Not worried about capacity addition in chemicals, FDA red flags in pharma: Kenneth Andrade

Andrade feels India’s chemical sector could soon be in a position of strength

Shares of chemicals companies have been under pressure of late on concerns of pricing pressure and the slowdown in the US and Europe, but the story of the chemical is far from over. That’s the view coming from Kenneth Andrade, founder and Chief Investment Officer of Old Bridge Capital Management.

“China is back in the market, and you had prices across all chemicals collapse, which has also led to a moderation in stock valuations,” Andrade said in an interview with Moneycontrol.

“Going ahead, this will lead Indian companies to invest in processes, in becoming more competitive, and developing strong customer franchises. So you pick the survivors in the downcycle and run with them,” he said, adding that the downtrend has not played out fully.

Full Interview: Old Bridge’s Kenneth Andrade takes a contrarian bet on IT services, pharma

Recently some broking firms have also cautioned about increasing competitive intensity in the sector because of the race by companies to add capacity. The traditional view among investors and analysts tracking the sector is that rapid capacity addition is usually followed by a drop in product prices and thereby lower stock valuations.

Andrade agrees that peak profitability may be behind, and that competition is expected to increase. And yet, there could be an opportunity for Indian chemical companies because of the changed priorities for governments and corporates post-pandemic.

“Chemical companies have tasted success, and that success has led to new capacities, with the new capacities, you have China getting back into the game and dumping its surplus into the world markets. It might just be an adjustment phase for (Indian) chemical companies in two things-build scales in a way that helps lower the cost of manufacturing (and hence the products), and use the lower costs to expand your client base and enter into long-term contracts and become the go-to market for clients,” he said.

Andrade feels India’s chemical sector could soon be in a position of strength that the steel industry is in—become the lowest-cost producer.

“There is nothing such as country + 1. There is no such thing as China + 1, there is either China or there is no China. You can see that in the effect on prices when they decide to come back with a vengeance,” adding that Indian companies will need to compete on the scale if they are to hold their own against competition from China.

Return of pharma

Pharma shares have been among the laggards in the market, with the NSE Pharma index returning 3 percent over the last year compared to a 12 percent gain in the Nifty. A key reason for the underperformance has been continued price pressure in the US generics market. Andrade feels that structurally and operationally, things are beginning to turn around for the factor.

“If you look at the financial metrics, Indian pharma companies are solvent, they have cash and are willing to invest in capacity and to invest in growing market share. On the other hand, pharma companies in the West have too much debt, that debt is expensive, and these companies are now vacating some of their strongholds giving an opportunity to Indian companies,” he said.

And he is unfazed by the string of observations that many pharma companies have received from the US FDA, highlighting the fact that Indian companies had a 60-65 percent market share by volumes and 30 percent by value in the US generics market.

“More the number of plants we have, the more scrutiny you will attract. If the number of plants being shut down in India rises, so will prices of medicines in the US, and that will create a problem for the US as well,” he said, adding that US generic exports to the US were at a record high last quarter despite the regulatory setbacks.

Andrade is betting that Indian companies will improve their manufacturing processes over time.

“You can’t wish the FDA away, they will ensure that the standards of production are met, and over time you will see Indian companies improving their manufacturing processes,” he said.

Bullish IT, neutral banks

IT is another laggard where the market may have gotten too pessimistic, feels Andrade. The NSE IT Index is down 5 percent over the last year on concerns of a slowdown in discretionary tech spending by US and European companies.

Andrade’s bet is that persistent wage inflation in the US will turn out to the advantage of Indian IT companies, the stocks of which are now factoring slowing growth rates.

“You have companies that are cash flow positive, have cash on the balance sheet and are now available at attractive valuations. Of course, there are debates about AI and India losing IT jobs, but at its core, Indian IT is a pure play on wage inflation,” he said.

“Roughly, the cost of a mid-level executive in India and a fresher in the US is the same. What we are doing is importing US wage inflation. Growth will be softer this year, but from the earnings commentary, it is clear there is no major risk to the industry,” he said.

Andrade is not so upbeat on banks because companies are flush with funds and are financing capital expenditure through internal accrual. The good news for banks is that there is little corporate risk on their balance sheets because of the sound health of their borrowers. At the same time, growth will be a challenge.

Chief Economic Advisor V Anantha Nageswaran made the same point in an interview with CNBC-TV18 last week. This comes at a time when the cost of funds to has risen for banks, squeezing their net interest margins.

“A large part of the business is now centered around SMEs and SMEs are in a good financial position. Their growth has been decent, and they have opportunities, but access to capital has been limited. So banks are looking at this segment as an opportunity,” he said.

Big picture

Andrade sees equities in India facing stiff competition from other asset classes like gold and real estate. But he is hopeful of the stock market doing well in 2023 and even 2024.

“Equities are not cheap, but they are not terribly expensive at about 20 times forward earnings. A lot of these earnings are now transitioning into cash flows,” he said.

Andrade is betting that inflation in most parts of the world will stay high in the foreseeable future even if the pace slows down.

“If the overall trend is inflationary, which I feel it will be, India is the best market to be in and our corporates have the best balance sheets to capture that. And if our companies can capture market share globally, then we will be completely home,” he said.

Read the full interview here: