Aarti Industries Ltd

-Exports to aid growth

Recommendation : Buy

CMP : Rs 557

Target : NA

% Allocation : 5%

Sector : Chemicals

Sensex : 28209

Bloomberg code : ARTO. IN

Reuters Code : ARTI.BO

AT A GLANCE

52 Week High Low :587.00/377.25

Mkt. Cap (Rs. in Crs) :4624

Major Shareholders

Promoters (%) :54.64%

Free Float (%) :45.36%

Leading global Player

Aarti’s specialty chemicals segment is mainly focused on

benzene derivatives and contributes to 82% of sales. Aarti is the

largest producers of benzene derivatives in India and one of the

leading manufacturers globally. Its global market share in various

products is 25-40%.

Low Cost Producer

Apart from the India advantage, Aarti’s continued focus on process development, plant automation/upgradation, and quality

standards made it the lowest-cost producers of benzene

derivatives in the world. Additionally, its capability in converting

its by-products from various processes into commercially viable

products, and more importantly, its capability in balancing the co-

products demand, is the key to its competitive positioning globally

Outlook & Valuation

We Initiate coverage of Aarti Industries Ltd with a BUY rating. Given the

Increasing Capacity ,Increasing Capacity Utilization Low Cost producer,Global

market share and an improving product mix are key positives for the stock. We

expect Aarti to report an EPS growth of 17% for the next 2 years. At the CMP of

INR 557, the stock trades at 13.26x EPS of FY18. Key Risks to our

recommendation include any steep increase in competition from Chinese

companies and any steep decrease in global crude oil prices will adversely

impact the company.

Year(Rs.Cr) Net Sales*

Operating Profit

Pre-tax Profit*

Net Profit*

OPM Margin

PBT Margin

PAT Margin PE (X)

2016 2,779.62 578.20 173.47 268.10 20.80 6.24 9.65 18.29

2017E 3,218.91 660.28 213.99 312.75 20.51 6.65 9.72 15.62

2018E 3,735.53 752.57 250.21 365.70 20.15 6.70 9.79 13.26

29 July 2016

Aarti Industries Ltd (Aarti) 28-07-2016

Multibagger Report

Background: Aarti is one of the leading suppliers to global

manufacturers of dyes, pigments, agrochemicals,

pharmaceuticals and rubber chemical manufacturers. Aarti

has acquired world- class expertise in the development and

manufacture of these chemicals and is amongst the largest

producers of benzene based basic and intermediate

chemicals in India. Aarti is strategically placed to exploit

growth opportunities in the chemical industry with products

available across value chains of benzene, toluene and

ethylene, and nitro toluene. With 16 manufacturing units in

Gujarat and Maharashtra, the company has customers

spread across the globe in 60 countries with a major

presence in USA, Europe, Japan and India.

.

Investment Arguments

Company Profile: Aarti is one of the leading suppliers to global manufacturers of dyes, pigments, agrochemicals, pharmaceuticals and rubber chemical manufacturers. Aarti has acquired world- class expertise in the development and manufacture of these chemicals and is amongst the largest producers of benzene based basic and intermediate chemicals in India. Aarti is strategically placed to exploit growth opportunities in the chemical industry with products available across value chains of benzene, toluene and ethylene, and nitro toluene. With 16 manufacturing units in Gujarat and Maharashtra, the company has customers spread across the globe in 60 countries with a major presence in USA, Europe, Japan and India. Aarti has aggressive expansion plans not only in its specialty chemicals segment, but also in the pharmaceuticals and the personal care space. Evolution of Aarti

Business Model

Leading global player of benzene derivatives Its specialty chemicals segment is mainly focused on benzene derivatives and contributes to 82% of sales. Aarti is the largest producers of benzene derivatives in India and one of the leading manufacturers globally. Its global market share in various products is 25-40%.

