Result Update Rating matrix Rating : Hold Target : 160 Target Period : 12 months Potential Upside : -3% What s Changed? Target Changed from 150 to 160 EPS FY17E Changed from 1.0 to 1.5 EPS FY18E Changed from 8.0 to 9.6 Rating Changed from Sell to Hold Quarterly Performance Q2FY17 Q2FY16 YoY (%) Q1FY17 QoQ (%) Revenue 190.1 249.0 (23.7) 163.2 16.5 EBITDA 18.7 59.7 (68.7) 3.1 502.3 EBITDA Margin (%) 9.8 24.0-1415 bps 1.9 792 bps PAT (13.5) 20.2 PL (29.0) (53.5) Key Financials ( Crore) FY15 FY16E FY17E FY18E Net Sales 1240.5 827.5 985.2 1102.8 EBITDA 196.0 124.5 128.0 176.1 Adjusted Net Profit 61.1-15.2 5.9 38.5 Adj EPS ( ) 15.3-3.8 1.5 9.6 Valuation summary FY15 FY16E FY17E FY18E PE (x) 10.8 NA 112.3 17.1 Target PE (x) 10.4 NA 108.8 16.6 EV/EBITDA (x) 7.6 10.3 10.0 7.2 P/BV (x) 0.7 0.7 0.7 0.7 RoE (%) 4.1-1.6 0.6 4.1 RoCE (%) 6.8 2.9 3.2 6.0 Stock data Particular Amount Market Capitalisation 659 Crore Debt (FY16) 631 Crore Cash (FY16) 5 Crore EV 1285 Crore 52 week H/L ( ) 203 / 115 Equity capital 39.96 Crore Face value 10 Price performance (%) Return % 1M 3M 6M 12M HEG -4.6 3.3 7.9 5.4 Graphite India 0.0-0.1 0.4 6.8 Research Analyst Dewang Sanghavi dewang.sanghavi@icicisecurities.com Akshay Kadam akshay.kadam@icicisecurities.com November 11, 2016 HEG Ltd (HEG) 165 Lower operating costs support margins HEG s Q2FY17 performance came in above our estimates wherein EBITDA surprised positively on the back of lower raw material & employee cost Topline for the quarter came in at 190.1 crore (up 16.5% QoQ, down 23.7% YoY and higher than our estimate of 181.3 crore). The capacity utilisation came in at 65%, higher than our estimate of ~55% EBITDA came in at 18.7 crore, significantly higher than our estimate of 5.3 crore primarily on account of lower operating costs. The corresponding EBITDA margin came in at 9.8% (our estimate of 3.0%, Q1FY17: 3.2% and Q2FY16: 22.3%) At the PAT level, the company reported a loss to the tune of 13.5 crore, lower than our estimate of net loss of 27.2 crore Demand pressure persists The World Steel Association (WSA) estimates global steel demand will register tepid growth of 0.2% in CY17. With a subdued global demand scenario, HEG is witnessing demand pressure with subdued utilisation (56% in FY16 vis-à-vis 70% in FY15 73% in FY14 and 78% in FY13). Q2FY17 capacity utilisation came in at 65% (capacity utilisation of 50% in Q1FY17 and 60% in Q2FY16). Realisations under pressure on account of muted demand scenario Globally, steel is produced via two main routes: the blast furnace - basic oxygen furnace (BF-BOF) route and electric arc furnace (EAF) route. Graphite electrodes are used in the EAF route of steel making. On the back of a slowdown in China, the global steel industry is undergoing challenging times. The EAF share in total production of steel has fallen in the last decade from 33% to 25% in 2015 adversely impacting the prospects of the graphite electrodes sector. A muted demand scenario has resulted in subdued realisations of graphite electrodes. Margins to remain flattish due to muted graphite electrode prices We believe muted graphite electrode prices would offset benefits of a fall in price of needle coke, a key raw material used in graphite electrode manufacturing. Going forward, we expect EBITDA margin to stay flattish in next couple of years (13.0% in FY17E, 15.0% in FY18E, 15% in FY16). Capacity utilisation revised upwards; upgrade to HOLD HEG reported higher capacity utilisation levels in Q2FY17 of 65% (our estimate of 55%, Q2FY16: 60%). Subsequently, we have revised upward our capacity utilisation estimate to 65% for FY17E (from earlier 55%) and to 70% for FY18E (from earlier 65%). We have valued the stock on an SOTP basis valuing the core business at EV/EBITDA of 6.5x and assign a 20% discount to HEG s stake in BEL. Subsequently, we arrive at a target price of 160. We have a HOLD recommendation on the stock. ICICI Securities Ltd Retail Equity Research
