Jefferies turns cautious on chemicals sector on steep valuations, demand headwinds

Brokerage firm Jefferies has expressed a cautious outlook on the chemicals sector's steep growth expectations, which saw cut in the consensus FY24 earnings estimate, despite a strong third-quarter performance.

According to the brokerage, some players have indicated possible headwinds obstructing the growth outlook in the near to medium term.

Navin Fluorine International Ltd (NFIL) “alluded to possible demand headwinds in 2HCY23 in new generation refrigerant gas (HFO) from a possible US recession and in speciality chemicals from elevated channel inventories in Brazil,” it said.

Aarti Industries sees weakness in the automotive and textile sector potentially lasting 2-3 quarters affecting volume outlook. Meanwhile, Gujarat Fluorochemicals expects demand to remain at current levels in the near term.

SRF Ltd, on the other hand, remains unaffected by higher channel inventories and expects robust growth in the speciality chemicals segment in the first half of this calendar year.

Margin outlook

Despite concerns regarding demand growth, companies’ margin outlooks are better.

NFIL expects a sequential improvement in margins from near-life highs in the fourth quarter. Over the medium term, it expects margins to head higher as new contracts with better margin profile increase their contribution in revenues. While SRF said the life-high chemical segment margin could sustain in the near term with Q4 likely to see sequential improvement, as per the brokerage.

Specialty chemical revenues in Q3 were in line with expectations, with EBITDA margins improving quarter on quarter due to strong pricing despite falling raw material costs. Ref-gas revenue growth exceeded estimates, with high margins and new contracts leading to better margin profiles. However, the brokerage highlights that the planned phase-down of Ref-gas consumption in the US and the EU's proposed ban on PFAS could impact margins. Lower export demand could normalize Ref-gas margins, it said.

While the brokerage raised estimates for NFIL on better-than-expected HFO performance with a stronger margin outlook and SRF's on stronger Ref-gas pricing, it has maintained a hold rating on both with price targets (PT) of Rs 4,235 and Rs 2,450, respectively.

“Despite the strong showing in Q3, consensus FY24E earnings estimates for NFIL and SRF have seen cuts indicating stretched growth expectations. Valuations prevail at premiums to the five-year average possibly on optimistic earnings estimates. We would consider becoming more constructive were valuations to turn more reasonable – maintain Hold on NFIL and SRF with PT Rs 4,235 and Rs 2,450, respectively. ANURAS stock has corrected on concerns of high inventory days that it is addressing over 2HFY23-24. We see the current valuation of 25x forward PE as attractive vis-a-vis 35x LT average in light of our projected 32 percent EPS CAGR over FY23-25E. Maintain Buy with PT Rs 905.” Jefferies said.