Agro chemicals are the leading end‐ user industry for benzene derivatives (30% share of specialty chemicals sales) followed by polymers (27%), pigments (19%), and dyes (5%). Incidentally, India is among the top-four producers of agro chemicals (after China, USA, and Japan) and second-largest producer of dyes and pigments in the world. Aarti has leveraged locational cost advantage and has emerged a global-scale manufacturer of benzene derivatives. Low Cost Producer Apart from the India advantage, Aarti’s continued focus on process development, plant automation/upgradation, and quality standards made it the lowest-cost producers of benzene derivatives in the world. Additionally, its capability in converting its by-products from various processes into commercially viable products, and more importantly, its capability in balancing the co-products demand, is the key to its competitive positioning globally. As a result, Aarti has built a strong base of marquee clients across end-user industries including in polymer and additives, dyes and pigments, agro intermediates, and fertilizers.

High margin products - Growth Driver In an effort to balance co‐ products demand and move up the value chain for better margin downstream products, Aarti expanded its chemistry skills to a global scale for processes starting from chlorination (3rd largest globally), nitration (4th in the world), ammonolysis (2nd globally), to hydrogenation (2nd largest) and fluoro-compounding (only player in India). While chlorination/nitration is the primary process, with limited value addition (in benzene), others are premium processes.

According to the management, the revenue contribution of chlorination/nitration based products and by-products contributed 60% to Aarti’s specialty chemicals operation. With increasing focus on downstream products, the revenue mix is likely to improve towards more value-added products that will lead to value growth for Aarti. China Slowdown – Key beneficiary Aarti is already established as one of the lowest-cost manufacturers of benzene derivatives globally, which can be evidenced from the fact that 10% of its exports are towards China – the lowest cost base of the world. Aarti is well set to make the most of the opportunity of a slowdown in Chinese exports (led by plant shut downs due to a stricter environment policy from 1st January 2015) and rising manufacturing cost (led by enhanced compliance requirements leading to additional

investments into Effluent Treatment Plant (ETP)). Additionally, its on-going and timely capacity expansion will help it to use the enhanced export opportunity. Toluene derivatives and ethylene product-line add new growth drivers After a successful global-scale benzene derivative chain, Aarti diversified into toluene chain of products (nitro-toluene and derivatives) by setting up a green field facility with an investment of around Rs 1.3bn. The project is expected to commercialise early FY17. Aarti expects to leverage its well established clientele for benzene derivatives to promote its toluene derivatives, as the end-user industries are the same (i.e., optical brighteners, agrochemicals, pigments, and pharmaceuticals). Simultaneously, it has set up an ethylation unit by adopting Swiss technology at the Dahej SEZ, which will receive input material from its toluene plant. Aarti will be the first company ever to procure ethylene by a pipeline and operate a greener ethylation process. It plans to introduce gradually a range of ethylene-based chemicals catering to end-user applications of agrochemicals, engineering polymers, pigments, and additives.

Import substitution – Strategy behind Toulene Project The toluene chain is a more competitive market globally with many big names, led by Lanxess (Germany). Deepak Nitrite is a leading domestic player. Aarti initially strategically targets the domestic market (which imports nitro-toluene and its derivatives – worth ~US$ 22mn per year) and to tap the export market with more downstream products gradually. We expect a gradual pick up in Aarti’s toluene operation with ~30%/50% utilisation in FY17/18 as it has to build a clientele. However, Aarti plans to fill the unutilised toluene plant with benzene products initially. Strong Asset Turnover Aarti has been very successful in executing its capacity expansion projects, as its capex of about Rs 12bn over the last five years added incremental revenue of Rs 41bn (implying an asset turnover of ~3.6x). However, on its overall assets, Aarti maintained asset turnover of ~2x.

