In August last year, Aarti Industries announced a plan to separate its speciality chemicals business (to operate under Aarti Industries Limited – AIL) and its pharma business (Aarti Pharmalabs Limited – APL), with October 20, 2022, as the record date for the demerger. Accordingly, the pharma business (22 per cent of FY22 revenues) will be demerged into APL, and the original speciality chemicals business will continue under AIL.

As of the record date, all shareholders will receive one equity share of APL for every four shares of AIL. The demerger allows the two entities, with different end-markets and capital funding requirements, to streamline and improve their respective operations. The proposed demerger was one of the reasons for the ‘accumulate’ recommendation given in our bl.portfolio edition dated August 21.

Trading at ₹690, the 7 per cent decline recorded by AIL shares versus yesterday is due to the upcoming record date tomorrow; only shareholders who had bought AIL till yesterday can receive APL shares. Theoretically, while shareholders could have expected a 10-15 per cent decline (equal to the value of the new business — APL, being demerged), the actual decline is lower, reflecting investor perception of the benefits of value unlocking from the demerger. The new shares of APL will be listed by mid-December, according to the company.

Aarti Pharma Labs

APL operates in three segments — active pharmaceutical ingredient (API), intermediaries, and manufacture of xanthine derivatives (used in lung conditions). The pharma division operates from four plants, of which two are US FDA-approved, and one received two observations from a recent US FDA audit.

The company is expanding its portfolio of ‘products under development’ on the pharma side. Brownfield expansion at the second facility should add $30 million (around ₹240 crore) at full capacity utilisation in two years, in addition to the third facility’s contribution on clearing FDA audits.

The segment has reported strong growth of 24 per cent CAGR in FY17-22 (FY22 revenue of ₹1,300 crore) compared to the speciality chemical division’s 18 per cent CAGR in the same period (speciality revenues of ₹5,993 crore in FY22). The pharma segment’s EBIT margin shrunk 400 basis points in FY22 to 17 per cent (speciality business reported 17 per cent EBIT margin in FY22) owing to input material cost inflation.

Relative valuation

Going by an average EV/EBIT of 17 times in API-focused peers, Aarti Pharma Labs can expect to be valued at around ₹3,200 crore. This implies that AIL share price should theoretically decline by around 10-15 per cent (depending on debt and cash attributed to APL) today, with tomorrow being the record date. However, the demerger unlocks value for both entities and hence the decline in markets is lower.

Apart from operational considerations, the demerger can result in better valuation multiples for AIL’s speciality chemicals business. AIL (before the merger) traded at 10-15 per cent discount to speciality chemicals peers (33 times one-year forward earnings) despite reporting similar growth rates and business expansion plans. This could be partly attributed to API business contribution and investors’ optimism in the current period towards pure-play speciality chemicals businesses. On the other hand, the high-growing API business could also be valued for its high-growth momentum compared to its API peers when it gets traded as an independent entity.

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