Company Description:

Astec manufactures a wide range of Agrochemical active ingredients and pharmaceutical intermediates. Astec is a leader in Triazole fungicides and has a portfolio of fungicide and herbicide technical products for Indian and global markets. Its emphasis on quality, adherence to global norms on environmental standards and continued focus on R&D has helped it to cement deep relationships with large domestic and global Agrochemical & Pharmaceutical players. The Company has 214 product registrations across 32 countries including 139 product registrations in India.

Astec also offers contract manufacturing services and has long-standing preferred partner relationships with global customers. The Company has 2 multiproduct plants in Mahad, Maharashtra and an R&D site, manufacturing and pilot plant in Dombivli near Mumbai.

Company Description:

• Acquisition by Godrej Agrovet a game changer: N.B Godrej, MD of Godrej Industries, has joined the board in October in Chairman’s capacity. Through Astec’s manufacturing facilities, Godrej Agrovet gets backward integration. Management sees ample synergistic benefits. By leveraging Godrej’s relationships with foreign companies as well as brand name, they are confident of securing in-licensing opportunities. Astec gets access to Godrej’s distribution channels which shall aid revenues as well.
• Scaling up CRAMS key to sustainable revenue growth: Astec has consistently strived to build world class manufacturing facilities by incurring high spends on effluent treatment in order to meet global norms on environment regulations. It had obtained two long term mutually exclusive confidential manufacturing and supply agreement with Nufarm & Sumitomo in 2013. Currently, they are in discussion with a number of partners. Recently, they developed a product for Dow Chemicals.
• Focus on a niche area ‘Triazole Fungicides’ preferable over a multi-crop protection play: Astec claims to have pioneered Triazole fungicides in India, apart from being a leader in this segment in India. Its portfolio consists of foliar and seed treatment of a wide range of crop including paddy, cereals, plantation crops, fruits and vegetables. It’s well entrenched relationship with domestic and global agrochemical majors has led it to being an exclusive supplier of Triazole fungicides to a number of companies.

View: With Godrej Agrovet taking over the company, we believe Astec is at an inflection point. With cumulative capex of 160cr on CRAMS and current revenues being generated at around 110-115cr, this effectively translates into a capacity utilization of below 50%. As per management, Asset turnover on CRAMS would easily be ~2x which would imply a revenue potential of ~320cr. We believe current valuations do not factor in the inherent potential of Astec’s business model.

• Nearly a 100 year old company, Dharamsi was originally a widely known fertilizer producer via its brand SSP with prime expertise in sulphur chemistry. Over the past few years, it has leveraged its extensive know-how in sulphur chemistry to develop downstream products by focusing heavily on R&D. Unfavorable government polices and deteriorating economics in the former subsidized business has prompted it to focus solely on developing a specialty chemicals pipeline. As per the management, the company was forced to continue bearing losses in the fertilizer business as they couldn’t secure a government approval to exit the business. In-spite of delivering high quality products, government favoritism to selected firms forced them to sell at lower prices thus rendering production unviable.
• With nearly zero contribution from fertilizers( doing brand licensing and micro nutrients), top-line is contributed of specialty chemicals(FY11-FY15 Cagr 42%, 62% of topline) and commodity chemicals(FY11-FY15 Cagr 18%, 38% of topline). Ebitda Margins in the specialty business are extremely high around 30%, while that of commodity is lower at 10%. Now there are 2 approaches to specialty chemicals. Either you take a high volume, low value approach where ones portfolio basket consists of a wide range of products(Atul, Aarti Ind). Or you take a high value, low volume approach where ones portfolio basket consists of a smaller array of products(Vinati Organics). Dharamsi sales are driven primarily only by 10-15 products, where its achieved cost leadership globally( Vinati Organics has taken a similar approach). The latter approach is much superior as margins, return ratios, barriers to entry are high as well as it demonstrates one’s niche process capabilities. Going ahead, they plan to focus only on the specialty side of the equation where they expect net margins of minimum 20%. Below that, they are not interested. Have at least 10 products in the pipeline and they recently scaled up their R&D team by hiring talent from UDCT. They desire to be only in extremely niche chemicals and are also looking at Toll manufacturing.
• By having developed a multi-purpose plant, they can sweat multiple products from the same plant as per the clients convenience. If demand picks up, they can easily debottle-neck at low cost. This essentially leads to higher asset turnovers and minimizes capex requirements. Aiming to be 100% effluent free discharge within the next few years. In FY16, they plan to spend 3cr on ethanol and sulphur based plants. Similar investments of 5-10cr will be required in the medium term. The focus is to drive bottomline, rather than topline. Management refused to give any sort of guidance but the sense i got was that sales growth should not be higher than 10-20%( Lower commodity prices as well as euro to impact).

