Deepak Nitrite: The upcoming stalwart of the Indian Chemical Industry
Deepak Nitrite: The upcoming stalwart of the Indian Chemical Industry
Introduction:
Catalysts accelerate change. They can significantly reduce the time required for a change to occur. The catalyst behind Deepak Nitrite is its management & its execution. The management has allocated capital prudently and has always found a way to scale the business and become a dominant player in the Indian Chemical Industry within its products. The management calls this “Deepak’s Right to Win”. This is evident from their journey from being a chemical trading company to a truly diversified chemical manufacturing company and their market capitalization growth from Rs. 45 lakhs in 1970 to Rs.39,000 crores at present. The Chemical Industry is an industry that has multiple niche industries within because of the gestation period and R&D that it takes for a company to specialise in different chemistries and processes.
Global Chemical Industry:
The chemical industry is one of the most diversified industries in manufacturing having a critical & wide range of end-use applications. This includes products that are used in all facets of our daily life from food, agriculture, home & personal care, health, electronics, water, beverages etc. The global chemical industry was estimated to be around $4 trillion in 2019 and it is classified into two categories:
Bulk/Commodity Chemicals:
Bulk/Commodity chemicals are produced in large quantities. As the name suggests, they are produced by a large number of chemical manufacturers.The bulk chemicals market is highly fragmented with a large number of global players and small regional players. The products are high in volume & low in value.The bulk chemicals or commodity chemicals are traded as organic chemicals and inorganic chemicals. Bulk Chemicals make up 80% of the global chemical industry.
Specialty Chemicals:
Specialty chemicals are complex to manufacture and require R&D and technical know-how for their manufacturing. They are exclusive towards customised services based on the customer needs and have restrictions to their manufacturing because of patents or technical know-how. The products are low in volume and high in value. These products act as catalysts to improve the performance of the end product. Specialty chemicals make up 20% of the global chemical industry.
Globally, the specialty chemicals industry grew at 5.7% CAGR ($805 billion in 2019)
In the last two decades, there has been a shift in terms of manufacturing & consumption of specialty chemicals from the Western hemisphere to the Eastern hemisphere. Asia has gone on to become the net exporter of specialty chemicals. China is a leading supplier of specialty chemicals with exports around the globe worth $35 billion in 2019 which is 4x of India’s specialty exports.
Indian Chemical Industry: Paradigm Shift
The Indian chemical industry was estimated to be worth $178 billion in FY20 and has the potential to reach $300 billion by 2025. The industry has grown at approximately 1.3 times the country's average GDP growth in the last five years.
India is ranked as the sixth largest chemical market in the world. The specialty chemicals industry in India is estimated to be worth $30 billion in 2019 and constitutes about 18% of the total chemical industry in India. It has been consistently outgrowing the overall chemical industry with a CAGR of 11% between 2014-2019.
The Indian specialty chemical industry is fragmented with multiple chemical companies which are specialised in different processes and chemistries. Few companies which are champions in their niche industries:
Navin Fluorine: Fluorination
Neogen Chemicals: Bromination
Deepak Nitrite: Nitration
Paushak: Phosgenation etc.
Let;s discuss how the Chinese industry has evolved and why Indian industry seems well poised.
The Chinese Chemical Industry:
Phase 1 (2003-2008):
Rapid economic growth backed by growth in electronic chemicals, construction chemicals etc. China positioned itself as the supplier to the world taking advantage of easy regulatory permissions and at lower operating costs. This gave China a cost advantage of 15%-20% over its Indian peers.
Phase 2 (2008-2016):
Gaining world market share continues on the back of a solid domestic ecosystem of being self-sufficient from feedstock to the end product. However, pollution crackdowns start happening, as past overcapacity starts biting back.Compliances became rigid with green taxes and manufacturing shifting to industrial parks.
This led to supply chain disruptions that caused a lot of companies to shut down due to the compliance standards and Effluent Treatment Costs. The global companies started shifting their supply chains and this is where the China + 1 tailwind began as India started becoming the beneficiary of this pollution crackdown in China.
Phase 3 (2018-Now):
Slowing economic growth and shutting down inefficient/small scale companies that cannot comply with the pollution norms. Coupled with increasing wages and stringent regulations & compliance which increased the costs and affected the margins.
One of the key Beneficiaries of these tailwinds has been Deepak Nitrite. We will break the journey of Deepak from a small cap to a large cap chemical stalwart in four phases.
Journey and Evolution of Deepak Nitrite: From a Chemical Trading company to a Global Diversified Chemical Manufacturing Company
Phase 1: 1970-2010
Deepak Nitrite was incorporated by C.K Mehta in 1970. He began his journey by starting a chemical trading business under the name of Deepak Trading during the early 1960s and gradually got into the chemical manufacturing of Sodium Nitrite & Sodium Nitrate. Thus, Deepak Nitrite was born. The first Sodium Nitrite manufacturing plant was set up in Nandesari, Gujrat.