Variance analysis Q2FY17 Q2FY17E Q2FY16 YoY (%) Q1FY17 QoQ (%) Comments Revenue 190.1 181.3 249.0-23.7 163.2 16.5 Revenues came in above our estimate Other Income 3.6 1.5 0.4 768.3 1.1 223.6 Other Income came in higher than our estimate Employee Expense 13.3 15.4 16.1-17.1 14.6-8.6 Employee came in lower than our estimate Raw Material Expense 90.6 114.7 93.5-3.1 102.8-11.9 Raw material cost came in significantly lower than our estimate Power & Fuel Expense 14.7 10.4 14.0 4.7 9.7 51.2 Power and Fuel came in higher than our estimate Other operating Expenses 52.8 35.3 65.8-19.7 33.0 60.0 Other expenses came in higher than our estimate EBITDA 18.7 5.3 59.7-68.7 3.1 502.3 EBITDA came in higher than our estimate EBITDA Margin (%) 9.8 3.0 24.0-1415 bps 1.9 792 bps EBITDA margin came in higher than our estimate Depreciation 18.3 20.1 20.2-9.6 19.1-4.4 Interest 15.5 12.2 18.3-15.6 13.0 19.1 Exceptional Item - - - NA - NA PBT (11.5) (25.5) 21.6 PL (27.9) -58.7 Tax Outgo 2.0 1.7 1.4 43.8 1.1 79.1 PAT (13.5) (27.2) 20.2 PL (29.0) -53.5 Loss at PAT level came in lower than our estimate Key Metrics Capacity Utilisation (%) 65 55 60 8.3 50 30.0 The capacity utilisation rate came in higher than our estimate Change in estimates FY17E FY18E ( Crore) Old New % Change Old New % Change Comments Revenue 904.5 985.2 8.9 1,084.8 1,102.8 1.7 Upward revised topline estimates for both years EBITDA 125.0 128.0 2.3 162.5 176.1 8.4 Upward revised EBITDA estimates for both years EBITDA Margin (%) 13.8 13.0-84 bps 15.0 16.0 99 bps EBITDA margin revised downwards for FY17E, upward revised for FY18E PAT 4.0 5.9 48.5 32.1 38.5 20.1 Upward revised PAT estimates for both years EPS ( ) 1.0 1.5 48.5 8.0 9.6 20.1 Assumptions Current Earlier Comments FY16 FY17E FY18E FY17E FY18E Capacity Utilisation (%) 56 65 70 55 65 Upward revised capacity utilisation estimates for both years ICICI Securities Ltd Retail Equity Research Page 2
Company Analysis The company is a leading manufacturer of graphite electrodes in India with an installed capacity of 80,000 tonne per annum (TPA). HEG commissioned its last capacity expansion way back in Q4FY12 (February 2012) wherein it installed a capacity of 14,000 tonne while incurring a capex of 225 crore. We expect graphite electrodes sales volumes to remain flattish from 45000 tonnes in FY16 to 52000 tonnes in FY17E, marginally recovering to 56000 tonnes in FY18E Exhibit 1: Graphite electrode production & growth rate tonne 75000 65000 55000 45000 35000 25000 15.0 15.6-0.1-6.1-4.5 7.7-19.1 56000 52000 45000 55600 58200 62000 62055 FY2012 FY2013 FY2014 FY2015 FY2016 FY2017E FY2018E 20.0 10.0 0.0-10.0-20.0-30.0 % Production YoY Growth Rate, FY12, FY13 and FY14 numbers have been assumed on basis of capacity utilisation rates Exhibit 2: Capacity & utilisation rates We have assumed a capacity utilisation of 65% in FY17E and 70% in FY18E tonne per annum 100000 80000 60000 40000 20000 0 70 70 65 56 80000 80000 80000 80000 FY2015 FY2016 FY2017E FY2018E 80 60 40 20 0 % Capacity Capacity Utilization Rates Segmental performance Apart from operating the graphite electrode facility, the