Following a transfer of coverage, we are downgrading Pidilite to Reduce and scaling back our target price to R142 as we factor in a more conservative target multiple in context of weakening demand outlook, factor in headwinds from higher raw material (VAM) prices mainly due to a depreciating INR, and highlight increased uncertainty around the prospects of its elastomer project.
Our detailed analysis on the elastomer project (R5 billion of planned investment, of which R3.4 billion or 23% of the total capital employed has already been invested) indicates that it will be difficult for the project ROCE (return on capital employed) to exceed the group cost of capital even in the next three years.
Our detailed analysis of this project, which will be majorly reliant on exports, indicates that global demand for polycholoroprene elastomer has been adversely affected by an increasing trend of substitution in the automotive and adhesive sectors by cheaper elastomers.
After Pidilite?s outperformance this year (outperformed Sensex by about 25% and midcap index by 27% year-to-date), its valuation at 20.5x (times) one-year forward P/E (price-to-earnings) multiple implies a 68% premium to the Sensex, which is the highest level in the past eight years. Our TP (target price) of R142 is based on a one-year forward P/E multiple of 17.5x, in line with its three-year average.
We flag Asian Paints, which has a similar end-market profile, as a more compelling buy at this point for investors and believe that its current valuation premium is justified given its stronger growth profile.
Our detailed analysis of the elastomer project (R5 billion+investment, of which R3.4 billion or 23% of the total capital employed has already been invested) indicates that it will be difficult for the project ROCE to exceed the group cost of capital even in the next three years. This is likely in our view, especially considering that the end market primarily exports to the auto component industry globally, where the outlook has moderated significantly and the global demand has been decreasing in the past few years.
The project has already been delayed once from March 2010 to FY13 because of the economic crisis. The company planned to commission the first phase of the 20,000 tpa (final capacity 35,000 tpa?tonnes per annum) unit by the H1FY13, but we believe that there is a possibility of a further delay given the macro backdrop. Even assuming that the plant starts, we believe that it will largely be reliant on exports and the company will at best be a marginal player (with about 4.5% capacity share in the global market) in a product where global supply is significantly higher than consumption. As per the Q2FY12 management conference call, the company has sought external advice in the form of an international consultant to re-assess the prospects of this project.
Our sensitivity analysis indicates significant downside risks in this project, especially if the price of elastomer falls below R4.5/kg (currently it is close to $5-5.5/kg). We believe that there is downside risk to elastomer prices, given the moderating global economic prospects and considering the fact that the current supply exceeds demand. While our discussion with the management indicates that there is limited technology risk at this point as some grades of elastomer have been made at the pilot plant, our concerns are more around the demand and prices on the end product at this point.
As per management, Pidilite?s plant in Dahej, Gujarat, is expected to manufacture a specific variety of elastomer called polycholoroprene (CR), but demand for this has been moderating globally. Polycholoroprene rubber or chloroprene rubber (CR) is noted primarily for its high resilience and very strong resistance to ozone, flame and weathering. It also possesses high strength and offers good resistance to abrasion, oxidants, oil and aging. Among its drawbacks are fair dielectric properties, mediocre resistance to low temperatures and a high price relative to competing elastomers.
CR is primarily used in industrial and automotive rubber goods such as hoses and belts, waterborne adhesives and dipped goods, such as gloves as well as in footwear. Apart from the traditional rubber applications, an extensive range of special lattices and adhesive raw materials based on chloroprene rubber can also be produced. This is a premium application with higher margins than the other CR businesses.
Global demand for CR has been muted in recent years. This is due to its relatively high price and increasing substitution from competing elastomers. This trend has been most notable in the automotive sector, which represents more than a quarter of the global consumption. As engine temperatures increases, the need for thermoplastic or elastomers with higher
heat resistance increases. Even in adhesive, which is the second-biggest segment, there has been a general trend towards growth of water-based formulations at the expense of solvent-based products. Over the past few years, consumption has increased in China
but has declined in North America, Western Europe and Japan.
?Nomura