The company struggled to position itself in the Indian chemical industry. In 1997, it made a loss of Rs.2 crores with a Debt of Rs. 80 crores and Equity of Rs.40 crores.
The company was making an ROE of low single-digit and was struggling to earn more than the cost of capital between 1997-2008. This was mainly due to competition from China’s large scale manufacturing plants and Deepak’s inability to pass on the raw material volatility. Three acquisitions that Deepak made along the way:
Deepak came back to life in 2009 when it reported a six-fold jump in its profits. This was driven by the shutdown of chemical companies and the reduction of capacities in China during the Beijing Olympics 2008.
And from 2010 onwards, the management became more confident and aggressive by announcing a new capex in OBA and Fuel Additives. Deepak became the largest producer of Sodium Nitrate and Sodium Nitrite in India.
This is how the financials of Deepak looked like in Phase 1 of its journey:
Phase 2: 2010-2013
Deepak Nitrite’s Strategic business units (SBUs) were split into end-use inorganic Intermediates, Organic Intermediates and Fine & Specialty Chemical. The product portfolio is highly commoditized. Let's look at how the management explains the SBUs:
It was in FY13 that the management first time gave the guidance of achieving a turnover of 1000 crores.
The management announced a capex for making OBA (Optical Brightening Agents) which is a forward integration of DASDA. This made Deepak a fully integrated player in this segment across the world. Oba or Optical Brightening Agents (OBA) are the hidden chemicals present in almost any detergent that promises to make clothes appear cleaner, brighter and whiter. OBA is also used by paper manufacturers (for manufacturing writing and printing papers), especially high brightness papers and for coating and is also extensively used by the textile industry.
And DASDA (Diamino Stilbene Disulphonic Acid) is a key compound used in making OBA.
Deepak crossed the overall turnover of Rs.1000 crores in 2013 thereby walking the talk. Deepak also got into the manufacturing of solar salts & the previously launched Fuel additives crossed 100 crores in sales.
This is how the financials of Deepak looked like in Phase 2 of its journey:
Phase 3: 2014 onwards
The management restructured the SBUs as Bulk & Commodities Chemicals, Fine & Specialty chemicals and Fluorescent Whitening Agents (FWA). Deepak became a beneficiary of the company and plant shutdowns in China. Deepak got the benefit of outsourcing and shifting of the base from the rest of the world to India. China became uncompetitive due to high labour and power costs, compliance permits & costs and its own domestic issues.
In this phase Deepak stuck to its core strategy of import substitution, which is the DNA with which the organization is born with. The company successfully identifies the products that are imported and have a high domestic demand. It capitalises over the opportunity and gradually emerges as a dominant market leader with its execution. In 2016 it announced a new vertical of Phenol.
The company announced a greenfield mega capex with a capital outlay of Rs.1,400 crores in Phenol and Acetone under the name of Deepak Phenolics, wholly-owned subsidiary. The capacity for Phenol announced was 2,00,000 MTPA and 1,20,000 MTPA for Acetone (a by-product of Acetone) supported by 2,60,000 MT of Cumene which is a feedstock for manufacturing Phenol & Acetone. This was a very aggressive step taken by the management. As good as it seems right now but in hindsight, the company’s debt-equity shot up and the balance sheet was levered. The company had to do multiple QIPs to execute this mega capex.
Phenol & Acetone:
The company sourced its technology for Phenol & Acetone from Kellogg, Brown & Root International and sourced its technology for Cumene from UOP Honeywell. The company assigned ThyssenKrupp Industrial Solutions in Engineering, Procurement & Construction management contracts. The availability of two key raw materials i.e. Benzene and Propylene have immensely helped this project.
Deepak Phenolics:
Phenol is used in the manufacturing of a large range of commercial products. It is consumed in laminates, automobiles, foundry, paints, rubber, surfactants, pharma, agrochemicals, etc.
Around 100,000 tpa of Phenol is being imported in the form of derivatives which go for infrastructure products, epoxy resins, polycarbonates, etc.
Reasons for getting into Phenol:
Import substitution opportunity
The capacity utilisation rate of domestic manufacturers had fallen from 100% in FY 2010-11 to 50% in FY 2015-16.
Domestic capacities stagnated with two sub-optimal plants with around 30,000 - 40,000 tpa, hence the country’s demand was met with imports.
Indian acetone production stood at ~30,000 MT, whereas close to 140,000 MT was imported.
The Indian Phenol market growing at 8%-10%
Saving transportation costs and lower working capital for domestic customers.
Acetone:
Acetone is used in the production of pharmaceuticals, paints, adhesives and thinners, etc. It is used in industries such as the pharma industry, paints and adhesives and other key sectors including Aldol chemicals, Methyl Methacrylate (MMA), etc
Reasons for getting into Phenol & Acetone:
Import substitution opportunity
The domestic capacity of acetone stood at 48,000 MTPA which was incapable of meeting the rising demand
Likewise, Indian acetone production stood at ~30,000 MT, whereas close to 1,40,000 MT was imported.
