Gaining lustre

PENNY WISE/ Hindustan Electro Graphite

Firm product prices and plans to expand capacity are expected to improve HEG's profitability

LNJ Bhilwara Group company, Hindustan Electro Graphite, has seen its share price rise 79 per cent to Rs 113 levels over the past six months.

For HEG, "it is payback time now," says Vikas Shah, analyst at Refco Sify Securities. Shah's year-end price target for the stock is Rs 152, a rise of 37 per cent from its current level.

HEG manufactures graphite electrodes and sponge iron. Graphite electrodes - which constitute three-fourths of its revenues - are used in furnaces to melt metal as they can render high temperatures.

Sales are expected to rise 5 per cent in FY05 from Rs 462.3 crore in FY04 while net profit is expected to dip 20 per cent due to higher expenditure. 

HEG is expected to improve earnings FY06 onwards
(Year ended March, in Rs crore)	FY04	FY05E	FY06E	FY07E
Net sales	462.30	486.90	867.10	1101.60
EBITDA	82.50	75.00	135.20	167.80
OPM (%)	17.90	15.40	15.60	15.20
PAT	51.10	40.40	63.60	92.80
Growth (%)	36.90	-21.00	57.70	45.90
EPS (Rs)	12.70	10.00	15.80	23.00
ROCE (%)	15.90	10.20	16.50	19.40
ROE (%)	19.10	13.70	18.60	22.40
P/E (x)	8.90	11.30	7.15	4.91
P/BV (x)	1.74	1.49	1.37	1.12
Source - Refco Sify Securities

HEG is expected to do better from FY06 onwards as its drive to expand capacity starts delivering.

Besides, the demand for graphite electrodes is moving up with more steel companies choosing the EAF (electric arc furnace) mode for production (electrodes are not used in induction furnace mode, which most steel firms currently employ). Prices of graphite electrodes are, thus, ruling firm.

The drivers
HEG's graphite electrode manufacturing capacity is expected to double to 60,000 metric tonnes per annum (mtpa) by December 2005. This will bring down its production cost per tonne by around 35 basis points to Rs 86,500 per mt.

"The move will enable HEG to profit from the firm prices expected through the next couple of years as well as improve its competitiveness," says Shah.

The share of steel production via the EAF route is expected to increase to about 43 per cent by 2010 from 34 per cent in 2003, mainly driven by the demand from steel manufacturers in Europe and the Middle East. This will drive demand for graphite electrodes.

The demand is expected to grow at about 5 per cent CAGR (compounded annual growth rate) for next five years from 1.11 million mt in 2003 from these two regions.

HEG's realisations touched $2,450 per mt, an increase of 22.5 per cent over the previous year. For FY06 and FY07, realisations are expected to be $2,750 and $3,000 respectively.

The company has increased its sponge iron manufacturing capacity from 60,000 mtpa to 90,000 mtpa which will enhance profitability as prices for sponge iron are expected to remain strong.

Some obstacles
But HEG's profit is set to be hit in FY05 due to a shut-down of plants, high raw material prices, and lower DEPB (duty entitlement pass book) benefits.

The power segment has been affected due to closure of the waste heat recovery plant for 50 days during the quarter. Besides, generation of power at the hydro electric plant was lower than last year due to lower rainfall in the catchment area. Subsequently, revenues from this segment dipped 33.5 per cent to Rs 28.33 crore in FY04.

DEPB rates on exports of graphite electrodes were reduced from 18 per cent to 11 per cent in the Budget last year. This combined with an increase in input costs hit the profitability of the graphite segment.

However, these factors were partly offset by higher realisations. The levy of anti-dumping duty of 7 per cent by the European Union on graphite electrodes exported to Europe also hit the segment's performance (the division's EBITDA (earnings before interest, tax, depreciation and amortisation) fell 15.8 per cent to Rs 23.3 crore).

The prices of calcined petroleum coke (CPC) - the key input for graphite electrodes - rose about 6-8 per cent over the last one year which have hurt margins. However, CPC prices are expected to stabilise through FY06 and FY07.

Raw material costs for the nine months ended December 31 rose 35 per cent to Rs 124.84 crore and increased 650 basis points as a percentage of sales. This impacted operating margins which fell over 370 basis points to 15.8 per cent.

Valuation remains attractive
The stock has risen 25 per cent over the last one year to levels of Rs 113. The company is expected to post an EPS of Rs 10 for FY05, down 20 per cent.

But for FY06 and FY07, we can expect EPS growth of 58 per cent and 45 per cent respectively. The stock trades at P/E multiples of 10, 6.3 and 4.3 for the next three years.