Other points:

• All products backed by in-house R&D. Dont in-license technology.
• Commodity – 95% sold in India, Specialty – 70% exports, Sell in over 25 countries
• Largest market is US. Then Europe.
• Loans on the BS primarily consist of interest free loans provided by the promoter. Going ahead, may start charging interest perhaps from FY16 itself.
• Deferred Tax assets of 27cr on the BS. Not paying any tax as of now, which will change in the future.
• Working on improving the BS. Want to further cut down on debt. Will start distributing dividend once past losses are written off completely.
• On merger with Related party company Borax, if it ever decides to, it said it will first come to shareholders before taking such a step. Transactions are small.

View: Management candidly admitted their past issues faced in the fertilizer business and seem to be genuinely focused on creating a high value specialty chemicals business (sulphur based). The product portfolio which it aspires to have enjoy high Ebitda margins (minimum 18-20%+) as well as return ratios(30%+) (Case in point: Vinati Organics, SRF although their scale is much larger compared to what Dharamsi is sitting on right now). The PE multiple assigned to such a business is higher(18-25x) than the average multiple(12-14x currently) enjoyed by the specialty chemicals space. Once the legacy issues are completely behind the company and the BS undergoes considerable improvement, potential of re-rating and scaling up of the specialty chemicals business over the next 3-4 years is large. Trailing EV/Ebitda & PE both stand at around 9 – 10 times. PAT may not see a large jump in the next few years as the company starts paying higher interest and taxes. Ebitda should grow faster as specialty chemicals grows and new products get commercialized. Structural ongoing change in the company’s business model render current valuations highly attractive.

One interesting observation in the specialty chemicals space. Earlier, most chemical companies in India used to focus on what their peers are doing and aiming to be one step ahead of the other. However, recent trends indicate each player is focusing on the chemistry in which they have deep expertise in and then directing energies only towards that space. Like for Fluorine chemistry, you have SRF, Navin and Gujurat Fluoro which are only focusing on Fluorine downstream products. Dharamsi’s is sulphur based chemistry.

Company Profile

SRF is the market leader in fluorine chemistry, technical textiles, refrigerant gases besides being a preferred supplier of other fluoro chemicals products and polyester films in India. SRF has developed a niche in fluorine chemistry. It has rich experience of 30 years in handling fluorine and over 10 years in core R&D work. It has strong workforce of around 6500 of different nationalities working in 9 manufacturing plants in India, 2 in Thailand and 2 in South Africa, we continue to cater to customers spread over 75 countries.

Investment Rational

Innovation led approach with high focus on IP :

We expect the chemicals business to be the biggest value-creating business for the company. SRF reported 32% revenue growth in FY15 led by 35% growth in the specialty chemicals business. SRF is still at a nascent stage—with 40-50 molecules commercialized against 17,000 molecules already known globally. Therefore, the opportunity for the company is immense. SRF continue to invest aggressively in R&D i.e 10% of speciality chemical revenue FY15 to build capacities in new fluorine molecule.

Changing Product mix to fuel profitability:

The revenue from chemical segment is expected to increase from 28% in FY15 to 35% in FY17 while from Packaging business the contribution is expected to stable 25 – 27 % & Technical Textile is expected to reduce from 45% to 38% which will lead to margin expansion The change in mix shall lead to margin expansion.

Well poised to take advantage of the long term structural opportunity present in specialty chemicals:

Specialty Chemicals revenue has grown at a CAGR of 62% over FY12-15—from INR1,407m to INR5,980m, mainly driven by introduction of new molecules. Currently, SRF mainly caters to the agrochemicals industry and some of its clients are BASF, Syngenta and Bayer Crop Science .SRF’s is the largest beneficiary due to China which was considered as preferred destination for fluorine chemistry has taken a hit over the years due to IPR related issues faced by companies operating there. As a result, India has emerged as the best option from cost and quality perspective. Due to the hazardous nature of fluorine, building capabilities requires a long gestation period, which acts as an entry barrier.

Our view

Over the past five years, SRF has clearly outperformed majority of its Indian peers in capturing the massive opportunity presented by the change in manufacturing base for global innovators from China to India. High emphasis on innovation led R&D has propelled it to command superior specialty chemical Ebitda margins (~30-35%) as a result of its owning IP’s of most of its processes allowing it to sell to multiple clients. After a 50% cagr in specialty chemicals over the last 5 years, we believe it can continue to maintain a high growth cagr (25-30%) over the long term leading to sustained outperformance. High management integrity reaffirms our faith in the company. Although the stock has been a major mover over the last 1 year, we believe there is sufficient headroom for outperformance. Misallocation of capital to packaging is the key risk to our thesis.

Company Profile:

Strides Arcolab is a pharmaceutical company with a key focus on development and manufacture of IP-led niche generics and bio-pharmaceuticals. It is also among the world’s largest manufacturers of specialty soft gelatin capsules. With world-class manufacturing facilities, an innovative R&D hub in Bangalore and a strong commercial platform to market branded and commodity generics globally, Strides has earned a reputation for building and scaling profitable businesses in a short span of time.

