Analysis: HEG Limited

Modified: 08-Jun-21

The current section of “Analysis” series covers HEG Ltd, one of the leading graphite electrode manufacturers in India. This case study of HEG Ltd provides good insights into cyclical industries.

“Analysis” series is an attempt to share with all the readers, our inputs to the company analysis submitted by readers on the “Ask Your Queries” section of our website.

In order to benefit the maximum from this article, an investor should focus on the process of analysis instead of looking for good or bad aspects of the company. She should learn the interpretation of different types of data and transactions and pay attention to the parts of annual reports etc. used to get the information. This will help her in improving her stock analysis skills.

HEG Ltd Research Report by the Reader (Archit Sharma)

Hi Dr. Vijay,

It was a pleasure meeting you in your session in Bengaluru “Peaceful Investing” Workshop. Based on the learning, I have taken multiple investment decisions.

Today, I am sharing with you fundamental analysis of HEG Ltd as it is not fitting well in our basic parameters entirely, but it seems like a growth stock in future.

I would humbly request you to share your insight on HEG Ltd and help me with your analysis.

It will be great if you can revert and let me know any mistake/improvement area in my analysis process.


Archit Sharma

Financial Analysis of HEG Ltd:

The company manufactures Graphite electrodes that are primarily used in steelmaking through the Electric Arc Furnace (EAF) route, which is an environment-friendly technology for steel making.

Every ton of steel consumes about 2-2.5 kg of graphite electrode.

HEG Ltd has grown at a decent pace of 11% in the last 10 Years but its sales were continuously declining from 2014 until 2017. In 2018, the company bounced back and has displayed very high growth but that is tough to be maintained in future. It is to be noticed that this trend is very much same as of Graphite Industry across the globe, which resulted in consolidation in supply-side that strengthens the existing entry barrier (As it is a highly capital-intensive business).

HEG Ltd is one of the global leaders in this product.

HEG Ltd.’s major source of raw material is in India (Crude oil companies) and it supplies final product Graphite Electrodes across the world; thus, it is well diversified in terms of regions.

1) Sales & Profit Growth of HEG Ltd:

Peer comparison highlights that HEG Ltd grabs higher growth. Interestingly, Graphite India never went in losses but HEG Ltd had losses for four times.

A major reason for the decline was: China’s production capacity

  • 2014 to 2017 was a tough time from the crude price perspective, which led to an increase in the costs of raw material that HEG uses to develop graphite electrodes. As the raw product for HEG is a by-product of Crude industry.
  • China is no. 1 consumer of steel and until now, China was not building steel via EAF route. Thus, the requirement of the graphite electrode was very low. Chinese companies were able to produce the raw material required for steel.
    • NOTE: As other routes are not eco-friendly, thus China has stopped such steel plants and is slowly shifting towards EAF route. This might mean an increase in HEG Ltd.’s business.

On the other hand, HEG Ltd was able to survive in a tough time of 4 years though with heavy losses, especially in 2017 (50% loss). Normally, the company was earning a profit margin of 2-4%. HEG Ltd though suffered a drop in sales from 2014 to 2017 but was able to manage to earn a profit margin of around 3% until 2015.

Again, this should be seen with caution as the whole industry was going through the bad shape. Recently, due to environmental issues are major reasons thus it is expected that the graphite electrode industry will grow at a much faster pace (in 2018- PAT was around 39%).

From past trends, it is clear that HEG Ltd is highly dependent upon the crude oil price but is able to transfer its cost to its customer base (thus maintaining profit margin except for 2016 and 2017). Steel is a core commodity for any developed and developing nation to keep growing. Steel products are used in multiple industries like automobile, infrastructure, and machinery. Considering that the world is moving towards an environment-focused approach, the expectation of the EAF route is very high, which will bring HEG Ltd in a very sweet spot.

2) Margin of Safety – Cash Flow of HEG Ltd:

HEG Ltd is generating enough free cash from operations that it can pay its expenditure and keep running on its own.

On the other hand, CFO (₹2593 cr) is almost the same when it comes to supporting investing (-₹1073 cr) and financing (-₹1556 cr). Thus, unable to see any reason of worry here.

3) Impact of foreign exchange on HEG Ltd must be high:

HEG Ltd earns around 40:60 ratio in sales within and outside India respectively.

