Asignificant hike in iron prices, demand for graphite electrodes, and encouraging results forms the basis of the investment argument for HEG Ltd.

Business

HEG, primarily involved in the manufacturing of graphite electrodes, could be one of the beneficiaries from the significant hike in the iron ore price globally. This could see an augment in the use of steel and iron scrap as a raw material in the production of steel instead of iron ore.

HEG had enhanced the graphite electrode production capacity from 52,000 MT to 60,000 MT in the December 2008 quarter, which has come at the right time. And would further expand the capacity to 64,000 MT by FY08-09. It is also equipped with a 38-MW captive power plant at Mandideep near Bhopal, which constitutes the majority of the production cost and supplies more than 90% of the power requirement. Other than this, it also produces steel billets.

Rationale and drivers

Graphite electrodes are used to melt steel and iron scrap in the electric arc furnace (ERC) to make steel. The companies, which procure iron ore from the market, could see a shrink in their margins, due to a significant hike in the iron ore price. To improve the margins, over a period of time one could see a higher percentage in the use of steel scraps in the domestic market, currently on a lower side as compared to the rich iron ore reserves in the country.

On the other hand, global steel companies use more scrap material than iron ore, whereas HEG’s majority of the revenues are exported. One must note here that graphite electrodes constitute a very small fraction of the overall steel manufacturing cost; the rise in the price of electrodes doesn’t affect steel manufacturers.

According to the estimates, global demand for graphite electrodes is set to increase from about 1.02 million tonne in 2001 to 1.34 million tonne in 2010. With high-entry barriers and no significant capacities being added globally, established players should stand to benefit. The demand for graphite electrodes comes from the US, South America, Europe, Japan, and China.

HEG saw an increase in the net realisation in the electrode business inspite of an increase in the price of the needle coke, a critical raw material used in manufacturing graphite electrodes. Needle coke price are directly linked with crude oil prices, which is consistently increasing in the international market. The company has also seen a steady increase in the volumes due to higher demand of graphite electrodes globally.

Financials

The company generates revenues from graphite being the maximum contributor, followed by the steel and power segments with a small share. In the December 2007 quarter Rs 229.9 crore was contributed by graphite, steel is Rs 35 crore, and power at Rs 26.8 crore respectively.

HEG has delivered a very good result, showing a net profit growth of 150% from Rs 44 crore to Rs 110.34 crore for the nine months ended 2007. The net profit margins (NPM) have doubled from 7.21% in the corresponding nine-month period to 14.43%.

In the December quarter alone the NPM has grown from 8.78% to 15.32%. The sales and net profit for the FY06-07 was Rs 817.87 crore and Rs 73.84 crore. Improving realisations, higher capacity utilisation, and expansion in operating margins have helped this growth. Going forward, analysts expect the margins to remain stable at these levels given the focus of improving the cost efficiencies. The power generation would lead to considerable cost savings and would add to the bottomline.

Valuations and concerns

From the valuation perspective, the company’s fully diluted annualised earning per share is Rs 33.81. At the current market price, the price to earning multiple to 8.67 times is lower than Graphite India (12.64) in the peer group.

The company’s ability to secure raw material is critical. It may or may or not be able to pass on higher input costs to its clients due to the significant hike in critical raw material. This is one of the concerns.