company also operates captive power plants with capacity of 77 MW. Out of the 77 MW, 13.5 MW capacity is hydel. EBIT margins for graphite electrodes segment came in at -4.9% in FY16 while that for the power segment was 43.0%. Exhibit 3: Segment wise EBIT performance For Q2FY17, the graphite electrode segment reported an EBIT margin of -9.6% while the power segment EBIT margin was at 38.7% 50 40 30 22.6 35.2 43.4 37.6 43.0 % 20 10 0-10 10.4 9.3 9.9 6.2 FY2012 FY2013 FY2014 FY2015 FY2016-4.9 Graphite Power ICICI Securities Ltd Retail Equity Research Page 3
Conference call highlights Showa Denko, Japan, the largest electrode graphite manufacturer is in the process of acquiring SGL Carbon, Germany. The total capacity of Show Denko post acquisition would aggregate to ~290000 tonne The management has indicated that graphite electrode prices have bottomed, declining ~25% over the previous year Needle coke prices also declined around ~40%. The company is likely to benefit from the same in forthcoming quarters. The company liquidated the high cost needle coke and other raw material inventory during this quarter The management indicated that the liquidation of raw material and finished goods inventory has enabled the company to lower its working capital requirement During H1FY17, the company executed orders of ~ 370 crore (Q1FY17: 170 crore, Q2FY17: 200 crore). The management indicated that the order book for H2FY17 is healthier compared to H1 and around 75% of production capacity The management expects capacity utilisation of ~70% in H2FY17 The company exported around 65% of the produce while around 35% comprised of domestic sales During the quarter, the margins from the power segment were impacted due to expiry of the exemption of electricity duty ~12%, adversely affecting the cost of production. Going forward, the company would not benefit from such an exemption duty The management indicated that the company would benefit from the consolidation of the two large players in the graphite space as well as from the capacity closures of a few players in Japan The debt on the books of the company was at 666 crore as on September 2016 against 736 crore as on March 31, 2016. The company s cash balance as on September 30, 2016 was at ~ 10-11 crore ICICI Securities Ltd Retail Equity Research Page 4
Key takeaways from Annual Report FY16 was challenging for the global graphite electrodes industry wherein the drop in iron ore and coal prices vis-à-vis scrap prices made BOF steel more cost-competitive compared to EAF steel. Secondly, the steel industry faced excess supply from the increased Chinese exports severely affecting the prospects of the graphite electrode industry wherein majority of the players reported losses During 2015, prices of all commodities oil, iron ore, coke, steel, copper and aluminium declined on account of the slowdown witnessed in the Chinese economy. Commodity prices declined 25-45% while iron ore prices (a key input in blast furnaces) collapsed to US$45 (from US$135 in January 2014), scrap prices (key input in electric arc furnaces) declined from US$285 to about US$220, rendering the EAF route of steel production uneconomical. The EAF route steel production declined by more than 8% during the year In tough market conditions, the company strengthened its operations through diverse initiatives; wherein it streamlined operations to reduce wastages by about 50% of its earlier benchmark. Further the company invested in operational automation, procured productivity enhancing