4) Reducing leverage is a key focus area:

HEG Ltd kept paying back to their creditors. Thus, it understands the impact of interest as well as is looking forward to moving to the self-sustainable stage.

The company management looks focused on business growth. Though the business was down due to industry sentiments and Chinese oversupply of a different kind of steel that does not require graphite electrode, HEG Ltd was able to survive and tried to reduce debt. The moment it got the money, the first action it did was to repay the complete long-term debt as well as paying to shareholders as a dividend.

5) If the company is saying that it has paid the liabilities, then why liabilities increased in cash flow in CFO though, in CFF, the borrowing has been reduced.

6) Trade Receivables:

Trade receivables of HEG Ltd have increased but that is the nature of the industry and the trade receivable vis-à-vis revenue earned for the year is 35% of total sales of the year!

7) It has not disclosed the counterparty for a loan of ₹7 cr!

8) Cost of raw material consumed:

The cost of raw material consumed is around 20% this year but why did the cost of material consumed be so high last year? I am unable to understand. Other biggest expense is power – costing ₹350 cr (13%)

9) Related Party Transactions:

There does not seem to be any major challenge with respect to related party transaction except for Bhilwara Energy Ltd where the investment of ₹145.06 cr has been made.

Business Analysis of HEG Ltd:

1) The company develop Graphite electrodes in its plant, largest in the world, Mandideep, Madhya Pradesh:

  • Advantage – Economies of scale;
  • Disadvantage: New greenfield plant will take 5-6 years and huge investment to develop.

2) Plant Capacity:

Knowing the barriers of setting up a new plant, HEG Ltd has worked hard on increasing its operational efficiency from 55000 metric tons to 64000 MT. I am unable to understand if this was capacity expansion or company had never fully utilized existing capacity. HEG Ltd is now aiming to 100,000 MT. This is an expansion for sure from existing 80000 MT. All this within a span of 3 years.

3) Revenue Model:

In the case of HEG Ltd, it seems that the company charges a certain percentage over raw material cost. This is because, in the following chart, the raw material cost trend leads to sales trend from 2009 until now. Thus, in case raw material cost increases, the company will always be able to pass the cost of raw material to its customers. However, if the raw material costs decrease then it will be challenging for HEG Ltd to repay other expenses like salary, admin charges, electricity etc.

  • Raw material suppliers are from India, but customers are across the globe.

4) Electricity is the second largest cost for the company:

Citing same and knowing plant capability, HEG Ltd is able to generate its own electricity. The company is self-sufficient in this regard so far. Moreover, it is able to earn money from this channel.

5) Inventory vs Receivable Days:

Steel manufacturers do not work on advance payment basis, as they are not a B2C base. Thus, HEG Ltd has to rely on receivable days, which highlights that the company became desperate to increase sales. It happened in 2011, 2015 and 2016 when the market was bad and the receivable days increased as high as 152 days. However, HEG Ltd was able to bring them back to 89 days in the current year. However, still, the receivables days of HEG Ltd are much higher than its competitor Graphite India has. Graphite India Ltd is able to keep receivable days in a range of 70-100 days except for 2016 and 2017).

This business is inventory intensive as the plant needs to run on a daily basis and the demand is based on steel requirement basis. Managing inventory will become more important in the near future, as contracts have been shifted from yearly to quarterly. Considering the sales and volume difference between HEG and Graphite India, it looks that both the companies are carrying almost the same inventory levels in their warehouses.

6) Another perspective:

HEG Ltd is not able to manage its working capital efficiently, as its receivable, as well as inventory days, are high. It means that its cash is stuck with its customers. Surprisingly, which does not seem to be the case if we compare CFO to PAT, as CFO is ₹2,593 cr vs PAT of ₹1,442 cr i.e. company is converting its profit into cash.

7) How much HEG Ltd is able to produce as turnover based on its fixed assets – NFAT

This highlights that NFAT of HEG Ltd is in line with its major peer, though there is certainly a scope to improve it further. The increase from 0.9 to 3.3 could be the result of improved operational efficiency, which led to increased production within the same plant.