Before the commencement of the phenol plant, Deepak Nitrite's management mentioned that they will ramp up the capacity utilization to 75% in the first year, 85% in the second year & 95% in the third year. The capacity utilization of 85% in the first year of operations & 100% in the second year.
Running the plant beyond 100% Capacity:
Deepak also commissioned its plant for value-added downstream products with captive raw material consumption to manufacture Isopropyl Alcohol (IPA) from Acetone with a capacity of 30,000 MTPA in the month of April 2020.
Phenolics was a leap of faith project which ended up paying off. Lets talk about the other verticals and the margins Deepak earns in these verticals:- Basic Chemicals, Fine and Speciality and Performance Products.
Basic chemicals:
Basic Chemicals are moderate margin high volume products with heightened price sensitivity, high dependence on sustainable raw material availability and plant utilisation. They enjoy an entry barrier due to the high cost of putting up large scale operations but require very efficient chemical process and logistics management. They are building blocks, each goes into a variety of end applications. Basic chemicals contribute 17.31% to revenue from operations.
Products: Sodium Nitrate, Sodium Nitrite, Nitro Toluidines, Fuel Additives, Nitrosyl Sulphuric Acid
End Application: Colourants, Petrochemicals, Rubber, Agrochemicals, Pharmaceuticals, Water Treatment, Glass Industries, Industrial explosives and Fuel Additives.
Fine & Specialty Chemicals:
Deepak Nitrite manufactures niche and specialised products under its Fine & Speciality Chemicals segment. These are developed in-house, using the Company’s expertise in process engineering and technical know-how.
These products are specially tailored to the client’s specifications and are typically manufactured in lower volumes, but command a higher value.This segment contributes 17.45% to total revenue from operations.
Products: Xylidines, Oximes, Cumidines, Specialty Agrochemicals
End Application: Agrochemicals, Colours, Pigments, Paper, Personal Care, Pharmaceuticals etc.
Performance Products:
The Performance Products segment of the Company has two key products at present: Optical Brightening Agents (OBA) and DASDA. We have talked about this segment earlier and its end usage. This segment contributes 6.93% to revenue from operations. Here Deepak doesn’t have any pricing power as margins keep fluctuating and in some years Deepak has even made losses in this segment.
Overall in all segments, the company has been able to grow. Deepak Nitrite from the very beginning has been frugal and focused on its process efficiency, integration and saving costs in areas like logistics. This gives Deepak an advantage over its margins as even in the Basic Chemicals segment which is fully commoditised it is able to make margins in the range of 30%-34%.
In a nutshell we can conclude:
1. Deepak Nitrite benefits from being diversified and having integrated operations. Eg: Basic chemicals serve as feedstock for Deepak to manufacture Fine and Speciality.
2. The management is aggressive and doesn’t shy away from taking bbig and bold bets like the Phenol capex, which led to Debt to equity spiking to 1.2 times+.
3. Managements DNA is about import substitution as the company was founded on this basis. We shall expect more import substitution projects.
Valuations|Thesis Anti-Thesis
The investor of today makes money on what the company does in the future and not what it has done in the past. One of the key thesis for Deepak Nitrite is that the Indian Chemical Industry continues to do well. It is as much of a top down bet (sectoral) as it is Bottoms up. Looking at the Environmental clearance, it becomes clear that the company has a capex plan of almost 1600 crores.
They have already announced 700 crores of capex for solvents and 300 crores of capex for Life Sciences Products. These solvents, which are primarily used in applications like life sciences, paints and coatings, are seeing a healthy demand CAGR within the country and in target export markets.
In terms of valuations, the company trades at 40times PE and 26times Ev/Ebitda. The business can be looked through 2 viewpoints at the current valuations:
First view point, Deepak Nitrite will go downstream in Phenol and will add higher value added products using phenol. Second viewpoint is, until it goes downstream, The volatility in the phenol spreads will impact the margins.
We believe the truth lies somewhere in the middle, as Deepak will have to do capex for Phenol 2. Given the extremely healthy demand for Phenol and they cannot just vacate the market. At current valuations it seems to be fairly priced, and will keep witnessing healthy growth as the industry continues to do well.
Just before we end, we will explain the power of averaging up. Initial buying Market cap for us in Deepak Nitrite was at 7300 crores, we kept averaging up till 20,000 crore market cap. This reminds us of a famous saying, water your flowers and cut your weeds. Riding the winners and averaging in the companies that are doing well has led to one of the most important learning for us in our journey-
What matters is how much you win, you are right. It's the magnitude of allocation which eventually decides your portfolio returns more than anything else.
What do you think?
Let us know in the comment section below, what do you think about the story and the future of Deepak Nitrite :) We will read them eagerly!