Weekly Tactical Pick: Contra call on this chemical pick

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Since late March this year, there has been a strong run for domestic-focused stocks on the back of steady consumption and investment trends in India. However, valuations in most of these pockets are full or ahead of long-term averages.

On the other hand, export-focused sectors have been facing challenges related to weak demand, inventory de-stocking and, in recent times, dumping by China. These headwinds have been around for a while and have led to a significant time and price corrections, leading to the emergence of value. In this context, we recommend leading chemical company SRF (CMP: Rs 2,162; Market cap: Rs 64,069 crore; Nifty level: 19,659) as our weekly tactical pick.

Like most of the chemical companies, SRF also had a weak sequential show in Q1 FY24, primarily due to dumping from China in the fluorochemicals space. As per our estimates, this segment accounts for 15-20 percent of total sales. While this weakness could persist for the next couple of quarters, there are several factors that make us constructive.

First, new demand-side factors are emerging for refrigerant gases which include the mandatory installation of AC systems in truck cabins in India.

Second, key projects such as PTFE (Polytetrafluoroethylene) would be commissioned by the middle of FY24 and pave the way for opportunities in high-margin fluoropolymers.

Third, specialty chemicals, which constitute 30-35 percent of sales. are less of a drag and largely deal with contracted agrochemicals. In fact, on a year-on-year (YoY) basis, this segment has grown, though margins have dipped due to de-stocking at the distributors level and raw material price changes. The company continues to engage with global innovators for downstream products/new active ingredients

In a medium- to long-term basis, the chemicals business is expected to remain the key growth driver. It contributes 77 percent at the EBIT (earnings before interest and tax) level to the company and a large part of investments continues to be in this segment.

To provide a context, projects worth about Rs 3,200 crore are expected to get capitalised in FY24. They include Rs 1,100 crore capex for fluorochemicals and Rs 1,400 crore for specialty chemicals.

Additionally, the packaging business is showing signs of bottoming out, though the recovery would be gradual, given the supply overhang. However, diversification  into the aluminium foil project would help stabilise revenue profile in times to come.

In technical textiles, the medium-term expectations for belting fabrics remain steady due to the ongoing infrastructure spend and the growth commentary for end markets — coal, steel, and power.

Overall, non-chemical businesses are on the mend and the chemical business is expected to bottom out in 1-2 quarters.

We believe in cyclical lows; one should pick sector leaders that are better placed to counter headwinds. Further, as the company deals with innovators in the fluorochemicals value chain, it is more resilient compared to its commodity chemical peers.

The stock is reasonably priced (16x EV/EBITDA for FY25e) given the growth potential, aggressive investments, and yet supportive balance sheet.

Hence, the recent correction and the technicals provide an opportunity for a tactical pullback in our opinion.