The ongoing capex projects (including the toluene project) worth ~Rs 3.5bn over FY16‐ 17 would ensure sustained growth in the near future. Apart from this, Aarti is also in the process of setting up a multi-purpose specialty-chemicals complex at Jhagadia to manufacture a range of high-end polymers and engineering plastics that are used in the automobile industry. This project will add value growth from FY18. Major Capex Projects

Demerger -Value Unlocker Aarti has two operations that are non-core to its specialty chemicals operation - One is active-ingredient manufacturing for pharma players and the other is surfactant manufacturing for home and personal care players – both are relatively low-efficient and low-profitable operations. To focus more on value-added specialty chemicals, Aarti is likely to de-merge these businesses in FY17, which will unlock value for the company. Global Chemical Industry

The global chemical industry, estimated at US$ 3.9tn in 2013, is expected to grow to US$ 4.7tn by 2018 and to nearly double by 2030, growing at a CAGR of 3-4%. Bulk chemicals form the largest segment (~40%), followed by specialty chemicals (23%). Rising population and increasing disposable incomes are creating demand for improved urban infrastructure, personal mobility and consumer products in emerging economies, in turn creating growth opportunities for chemical and petrochemical products. Asia is expected to be the key driver of growth in the next decade, forming 60% of the incremental demand by 2030. China, which accounts for 33% of global chemical manufacturing, is rapidly emerging as a key chemical consumer market.

Asia emerging as a hub for global chemical manufacturing Historically, North American, Western European and Japanese firms have dominated the chemicals business. However, with trade liberalisation, the spread of process technology, breakdown of numerous economic barriers, rapid growth of newly industrialised Asian economies and rising standards of living in many developing countries, the centre of gravity of the global chemical industry is shifting toward the Middle East and Asia, where cheap petrochemical feedstock, low labour costs and higher economic growth is driving the industry. Over the last 10-12 years, the share of Asia (ex-Japan) in global chemical sales has increased from 23% (2003) to 53% (2013) and this is expected to increase further to 67-70% in the next decade.

By 2030, it is expected that out of the top 10 chemical companies, at least 5 would be Asian. North American, European and Japanese specialty chemical producers are increasingly looking to developing regions for growth as the key automobile and consumer electronics/instrumentation players shift their manufacturing and R&D base to Asia. Many global chemical companies have already established manufacturing facilities in Asia. This has spurred demand for Chinese and Indian specialty chemical manufacturers as they in turn supply key intermediates to the global chemical giants (such as BASF & DOW). China’s low-cost advantage waning The concept of China as a low-cost producer is gradually waning, as labour and environment costs rise. In addition, China is shifting from an export focus to meeting growing domestic needs for higher-value, downstream products – opening up opportunities for Indian companies in exports. India is currently the third largest chemical manufacturer in Asia, after China and Japan.

Another key trend evident in the industry is heightened concerns around climate change and environment protection, which add to the manufacturing costs. As a result, several global chemical players outsourced the production of intermediates to China, where environmental norms were relatively lax until last year, when the Chinese leadership cracked down on the same. Stronger regulation resulted in a drop in plant utilisation in China, shifting demand to India. India was ahead of the curve, having implemented stronger environmental norms three years ago. Thus, with most of the capex related to environmental norms behind them, Indian players are well prepared to cater to the demand shift. Indian Chemical Industry

India’s chemical industry sales stood at ~US$ 144bn in 2014 – the 6th largest globally in value terms and forming close to 3% of global chemical sales. In volume terms, India’s chemical industry is the 3rd largest in Asia and 12th largest globally. The industry contributed close to 2.5% to domestic GDP and 13% of total Indian exports in FY14. With over 70,000-80,000 products, the industry caters to downstream verticals such as construction, water treatment, auto, textiles and pharmaceuticals.

Bulk chemicals form the largest sub-segment with ~40% market share, followed by specialty chemicals and agrochemicals at ~20% each. Close to 50% of the chemical output comes from the states of Maharashtra, Gujarat and Uttar Pradesh.

Profit & Loss (Consolidated) Market

Balance Sheet(Consolidated)

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