Industry Analysis of HEG Ltd

  • The industry is changing its face. The external factors like environmental issues and macro development are playing a major role as the steel industry sits in the core for any developing economy. China will require major steel production due to the growth factor. This, in turn, will result in higher demand from China.
  • The industry has moved towards consolidation, which means higher entry barriers for any new entrant
  • HEG Ltd.’s plant was the last greenfield plan in this industry across the globe. It indicates how difficult and less economical it is to create new plants.
  • Now, graphite electrode suppliers have contracts on a quarterly basis with steelmakers. This displays an increase in selling power. It also indicates that there will be volatility in the price for the finished as well as the raw product.
  • The high cost of raw material (needle coke) as it is in high demand by Lithium-Ion Battery Industry
  • This also means limited supply but huge demand in future. This will result in higher margins, better buying/selling power in the hands of companies like HEG Ltd.
  • Chinese policy showcases favour for the core product of HEG Ltd.
  • Still, graphite electrode makers can go ahead for higher prices due to high demand, low supply and better quality ( )

Thus, overall the outlook looks positive for the industry especially in India, which was running in negative for the last 3-4 years. HEG Ltd might turn out to be a turnaround story; however, I am not sure.

Management Analysis of HEG Ltd:

1) Salary:

Ravi Jhunjhunwala has not increased his salary base for last 4 years. The recent increase in his salary is due to increase in profits of the company. This highlights professionalism in the organization by mapping salary to profits.

2) There were no major related party transactions, which again is a positive sign.

3) Even when the company was making losses, HEG Ltd kept paying off its debt to reduce the interest cost and therefore, it got ready for the worst. As per my understanding, it is prudent decision making.

4) HEG Ltd is able to expand its production capacity per person by 34%. It speaks for the operational capability of the organization and management’s focus towards the core business.

5) The company is not thinking about any di-worsification. Instead, it is diversifying in other related streams. This seems to be at an early stage as same words were said in previous year annual report as well. It seems that HEG Ltd is looking forward to making Graphene as they are talking about water/air purification. Graphene is very long (10-20 years) term but quite a hopeful bet. However, it is too early to say anything at this stage.

The investment in research & development (R&D) seems to be quite low, which indicates that the implementation stage is far away:

  • The size of the R&D team seems too small as there are only 6 members in the whole R&D team
  • These statements are repetitive from their last year’s annual report.

Other Observations for HEG Ltd:

  • HEG Ltd stands for what it says. Its recent report says that the company is trying to go for 100,000 TPA from 80,000 TPA (reached 85-90% capacity).
  • Foreign exchange (forex) movements might impact the performance of the company as it is a net exporter of goods from India

It seems interesting information’ however, it is tough to comprehend whether the tenfold change is due to the cost of needle coke or due to demand-supply un-equilibrium.

  • HEG Ltd looks like an ethical company. Otherwise, in order to meet government regulations, it has provided quite granular details of how it ensures that the product life cycle plan remains well in place.
  • I am unable to understand why an MP company will hire Delhi based chartered accountant for audit.


HEG Ltd had a rough time, especially in the last 4 years. It is highly dependent on steelmakers as well as needle coke suppliers. Raw material costs constitute about 40% of its sales revenue. Considering environment-friendly focus across the globe and the growth opportunities in China, India and other developing countries, graphite electrode’s demand will keep on increasing. Therefore, if HEG Ltd.’s management keeps its focus in the same way as it has today, then the chances of the company to grow are very high. HEG Ltd is investing ₹1,200 cr. to increase its manufacturing capacity by 25%, which is a positive sign.

HEG Ltd has its customer base across the globe. Therefore, it should not be a point of concern.

Major constraints to look for are:

  1. China’s graphite electrode production growth
  2. Trade wars, which look like in the medium term. However, it is expected to ease up in the long term
  3. Change in the debt/equity ratio of the company.
  4. Any development in Graphene could be a great advantage.

Dr Vijay Malik’s Response

Hi Archit,

Thanks for sharing the analysis of HEG Ltd with us! We appreciate the time & effort put in by you in the analysis.

Let us analyse the performance of HEG Ltd over the last 10 years.

While analyzing the past financial performance data of the company, an investor would notice that until FY2009, HEG Ltd used to disclose only standalone financials. However, in FY2010, the company established a subsidiary, HEG Graphite Products and Services Limited. Therefore, since FY2010, the company is preparing both standalone as well as consolidated financials. The consolidated financials presented by HEG Ltd reflect the impact of the financial performance of its subsidiary as well as the associate companies of LNJ Bhilwara group in which it has made significant investments.

