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

Fine & Specialty Chemicals – 13.63% Revenue Contribution

Performance Products – 17.87% Revenue Contribution

Phenolics – 46.6% Revenue Contribution

(Setup through a wholly owned subsidiary – Deepak Phenolics Limited – DPL)

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,

Image taken from Deepak Nitrite’s Financial Report

Manufacturing and R&D:

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:

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!

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