IOL Chemicals has delivered some phenomenal performance over the last few years.
Profits of the company increased from Rs 5 Cr in 2017 to Rs 237 Cr in 2019.
Revenues increased from Rs 711 Cr in FY17 to Rs 1685 Cr in FY19.
Total debt has reduced from 447 Cr in Mar-19 to Rs 284 Cr in Mar-19.
On the back of such brilliant performance, the stock is trading at a PE ratio of 2.9. Compare this to the PE ratio of Dmart (113), Gillette (95), 3M India (75) the stock looks very cheap. The stock is screaming from rooftops – “BUY ME”.
Let us investigate a little further.
What does IOL Chemicals do?
IOL is present in the Active Pharma Ingredients (API) and specialty chemicals space. It manufactures products like Ibuprofen which is used for producing pain killers and Metformin Hydrochloride which is used in anti-diabetic treatment. It also produces certain other chemicals like Ethyl Acetate, Acetyl Chloride, mono-chloro acetic acid.
The operating margins of IOL Chemical have dramatically increased from 9% to 31% in the last 3 years. Also, the company which was loss making in 2016 has managed to make profits of Rs 357 Cr in the trailing 12 months ended Sep-19.
Let us find out a little more from the credit rating report of IOL Chemicals dated 2nd Jul-19
90% of the revenue of IOL Chemicals comes from just 2 products – Ibuprofen and Ethyl Acetate.
So, what has been the trend of the selling price of these two chemicals
The selling price of Ibuprofen has increased from Rs 660 in Oct-16 to Rs 1170 in Sep-19 an increase of 77%.
The selling price of Ethyl Acetate went up from Rs 52 per kg in Oct-16 to as high as Rs 82 per kg in Sep-18 and has now settled back to Rs 59 per kg in Sep-19
Clearly, the massive increase in the operating profit margins from 9% in 2016 to 31% in 2019 has been due to significant increase in the selling prices of its two main products – Ibuprofen and Ethyl Acetate which comprise (90%) of the revenues. We can also conclude that the prices of the raw materials used to produce these chemicals have not increased as much as Ibuprofen and Ethyl Acetate given the fact that operating margins have improved so much.
Now let us go back a little more in the past to dig out whether IOL Chemicals can sustain such high operating margins in the future as well.
We don’t have to go too far – Annual Report 2015
Revenue reduced by a whopping 32% in the year ended 2015
IOL Chemicals also suffered losses in the year 2015
IOL Chemicals incurred losses because of a mis-match in input and output prices.
What this really means is that IOL Chemicals was not able to pass on the reduction in end-product prices to the suppliers of its raw material. Clearly, IOL Chemicals does not enjoy “pricing power”. The company has to take whatever price the market is offering for its end-products and also pay whatever price is demanded by its raw material suppliers.
The situation was so bad that IOL Chemicals could not repay its loans and had to enter Corporate Debt Restructuring.
More specifically, the debt restructuring had to be done due to the economics of the Ibuprofen market changing
Can this happen in the future as well?
If for some reason prices of Ibuprofen and/or Ethyl Acetate reduce substantially, will IOL Chemicals be able to control raw material prices and remain a profitable company? Chances are that a reduction in selling prices of Ibuprofen and Ethyl Acetate will be a big shock to IOL Chemicals and at the least its profits will drastically reduce.
To check out the trend in the selling price of Ibuprofen, let us check out what one of the producers & consumers of Ibuprofen has to say about the demand-supply scenario and the price trend of Ibuprofen. Granules India uses the Ibuprofen bulk drug to prepare other formulations.
From the price graph for Ibuprofen mentioned above, we observe that the prices of Ibuprofen started increasing rapidly since around Mar-18.
Let us look at what the management of Granules India said on the investor conference for Q1FY19 dated 24th Jul-18
One of the largest manufacturers of Ibuprofen – BASF has shut down its plant which has created a world-wide shortage of Ibuprofen. This is the reason for the significant increase in the prices of Ibuprofen.
Let us look at what has happened in the last 15 months,
Granules India Ltd – Q2FY20 Conference Call Transcript dated 23rd Oct-19
Several questions were asked about the pricing of Ibuprofen
Multiple times during the conference call, the Chairman & Managing Director of Granules India mentions that he expects the prices of Ibuprofen to reduce over the next several quarters.
He also mentions that there has been doubling of Ibuprofen capacity in India and now we are in a situation of excess/surplus capacity.
So, what is the reason for the stock of IOL Chemicals trading at a PE ration of 2.9?
The market has recognized that the prices of Ibuprofen will come down in the near future and correspondingly the profits of the company will reduce.
After IOL Chemicals had to enter corporate debt restructuring in FY15, the management has done well to improve the business operations. Around 2017, the management realized that environmental norms in China were tightening for chemical industries and hence there are likely to be supply disruptions/shortages in Ibuprofen. The cost of environmental compliance would require the Chinese players to invest in improving effluent treatment thus increasing the cost of production.
IOL Chemicals converted its multi-purpose plant to one which is capable of making just Ibuprofen in FY2017
This resulted in an expansion of Ibuprofen capacity.
The company aggressively expanded Ibuprofen capacity over the next two year to reach 12,000 TPA which is doubling production capacity in just 2 years.
Thus, the rapid rise in revenues of the company can be explained by 2 factors – doubling of production capacity for Ibuprofen and a 77% increase in the selling price of Ibuprofen.
With Ibuprofen prices expected to reduce due to excess production capacity in the industry, the profit margins of IOL Chemicals are sure to come down.
The general investor in this company without any specific knowledge of the chemical industry and the Ibuprofen supply chain in specific, can only take a wild guess as to how much the prices will reduce and where will the profit/loss margins settle at.
Investing in this company may turn out to be like driving in the night with the headlights switched off.
Disclaimer: Please do not consider this article as a stock recommendation. The article is an illustration of the kind of analysis that goes into fundamental research and equity investing. I do not hold the shares of IOL Chemicals.
Please consult your investment advisor before making any investment decisions.
The author (@amey153) is a SEBI registered Investment Advisor.
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