After the build-up phase of FY19-21 with subdued revenue and PAT growth of around 3.5 per cent CAGR, Aarti Industries posted strong growth of 40 per cent (topline) and 30 per cent (bottomline) in FY22 (adjusted for one-time gains of ₹650 crore), with top line growth split between volume and price equally. The company has gained from price pass through, volume growth, expansion of pharma products and addition of new long-term contracts in the past year. With expectations of continued momentum in capacity addition to serve new contracts as well as the base business and sustained addition of new products in both segments (speciality and pharma), the company can post similar growth in the medium term as well.

Aarti’s speciality business is a backward integrated producer of benzene and toluene chains of products, with downstream applications in agrochemicals, FMCG, textiles, paints and dyes. The other division of pharmaceuticals operates across API and intermediaries, and accounts for 18 per cent of revenues as on Q1 of FY23. With critical mass gathered in pharma business whose revenue and margin performance are in line with overall company, Aarti aims to demerge its pharma business. Independently operating, the speciality business should gain from China +1 opportunities while the pharma business can address fast growing domestic supply opportunities.

We recommend investors accumulate Aarti Industries on dips due to broader market volatility. The stock is trading at a valuation of 33 times FY23 earnings. While it is not expensive in the speciality chemicals space, it is not too cheap either. The higher capex driven growth is common denominator in the industry along with associated risks of execution, but the higher degree of revenue visibility with long term contracts should add an incremental comfort to Aarti’s stock.

Capital additions

Of the ₹4,500 crore capital addition the company has envisaged adding by FY24, Aarti has implemented ₹1,500 crore by FY22 end. Long-term contract- 1 and 2 have been commercialised in the speciality chemicals space in the last year. A typical contract, for instance, the contract 2, involves a product supply worth $1.5 billion (₹12,000 crore) spread over 20 years. The development costs, agreed between the customer and the company, influences the pass-through margins. An EBITDA margin of 12-14 per cent for projects primarily financed by customer or 30 per cent for projects financed by the company can be expected.

For the specific contract 2, the company can expect ₹500 crore per year at full utilisation (1-2 years after commercialisation) and 12-14 per cent EBITDA margins. Facilities for contract 3 are under construction and are expected to start commercialisation from FY24 onwards and 30-35 per cent EBITDA margin on full utilisation. The contracts can safeguard company interests with longer term visibility. Aarti had an earlier long-term contract cancelled, but the contract conditions allowed the company to recoup the cost (₹650 crore in Q3FY22) along with the right to utilise the facility (expects to generate ₹400 crore in two-three years). Alongside long-term facilities, capacity expansion for the base business Nitro chlorobenzene, upgradation of existing product lines, a multipurpose plant, and capacity additions for nitric acid (volatile raw material) are also progressing.

On the pharma side, Aarti has two FDA approved facilities and has commercialised a new facility at the existing second facility. A third facility faced two observations on FDA inspections and can be expected to ramp up contribution on clearance. The company has been investing on R&D side as well with a pipeline portfolio of 40-50 products in each segment, to expand its portfolio.

Longer term margin levers

There will be a longer ramp to margin benefits from the capacity addition in progress currently, but Aarti’s long-term margin expansion can be achieved through various levers. In the short-term, the company has added 10-15 per cent more personnel to man the new facilities, which can be levered only as utilisation levels increase over next two-three years. The current EBITDA margin range of 18-20 per cent is indicative of the commoditised nature of current products, but a higher proportion of value-added products after the expansion phase can support margin expansion as well. Aarti’s contracts, longer term or even in the base business, allow for pass through of commodity costs. In the highly inflationary Q1 of FY23 period, Aarti reported EBITDA margins of 19 per cent, which is similar to last year’s margins, adjusted for one-offs. But in the short-term, without the benefits of higher proportion of value-added products and leverage from high utilisation of new facilities, margin outlook will be weak for FY23.

Financials

Owing to volume growth from new projects and aided by price inflation, FY22 reported revenue/EBITDA/PAT of ₹7,919/1,929/1307 crore (including ₹650 crore contract termination fees) compared to ₹5,023/980/523 crore reported in FY21. On the FY21 base, Aarti provided an aspirational estimate of increasing the revenue, EBITDA and PAT to 1.7-2 times by FY24 and further 3-4 times by FY27. With the new long-term contracts themselves accounting for 0.3-0.4x of FY21 base (on full utilisation), a portion of the growth seems relatively tied down. The remaining addition from base business faces the similar opportunities of China +1 and improving domestic demand for speciality chemicals. The company’s total debt of ₹2,217 crore implies a debt-equity ratio of 0.4x, which is comfortable but not low.

Why
Well established chemicals business
Growth visibility from contractual supplier agreements
High capex and facility addition ongoing
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