We believe that while analysing any company, the investor should always look at the company as a whole and focus on financials, which represent the business picture of the entire group. Therefore, while analysing HEG Ltd, we have analysed standalone financials for FY2009 and consolidated financials from FY2010 onwards until FY2018.

Further advised reading: Standalone vs Consolidated Financials: A Complete Guide

HEG Financials FY2009 2018

Financial Analysis of HEG Ltd:

While analyzing the financials of HEG Ltd, an investor would note that in the past, the company has been able to grow its sales at a rate of 10-12% year on year. Sales of the company increased from ₹1,021 cr. in FY2009 to ₹2,748 cr in FY2018. However, an investor would notice that the sale performance of the company over the last 10 years has been very fluctuating. HEG Ltd witnessed its sales increase from ₹1,021 cr. in FY2009 to ₹1,619 cr in FY2013. However, from FY2014 onwards, the company faced a very difficult time and as a result, its sales started declining year on year. Sales of the company declined to ₹859 cr in FY2017. In FY2018, the company witnessed a revival in its performance and could increase its sales significantly to an all-time high of ₹2,748 cr.

Such a huge variation in the performance of the company was not limited to only sales/revenue. HEG Ltd witnessed significant changes in profitability as well. The operating profit margin (OPM) of the company declined consistently from 36% in FY2009 to 9% in FY2017. The resultant decline in the net profit margin was even higher. The net profit margin (NPM) of the company reduced from 17% in FY2010 to net losses in FY2017.

However, all of a sudden the business performance of the company in terms of overall sales, as well as profit margins, improved in FY2018. HEG Ltd reported an OPM of 63% and an NPM of 40% in FY2018.

An investor would notice that the business performance of HEG Ltd has witnessed cyclical nature during the last 10 years (FY2009-18). In the initial years, the company was growing with reasonable profit margins but then it faced tough times in subsequent years, which resulted in declining sales and profit margins (leading to losses as well). Thereafter, the performance of the company improved in recent times in terms of both sales and profitability.

Further advised reading: How to do Financial Analysis of Companies

Such fluctuating performance is a highlight of companies operating in any cyclical industry, where initially many players go for expansion of capacities in the hope of high demand in future. However, over time, the assumptions of increased demand prove incorrect due to internal/external factors. As a result, the anticipated demand increase does not materialize and instead the existing demand of the products declines. Therefore, the industry faces a situation of apparent oversupply and the sale volume as well as the sales price decline. The players find that their business operations have become less profitable/unviable. Therefore, many players go out of business/shut down their capacities, which results in a decline in the manufacturing capacity in the industry and shifts the balance of demand-supply equilibrium in favour of the suppliers/manufacturers.

As a result, when the demand for the product revives in the business cycle, the remaining players find that they have gained the negotiating power due to limited supply. Therefore, the remaining players get increased orders at higher prices leading to higher sales revenue with improving profit margins. This is the typical business cycle, which has played out in many cyclical industries over the years and it seems that the industry of HEG Ltd, the graphite electrode industry has gone through a similar cycle in the last 10 years (FY2009-18).

Moreover, an investor would notice that the graphite electrode industry is highly dependent on the steel industry, which is its most significant customer. The steel industry is highly cyclical in nature, which is impacted by intermittent periods of rising and falling end product as well as raw material (iron ore etc.) prices. When an investor analyses the dependence of graphite electrodes industry on the steel industry, which is cyclical in nature, then she can interpret that the graphite electrodes industry is also expected to show cyclical patterns in its performance over the years.

An analysis of expansion strategies of HEG Ltd by reading its annual reports indicates that in and prior to 2008 economic crisis, the company announced its expansion plans of 20,000 TPA in August 2008 (from 60,000 TPA to 80,000 TPA). This was the period when the global steel industry was on an uptrend in the business cycle. This period witnessed some larger mergers & acquisitions in the steel sector like Arcelor-Mittal (2006) and Tata-Corus (2007).

As per an article by Televisory Research, the period of 2003-2007 was the one where many graphite electrode manufacturers around the world increased their capacity:

An increase in the steel production through EAF route led to an increase in the demand of graphite electrodes. This increase augured well for industry participants leading to capacity additions and high utilisation levels (although capacity utilisation exhibited a declining trend due to the addition of new capacities at a faster pace than demand growth, capacity utilisation remained high for the industry). A healthy demand also led to improved realisations and profitability for graphite electrode manufacturers during the period.

