Company update: SH Kelkar & Company (Outperformer) - Recovery in H2

The flavours and fragrance (F&F) industry has been fraught with challenges caused by disruption in raw material supplies. SHK, a key player in India, too was impacted by global headwinds in FY18 and reported muted 4.5% revenue growth and 107bps decline in EBITDA margin to 15.8%. However, improved demand from FMCG customers, normalisation of raw material situation in 2HFY19E and SHK’s 3x3 strategy make us upbeat on the company’s long-term growth prospects. In FY18, SHK bore the brunt of 1) lower consumer offtake, 2) slower re-stocking post GST (1HFY18), 3) raw material shortage, caused by fire at BASF (key supplier) and 4) several one–offs in 2HFY18. We have cut our earnings estimates by 4.5% to factor in subdued 1HFY19E performance and estimate 13.7% and 23% revenue and PAT CAGR, respectively, over FY18-20E. The stock currently trades at 22x FY19E and 17.2 FY20E EPS. We reiterate Outperformer rating on the stock with a revised target price of Rs253/share (22x FY20E EPS of Rs11.5/sh).

Demand remains buoyant: Improved demand in FMCG in 2HFY18 helped SHK post 18.5% revenue and ~15%+ volume growth in the fragrance business (6.6% revenue growth in FY18). However, the flavours business   de-grew by 8.9% in FY18 due to subdued export performance .We expect SHK to post healthy 12% revenue growth in  FY19E and 13.7% CAGR over FY18-20E supported by buoyant 10.5% growth in the FMCG industry, 16% revenue growth in SHK’s fragrance business and a pick-up in the flavours business from 2HFY19E.

Profitability to normalise 2HFY19E onwards: Unprecedented supply-side disruptions inflated raw material prices, causing SHK’s gross margins to contract 370bps to 42% in 2HFY18; one-time costs (restructuring and acquisitions) further hurt margins. SHK should see profitability normalise 2HFY19E onwards, shored by 1) ameliorating raw material situation, 2) new product launches coupled with price hikes, and 3) capacities coming on stream. We expect margins to improve from 15.8% currently to 17.1% in FY19E and 18.9% in FY20E.

3X3 strategy for long-term growth: SHK has enunciated a 3x3 strategy, wherein the company expects to focus on 3 fast-growing geographies (India, Indonesia and Italy) for F&F and 3 key product lines - Fine Fragrance, Air care and Fabric care. The company has made several acquisitions which we believe will support its strategy and aid long-term growth (15% revenue CAGR and 20-21% EBITDA margins).