Deepak Nitrite: Can the Bull Run Sustain?
About:
Deepak Nitrite is an Indian chemical company. It is an expert at demonstrating how value can be extracted from commodity chemicals and how it can be added through specialty chemicals.
Deepak Nitrite is the domestic leader (market share over 70%) for much of their product portfolio and has based its product strategy on ‘import substitution’.
The company’s business segments can be broken down into (on a consolidated basis):
Basic Chemicals – 21.9% Revenue Contribution
- This segment is characterized by the commodity nature of its products. Sales from this segment tend to be high volume with low-moderate margins.
- Pricing power is poor and to a large extent depends on the underlying raw material prices.
- Moderate entry barriers due to high initial capital outlay.
- The lowest cost producer dominates the market.
- Key Products of Deepak Nitrite,
- Sodium Nitrite / Sodium Nitrate (80% Domestic Market Share)
- Fuel Additives (75% Domestic Market Share)
- Nitro Toluidine (50% Domestic market Share)
- Nitrosyl Sulphuric Acid
- End User Industries – Colorants, Petrochemicals, Rubber
Fine & Specialty Chemicals – 13.63% Revenue Contribution
- High value intermediates that address the direct needs of the customer.
- Low-Moderate Volume with High Margins.
- Client stickiness is a lot higher and contracts tend to be longer.
- Key Product Portfolio of Deepak Nitrite,
- Xylidines (Amongst the Top 3 Global Producers, Domestic Market Leader)
- Oximes (Amongst the Top 3 Global Producers, Domestic Market Leader)
- Cumidines (Domestic Market Leader)
- Specialty Agrochemicals
- End User Industries – Agrochemicals, Pharmaceuticals, Personal Care, Colors & Pigments
Performance Products – 17.87% Revenue Contribution
- Encompasses special ‘optical brightening agents (OBA)’ that are used by the Paper, Textile, and Detergent industries (OBAs impart the ‘whitening effect’). The company offers OBA formulations in either liquid / solid / powder forms as per the exact needs of the customer. The value of the OBA is tied directly to the characteristic it is expected to provide.
- Entry barriers tend to be high due to the need for international certifications and customer approval.
- The company has two main products in this segment,
- DASDA – Diamino Stilbene Disulfonic Acid
- OBA (75% Domestic Market Share)
- This segment is fully backward integrated right from the feedstock (Toluene) to the intermediate (DASDA) and finally to the end product (OBA). Deepak Nitrite’s manufacturing facility for OBA and DASDA is amongst the largest in the world.
- The previous year saw abnormally high DASDA prices and realizations due to a major shutdown in China causing supply constraints (margins crossed 45%!).
- The recent Covid-19 pandemic has hit the end user industries incredibly hard and demand has been poor. This has led to a situation of oversupply. Going forward, the margins for the segment should move towards normalized margins of 15-20%.
Phenolics – 46.6% Revenue Contribution
(Setup through a wholly owned subsidiary – Deepak Phenolics Limited – DPL)
- This segment primarily manufactures Phenol, Acetone, and Iso Propyl Alcohol (IPA) today.
- The core emphasis of this segment is on ‘import substitution’. Earlier, India’s consumption of Phenol and Acetone was met through primarily through imports (over 80%). Sensing the opportunity to manufacture these products locally, Deepak Nitrite set up a massive manufacturing plant capable of producing 200,000 MTPA of Phenol and 1,20,000 MTPA of Acetone (started in 2014, commissioned in 2018). With such a large capacity, the company can address around 70-80% of India’s demand (maybe even more). It has already captured roughly 65% of the domestic market.
- Phenol and Acetone can generally be classified as Bulk Chemicals with commodity type behavior. However, the company also manufactures pharma grade high purity acetone which has much higher and stabler margins.
- The company has undertaken vertical integration to become the lowest cost producer (backward integration) as well as improve realizations by moving towards value-added derivatives (forward integration),
- Backward integration into the key raw material, Cumene, which will be captively consumed (Capacity of 2,60,000 MTPA).
- Forward integration into products like IPA (derivative of Acetone) which offers higher and stabler margins. Today, Deepak Phenolics is expanding IPA capacity from 30,000 MTPA to 60,000 MTPA. It has several other value-added derivatives in the pipeline (Possible candidates – Bisphenol A, MIBK).
- This business has also been aided by anti-dumping duty imposed on countries like Taiwan, South Africa, and USA, where oversupply of these products exists. Furthermore, some capacity in China has been removed and Chinese imports have reduced due to higher domestic consumption in China.
- The segment has also enjoyed ample and steady supply of domestic Benzene (key raw material used to make Cumene) which has allowed them to scale up incredibly fast (currently operating at over 100% capacity utilization). On the flipside, rising Benzene prices can shrink this segments margins drastically.
- End User Industries – Plywood & Laminates, Paints, Pharmaceuticals, Sanitizers, Rubber, Adhesives.
Another subsidiary, Deepak Clean Tech Ltd has been incorporated this year which will focus on developing a new product range using Deepak Nitrite’s core chemistries and Deepak Phenolic’s base product range.