Investment Rationale:

Shasun merger to strengthen key business segments – Shasun merger with Strides would bring necessary backward integration benefits in terms of API supplies, leverage strong presence in front ended markets like US and strengthen institutional business. Currently Shasun has two API and one CRAMS facility along with one FD unit; all the four plants are FDA approved which would fill the current need for an FDA approved API facility from Strides perspective. Merger would also facilitate faster DMF filings for APIs related to institutional business (Tenofovir DMF (for HIV and chronic Hepatitis B, Cycloscrine (for treatment of TB). Post Shasun merger, Strides will have a larger formulation basket of 160 products for the US (17 approved, 30 pending, 114 in the pipeline, excl. PEPFAR).

Investment Rationale:

Shasun merger to strengthen key business segments – Shasun merger with Strides would bring necessary backward integration benefits in terms of API supplies, leverage strong presence in front ended markets like US and strengthen institutional business. Currently Shasun has two API and one CRAMS facility along with one FD unit; all the four plants are FDA approved which would fill the current need for an FDA approved API facility from Strides perspective. Merger would also facilitate faster DMF filings for APIs related to institutional business (Tenofovir DMF (for HIV and chronic Hepatitis B, Cycloscrine (for treatment of TB). Post Shasun merger, Strides will have a larger formulation basket of 160 products for the US (17 approved, 30 pending, 114 in the pipeline, excl. PEPFAR).

Australia acquisition – to add scale & profitability – Strides Arcolab has acquired the Australian generic pharma business along with certain branded pharma assets of Johannesburg listed Aspen Pharmacare Holdings for A$380mn. The deal to be funded through mix of debt and internal accruals and would be immediately EPS accretive. Arrow has the second largest generic drug product basket in Australia and third largest share of domestic generic sales. The acquired business had revenues of A$120mn and EBIDTA margin of 31% in FY ended June 2014 which implies margins are much higher than combined entity of Strides + Shasun. Acquisition would provide access to generic molecule pipeline with 51 products under development and current basket of ~150 molecules.

Building branded generics business in Emerging market – Africa accounted for ~73% of emerging market revenues in FY15 while the rest is derived from India. India business is a small pie of the consolidated revenues and company has been a relatively late entrant to the market and does not expect to see aggressive growth rates; India revenues crossed Rs. 100cr mark in FY15. Strides caters to several therapeutic areas like CNS, Diabetes, Cardiovascular, Women’s health and Pain management. Flagship brand ‘ReNerve’ a vitamin B12 supplement in soft gel capsules and injections is among the fastest growing brands in India while ReNerve Plus is the largest brand by value in vitamin B1-B6-B12 category with more than 50% market share. Acquired brand Raricap is among the top 10 in oral Haematinic (nutrients including iron, vitamin B12) category in the domestic market.

US strategy: focus on niche but high margin – In FY15, Strides made six ANDA filings including two FTFs and launched 5 new products in US with Tacrolimus being the largest in market size. In soft gels, Strides expects about US$1bn worth of products going off patents in the next 2-3 years. Company has already filed for these products (mostly in Rx segment with small presence in OTC) and expects itself to be among the first movers in the first wave of generic launches. Both prescription and OTC together constitute ~US$4-4.5bn market with not more than 5-6 players. The combined entity has filed 5 ANDAs with 1 in pipeline in the soft gels segment.

Anti malaria & Hepatitis business to aid growth – Strides supplies Artemether + Lumifantrine tablets and Artemether injection in its anti malarial business. It targets 15- 20% of the market opportunity which is pegged at 25-30cr doses. Strides has also partnered with Gilead Sciences to launch generic Sofosbuvir (Sovaldi) for treatment of Hepatitis C for distribution in 91 countries and in March 2015 it has launched generic Sofosbuvir under brand name Virso. Hep C affects 1.2-1.8cr patients in India, much more than those with HIV hence Hep C sales can create material upsides to longer term revenues.

Our View

Strides has a terrific track record of creating wealth for its shareholders and we find the management as among the best in the Pharma space given their focus on maintaining high corporate governance standards as well as positioning themselves for sustained growth after a spate of acquisitions over the last 12-24 months. While its peers have chosen to focus aggressively on US generics, it’s strived to build a strong presence in growing markets such as Africa, the benefits of which shall accrue in the long run. Currently, high leverage and lower profitability along with subdued return ratios has led it to trade at a significant discount to its peers which should narrow going ahead. We believe Strides transition to an integrated robust scalable business model across key geographies will play out over the next 3-4 years. Key risk remains of inability to successfully integrate acquisitions as well as further capital allocation in pursuing inorganic opportunities.