troubles in the automotive sector.
EBITDA (Earnings before interest, tax, depreciation and amortization) margin improved in Q2 to 19.3 percent (+120 bps YoY), aided by the chemicals and packaging film businesses. In case of technical textiles, reported EBIT margin was 6.5 percent. However, excluding one-time stamp duty paid for the tyre cord division (around Rs 29 crore), EBIT margin was a healthy 15.4 percent. Further, at the EBIT level, the chemicals segment contribution has increased to 45.2 percent from 24.4 percent last year.
Update on capex projects
Chemicals: The dedicated facility to produce agrichemical intermediates at the cost of Rs 166 crore has been commissioned. This project was announced in February 2019 and has incurred an additional cost of Rs 26 crore required for an effluent treatment installation and change in design. The company has also commissioned an integrated facility (spend of Rs 477 crore vs Rs 356 crore earlier) to produce its key hydrofluorocarbons – (HFC 134a, HFC 32 and HFC 125) in Oct’19 which doubles its HFC capacity to 34,000 tonne.
Further, the company has announced a capex of Rs. 40 crore to expand the existing capacity (1800 tonne) for production of a specialty product (it has not disclosed the name) to 3400 tonne. This is expected to be commissioned by July 2020.
Additionally, the company is spending Rs 424 crore building an integrated facility for PTFE (Polytetrafluoroethylene). This would add a capacity of 5000 tonne (Asset turnover: 1.5x-1.7x) and the project is expected to complete by October 21. With this SRF plans to enter into the fluoropolymers segment of fluorocarbons to derive cost advantages from an integrated value chain. This plant would have R-22 refrigerant gas as the feedstock.
Packaging: The company announced a capex of Rs 350 crore for a BoPP Plant in Thailand which is expected to be commissioned in October 2021. This would be SRF’s third BoPP line after facilities in Indore and S.Africa, and targets to capitalize on Thailand’s demand as it is a net importer. For the BoPET segment, facilities in Hungary and Thailand are on track and expected to be commissioned in H1 FY21.
Technical textile: The company is planning to spend Rs 125 crore to enhance the technical textile fabric capacity in India which is partly required to meet customer demand due to the closure of a unit in Thailand.
Despite this heavy capex spend, SRF’s leverage ratio remains comfortable. Net debt to equity was 0.63x at the end of September compared to 0.86x six months earlier.
We continue to like SRF’s business transition given the challenges in the refrigerant gases industry and opportunities for value-added applications in specialty chemicals. SRF increasingly caters to the growing opportunity in ozone-friendly hydrofluorocarbons (HFCs) and specialty chemicals. The bulk of its capex allocation for next two years – about Rs 1,800 crore – is dedicated to chemicals. The near-term positive to note is that the company has maintained its guidance for 40-50 percent growth for the specialty chemicals business in FY20.
SRF is continually re-organising its product lines too. In recent times, while it has announced various projects, it has also sold its engineering plastic business and shut down a textile factory in Thailand owing to unfavorable dynamics. In this context, we find it encouraging that company only identifies and approves for capex projects where in RoIC (Return on Invested Capital) is atleast 10 percentage points greater than weighted average cost of capital.
Coming to margins, in the near term, the company seems well-positioned with respect to raw material trends. There has been a sharp decline in caprolactam prices and fluorspar prices don’t appear to be challenging. However, EBITDA margins can moderate as the benefit from the operating leverage in the chemical space can be offset by the anticipated margin contraction in other two divisions. While the BoPP market is witnessing a balanced demand- supply situation, the BoPET packaging industry is anticipated to be adversely impacted by higher supplies from Jindal, Polyplex and SRF’s own production lines. Margins in the technical textile business would also be a factor of operating leverage which is likely to remain under pressure due to a sluggish auto market.
Overall, we like the stock encouraged by the promising outlook in chemicals space, prudent capital allocation decisions and satisfactory execution of projects. SRF is currently trading at 19.1 x FY21e earnings and can be accumulated on every decline.