equipment and invested in intellectual capital to enhance man machine productivity. The company addressed new geographies while it also initiated developing graphite products with applications in diverse sectors (chemicals, urban infrastructure and heat exchangers The challenging global environment adversely impacted exports of the company, which were at 55% during the year. To protect the market share and competitiveness of the company, it has enhanced its domestic share from 20% to 45% during the year. In order to counter the volume erosion, the company added international customers from existing and new geographies The company scaled up the power business strengthening the availability, procured cheaper coal and reduced in-house consumption with the objective of increasing merchant sales In the last two years, falling electrode demand has seen the closure of about 200,000 metric tonnes of high-cost, non-competitive ultra high power (UHP) capacity in the European Union, US and Japan Going forward, the management expects prices to continue to remain under pressure given a subdued demand for electrodes. Softening needle coke prices are expected to provide some respite on the cost side. During the year, the company incurred an overall capex of 31.6 crore during the year of which 28.6 crore were towards the graphite business. ICICI Securities Ltd Retail Equity Research Page 5
Outlook and valuation HEG reported higher capacity utilisation levels in Q2FY17 of 65% (our estimate of 55%, Q2FY16: 60%). Subsequently, we have upward revised our capacity utilisation estimate to 65% for FY17E (from earlier 55%) and to 70% for FY18E (from earlier 65%). We have valued the stock on an SOTP basis valuing the core business at EV/EBITDA of 6.5x and assigned a 20% discount to HEG s stake in BEL. Subsequently, we arrive at a target price of 160. We have a HOLD recommendation on the stock. Exhibit 4: Valuation matrix Sales ( Crore) Growth (%) EPS ( ) Growth EV/EBIDTA (%) PE (x) (x) P/ BV (x) RoE (%) RoCE (%) FY15 1240.5-15.4 15.3-45.4 10.8 7.6 0.7 4.1 6.8 FY16 827.5-33.3-3.8-124.8 NA 10.3 0.7-1.6 2.9 FY17E 985.2 19.1 1.5 LP 112.3 10.0 0.7 0.6 3.2 FY18E 1102.8 11.9 9.6 556.1 17.1 7.2 0.7 4.1 6.0 ICICI Securities Ltd Retail Equity Research Page 6
Recommendation history vs. consensus estimate 400 120.0 300 100.0 80.0 ( ) 200 60.0 (%) 100 40.0 20.0 0 Sep-14 Dec-14 Feb-15 May-15 Jul-15 Oct-15 Dec-15 Feb-16 May-16 Jul-16 Oct-16 0.0 Price Idirect target Consensus Target Mean % Consensus with HOLD Source: Bloomberg, Company, ICICIdirect.com Research Key events Date Event Aug-08 Board approves buyback of equity shares (10% of paid up capital) at a price exceeding 350/share Mar-10 HEG embarks upon its expansion plan of increasing the capacity from 66000 TPA to 80000 TPA Jul-10 Bhilwara Energy (BEL) raises 230 crore (US$50 million) by selling 10.8% stake to Washington-based IFC and India Clean Energy Fund. Transaction results in dilution of HEG's stake in BEL from 28.9% to 25.5% Dec-10 European Union renews tariffs on graphite electrodes from India (tariff at 9.4%) Mar-11 Board approves buyback of 10% of equity capital of the company at a price not exceeding 350 per share Dec-11 Fitch (credit rating agency) revises HEG's outlook from neutral to negative Mar-12 Commissions new facility; capacity reaches 80000 TPA Sep-12 Company's international peer Graftech expected to hike electrode prices for 2013 contracts Nov-13 Global players announce production cuts to support graphite electrode prices Feb-15 GoI