Deepak Nitrite has over 700+ clients belonging to a diverse set of industries. Its client list includes,
Manufacturing and R&D:
- Nandesari (Gujarat)
- Basic Chemicals and Fine & Specialty Chemicals
- Dedicated centralized R&D facility (Over 70 scientists and 35 patents in hand)
- Taloja (Maharashtra)
- Synthetic Organic Chemicals and Fine & Specialty Chemicals
- Roha (Maharashtra)
- Intermediates for Agrochemicals, dyes, and other specialty chemicals
- Hyderabad (Telangana)
- DASDA and other OBA Intermediates
- Dahej (Gujarat)
- Deepak Nitrite – Basic Chemicals and Performance Chemicals
- Deepak Phenolics – Phenol, Acetone, IPA
Competitive Advantages and Economic Moats enjoyed by Deepak Nitrite (Consolidated Basis):
Unparalleled and Clear Focus on each Segment
The business segments that we see today were formulated in the year 2012 as a strategic decision to drive growth independently in each segment. This clean and precise segmentation has worked wonderfully for the company with each segment capable of driving growth and covering for other segments in bad years. In recent times, the Phenolics segment has been a lifesaver for the company, filling in for the Bulk Chemicals and Performance Products which have been facing headwinds.
Economies of Scale and Low-Cost Producer
Deepak Nitrite’s Basic Chemicals and Phenolics segments tend to be commoditized and hence it is paramount to be a low-cost producer to be successful. In both these segments the company drives massive volumes, evident from their large market share in these products. The Phenolics segment has been operating consistently at 100% capacity.
Vertical Integration
If you observe, the company has been backward and forward integrating into much of their commoditized businesses. The backward integration helps lower costs, cementing their position as a low-cost producer. The forward integration allows for premiumization by moving into value-added derivatives, thereby boosting profits and sales.
The integration also helps reduce the effect of commodity cycles.
Strong Execution and Strategy
Deepak Nitrite’s strategy seems to revolve around identifying suitable products for ‘import substitution’ and then executing them with agility.
The Phenolics project was a massive undertaking for the company. It required large fund raising via bank debt and QIPs. With the amount of time and money that was required, it seems like the management had decided to go all in. The agility and efficiency with which the project was completed and commissioned is admirable and is a testament to the management’s ability.
The company has tied up with leading research institutions such as National Chemical Laboratory (Pune), Institute of Chemical Technology (Mumbai), IIT Bombay and others to bolster their R&D capabilities and expand their knowledge base.
Diversified Customer Profile and Product Profile
The company’s customers belong to a diverse set of industries and hence overall cyclicality is low. The company (on a standalone basis) continues to derive healthy diversification of revenues from its business segments. Historically, Sodium Nitrite, Nitro Toluene, and OBA have been their key products (DASDA was a key product last year due to abnormally high realizations).
Risks Faced by Deepak Nitrite (Consolidated Basis):
Short Lived Boosters to Growth
The Phenolics segment has been aided by a large plant shutdown in the US as well as anti-dumping duty imposed by India. The DASDA manufacturing shutdowns in China led to abnormally high DASDA realizations for the company with margins jumping from -2% in 2017 to 54% in 2020. Going forward, these margins are expected to normalize at around 18-20%.
Hence, while the company has done phenomenally well, its important to be cognizant about the factors that led to it.
Commoditized Business Elements
The company has exposure to commodity cycles through its Basic Chemicals and Phenolics segment. Furthermore, the Performance Chemical segment caters to Paper and Textile industries, both of which are cyclical. Hence, we cannot downplay the cyclicality of the business.
However, Deepak Nitrite enjoys leadership position, economies of scale, and robust vertical integration in its product range.
Raw Material Risk
While the company has adopted formula based pricing, it still requires a few months before it can pass on the raw material price volatility. Hence, raw material price volatility can affect the company especially in their commoditized business segments.
Opportunities:
- Rising disposable incomes and purchasing power should boost demand for the company’s end users.
- Import Substitution.
- De risking of supply chains from China.
- Ability to move into value-added downstream derivatives.
Financials:
The company had taken on significant debt to fund the setting up of the Phenol and Acetone plant. Over the years, the debt has reduced considerably (from well above Book Value D/E of 100% to about 37% today). Although operating cash flows have been largely positive over the past few years, Free Cash Flow (to the firm) has been largely negative due to significant capital expenditure (last year the company finally posted positive FCFF).
Valuation:
Based on my narrative and understanding, Deepak Nitrite has the right growth levers which should allow it to grow its topline consistently. I expect normalized margins (terminal year) of about 15-16% with a Cost of Capital (terminal year) of 9.47%.
My intrinsic value for Deepak Nitrite is INR 615.24 (conservative basis). While the intrinsic value range is between INR 557.74 and INR 723.36!
Conclusion:
Deepak Nitrite has had a stupendous run on the bourses, surging nearly 5 times since March 2020 in line with the rapid improvement of its fundamentals over the past two years. As we have seen, most of these improvements have come via new projects and abnormally high realizations on some products. Going forward, I will keenly continue to track Deepak Nitrite to get a better understanding of the ‘normalized’ and ‘sustainable’ fundamentals of its business.
I feel that Deepak Nitrite will continue to improve fundamentally, but today’s price of INR 1523 does not offer any margin of safety when compared to my intrinsic value!
To read more on Chemical and Pharmaceutical companies head over to my other articles!