imposes antidumping duty on graphite electrodes (all diameters) originating in or exported from China. The amount of anti-dumping duty ranges from US$278.19 per MT to US$922.03 per MT, depending on the Chinese producer/exporter Nov-15 India Rating & Research (Ind-Ra) assigns 'IND A1+' rating for 80 crore commercial paper programme. Top 10 Shareholders Rank Name Latest Filing Date % O/S Position Change 1 Norbury Investments, Ltd. 30-Jun-2016 0.1 5.36M 0 2 Microlight Investments, Ltd. 30-Jun-2016 0.1 4.67M 0 3 Life Insurance Corporation of India 30-Jun-2016 0.1 3.39M 0 4 GPC Mauritius II, L.L.C. 30-Jun-2016 0.1 2.89M 0 5 Bharat Investments Growth, Ltd. 30-Jun-2016 0.1 2.61M 0 6 Mekima Corporation 30-Jun-2016 0.0 1.79M 0 7 Purvi Vanijya Niyojan, Ltd. 30-Jun-2016 0.0 1.75M 0 8 Raghav Commercial, Ltd. 30-Jun-2016 0.0 1.53M 0 9 LNJ Financial Services, Ltd. 30-Jun-2016 0.0 1.31M 0 10 LNJ Bhilwara Group 30-Jun-2016 0.0 0.98M 0 Shareholding Pattern (in %) Sep-15 Dec-15 Mar-16 Jun-16 Sep-16 Promoter 58.8 58.8 58.8 58.8 58.8 FII 1.3 1.0 0.8 0.8 0.7 DII 10.6 10.7 10.7 10.7 10.7 Others 29.3 29.5 29.7 29.8 29.9 Source: Reuters, ICICIdirect.com Research Recent Activity Buys Sells Investor name Value Shares Investor name Value Shares Goldman Sachs Asset Management (India) Private Ltd. -0.00M -0.00M Source: Reuters, ICICIdirect.com Research ICICI Securities Ltd Retail Equity Research Page 7
Financial summary Profit and loss statement Crore (Year-end March) FY15 FY16 FY17E FY18E Net Sales 1240.5 827.5 985.2 1102.8 Growth (%) -15.4-33.3 19.1 11.9 Raw Material Expenses 617.4 366.9 436.9 477.1 Employee Expenses 60.8 63.2 69.0 66.2 Other expenses 366.3 273.0 351.4 383.4 Total Operating Expenditure 1,044.5 703.1 857.3 926.6 EBITDA 196.0 124.5 128.0 176.1 Growth (%) -20.3-36.5 2.8 37.7 Depreciation 75.4 79.2 78.8 82.9 Interest 65.8 59.9 47.0 46.5 Other Income 11.6 4.2 5.5 5.2 PBT 66.5-10.5 7.7 51.9 Exceptional Item 22.2 0.0 0.0 0.0 Total Tax 5.3 4.6 1.8 13.4 Reported PAT 39.0-15.2 5.9 38.5 Adjusted PAT 61.1-15.2 5.9 38.5 Growth (%) -45.4-124.8 LP 556.1 EPS ( ) 15.3-3.8 1.5 9.6 Cash flow statement Crore (Year-end March) FY15 FY16 FY17E FY18E Profit after Tax 39.0-15.2 5.9 38.5 Add: Depreciation 75.4 79.2 78.8 82.9 (Inc)/dec in Current Assets 229.4 237.9-81.5-117.2 Inc/(dec) in CL and Provisions -79.8-76.3 45.4 32.2 Others 5.1 0.8 0.0 0.0 CF from operating activities 269.1 226.6 48.6 36.4 (Inc)/dec in Investments -25.4 1.6 0.0 36.0 (Inc)/dec in Fixed Assets -30.3-27.0-25.0-50.0 Others 0.0 0.0 0.0 0.0 CF from investing activities -55.7-25.5-25.0-14.0 Issue/(Buy back) of Equity 0.0 0.0 0.0 0.0 Inc/(dec) in loan funds -199.1-197.2-8.0-7.0 Dividend paid & dividend tax -42.1-42.1-14.0-14.0 Inc/(dec) in Share Cap 19.8 39.2 0.0 0.0 Others 0.0 0.0 0.0 0.0 CF from financing activities -221.4-200.1-22.0-21.0 Net Cash flow -7.9 1.0 1.5 1.4 Opening Cash 12.0 4.1 5.1 6.7 Closing Cash 4.1 5.1 6.7 8.1 Balance sheet Crore (Year-end March) FY15 FY16 FY17E FY18E Liabilities Equity Capital 40.0 40.0 40.0 40.0 Reserve and Surplus 900.7 882.7 874.5 899.0 Total Shareholders funds 940.7 922.6 914.5 939.0 Total Debt 828.3 631.1 623.1 616.1 Deferred Tax Liability 97.3 99.2 99.2 99.2 Minority Interest / Others 4.1 3.1 3.1 3.1 Total Liabilities 1,870.4 1,656.0 1,639.8 1,657.3 Assets Gross Block 1,553.9 1,630.9 1,685.9 1,735.9 Less: Acc Depreciation 654.2 733.4 812.1 895.1 Net Block 899.7 897.5 873.7 840.8 Capital WIP 114.5 64.5 34.5 34.5 Total Fixed Assets 1,014.2 962.0 908.3 875.3 Investments 151.1 149.6 149.6 113.6 Inventory 401.9 322.2 364.4 423.0 Debtors 405.5 325.1 364.4 429.0 Loans and Advances 196.1 118.3 118.3 112.3 Other Current Assets 0.0 0.0 0.0 0.0 Cash 4.1 5.1 6.7 8.1 Total Current Assets 1,007.6 770.7 853.7 972.3 Current Liabilities 286.4 224.5 269.9 302.1 Provisions 16.2 1.8 1.8 1.8 Current Liabilities & Prov 302.5 226.3 271.7 303.9 Net Current Assets 705.0 544.4 582.0 668.4 Misc Expenditure 0.0 0.0 0.0 0.0 Application of Funds 1,870.4 1,656.0 1,639.8 1,657.3 Key ratios (Year-end March) FY15 FY16 FY17E FY18E Per share data ( ) EPS 15.3-3.8 1.5 9.6 Cash EPS 28.6 16.0 21.2 30.4 BV 235.4 230.9 228.8 235.0 DPS 6.0 3.0 3.0 3.0 Cash Per Share 1.0 1.3 1.7 2.0 Operating Ratios (%) EBITDA Margin 15.8 15.0 13.0 16.0 PBT / Total Operating income 5.4-1.3 0.8 4.7 PAT Margin 3.1-1.8 0.6 3.5 Inventory days 118.3 142.1 135.0 140.0 Debtor days 119.3 143.4 135.0 142.0 Creditor days 84.3 99.0 100.0 100.0 Return Ratios (%) RoE 4.1-1.6 0.6 4.1 RoCE 6.8 2.9 3.2 6.0 RoIC 6.8 2.9 3.2 6.0 Valuation Ratios (x) P/E 10.8 NA 112.3 17.1 EV / EBITDA 7.6 10.3 10.0 7.2 EV / Net Sales 1.2 1.6 1.3 1.1 Market Cap / Sales 0.5 0.8 0.7 0.6 Price to Book Value 0.7 0.7 0.7 0.7 Solvency Ratios Debt/EBITDA 4.2 5.1 4.9 3.5 Debt / Equity 0.9 0.7 0.7 0.7 Current Ratio 3.3 3.4 3.1 3.2 Quick Ratio 2.0 2.0 1.8 1.8 ICICI Securities Ltd Retail Equity Research Page 8
ICICIdirect.com coverage universe (Graphite steel electrodes) Sector/Company CMP M Cap EPS ( ) P/E (x) EV/EBITDA (x) ROCE(%) ROE(%) ( ) TP ( ) Rating ( Cr) FY16 FY17E FY18E FY16 FY17E FY18E FY16 FY17E FY18E FY16 FY17E FY18E FY16 FY17E FY18E Graphite India 74 75 Hold 1446.0 3.1 3.5 4.5 23.5 21.1 16.5 9.4 10.2 6.5 4.4 3.9 5.7 3.5 4.0 5.0 HEG 165 160 Hold 671.3-3.8 1.5 9.6 NA 112.3 17.1 10.3 10.0 7.2 2.9 3.2 6.0-1.6 0.6 4.1 ICICI Securities Ltd Retail Equity Research Page 9
RATING RATIONALE ICICIdirect.com endeavours to provide objective opinions and recommendations. ICICIdirect.com assigns ratings to its stocks according to their notional target price vs. current market price and then categorises them as Strong Buy, Buy, Hold and Sell. The performance horizon is two years unless specified and the notional target price is defined as the analysts' valuation for a stock. Strong Buy: >15%/20% for large caps/midcaps, respectively, with high conviction; Buy: >10%/15% for large caps/midcaps, respectively; Hold: Up to +/-10%; Sell: -10% or more; Pankaj Pandey Head Research pankaj.pandey@icicisecurities.com ICICIdirect.com Research Desk, ICICI Securities Limited, 1st Floor, Akruti Trade Centre, Road No 7, MIDC, Andheri (East) Mumbai 400 093 research@icicidirect.com ICICI Securities Ltd Retail Equity Research Page 10
Disclaimer ANALYST CERTIFICATION We /I, Dewang Sanghavi, MBA (FIN) and Akshay Kadam MBA (FIN) research analysts, authors and the names subscribed to this report, hereby certify that all of the views expressed in this research report accurately reflect our views about the subject issuer(s) or securities. We also certify that no part of our compensation was, is, or will be directly or indirectly related to the specific recommendation(s) or view(s) in this report. Terms & conditions and other disclosures: ICICI Securities Limited (ICICI Securities) is a Sebi registered Research Analyst having registration no. INH000000990. ICICI Securities Limited (ICICI Securities) is a full-service, integrated investment banking and is, inter alia, engaged in the business of stock brokering and distribution of financial products. 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