HEG 2003 2007 Graphite Electrodes Capacity Expansion

An investor would appreciate that such positive sentiment regarding the steel industry led to many graphite electrode manufacturers including HEG Ltd increase their capacity. However, soon thereafter, the 2008 financial crisis struck and the business cycle in the steel sector took a downturn. As a result, HEG Ltd had to scale down its expansion plans from 20,000 TPA to 6,000 TPA.

FY2009 annual report, page 13:

Capacity Expansion of Graphite Electrode Plant at Mandideep: In light of the slowdown in economic environment and steel industry that the global industry faced in 2008, HEG announced in August 2008 to moderate the expansion plans from current 60,000 MT to 66,000 MT (as against 80,000 MT planned earlier) in graphite electrodes at a contained cost of Rs. 42.50 crore as against Rs. 190 crore.

Further advised reading: Understanding the Annual Report of a Company

The company initially scaled down its expansion plans in FY2009 and deferred the addition of remaining 14,000 TPA manufacturing capacity. However, it did not wait for long and next year (FY2010) announced that it would go ahead with the expansion plans for 14,000 TPA.

FY2010 annual report, page 5:

Considering the improved scenario, we have expanded HEG’s capacity from 60,000 tons to 66,000 tons in the year under review. With this, our plant has become the largest single-site facility for graphite electrode manufacturing in the world, a feat which bolsters our confidence. The expansion has helped us achieve optimization of costs and better operating efficiencies. The current sentiments also gives us the confidence to move ahead with the next phase of expansion to take the capacity to 80,000 MTs per annum. This expansion will require an investment of approximately Rs.206 crore and we hope to achieve this by September – October 2011. The financial requirement will be met by a combination of internal accruals and debt. Currently this expansion is on schedule.

HEG Ltd continued with its expansion plans whereas the outside environment was becoming challenging. The company acknowledged it in its FY2012 annual report when its capacity expansion was completed.

FY2012 annual report, page 18:

On the face of it, the numbers showcase a gloomy picture of our working in 2011-12. However, there were some positive sparks, which helped progressively de-risk our business from volatile external factors.

Capacity expansion: Our ₹225 crore expansion was commissioned in February 2012. This provides us with the opportunity to increase our market share in the top-end of the graphite electrode market.

One of the features of cyclical industries is that during good times many players increase manufacturing capacity. These manufacturing capacities take some time to become operational and by the time these capacities are completed, the business cycle takes a turn. Thereafter, the demand of the product declines but the industry is ready with higher manufacturing capacity.

When an investor reads the annual report of the next year, FY2013, then she realizes that the above-mentioned scenario played out in the graphite electrode industry as well.

FY2013 annual report, page 12:

In 2012, the global economic momentum decelerated on account of various intertwined factors – the eurozone crisis, US fiscal cliff, forex volatility, disruption of global oil supplies and slowing investments in emerging economies. The result is that the global steel industry grew a mere 1.2% (but for China it would have gone down), the lowest in a decade. Global steel players incurred sizeable losses in 2012. As a natural extension, this affected graphite electrode demand. Long-term contracts gave way to need-based spot purchases. The global industry encountered a 100,000 MT increase in production capacity (65,000 MT in China), creating an oversupply that pared realisations.

HEG Ltd acknowledges that the capacity additions by the graphite electrodes manufacturers along with the dismal performance of the steel industry has created an oversupply situation in the industry. Moreover, the company fears that the situation is going to worsen in future. This is because more graphite electrode manufacturing capacity (130,000 TPA) is going to be completed in the coming year, which will further reduce the prices of graphite electrodes.

FY2013 annual report, page 14:

While the demand side appears tentatively encouraging, supply side estimates suggest 130,000 MT of additional graphite electrode capacity coming into play in 2013-14 (100,000 MT in China), increasing the overhang and depressing realisations.

In FY2014, the graphite electrode industry is faced with challenging times of high manufacturing capacity and declining demand. As a result, the sales volume as well as the sales price decline.

FY2014 annual report, page 14:

Fiscal 2013-14 was one of the most challenging years for the international graphite electrode industry due to a number of concurrent factors: slow economic growth, political inertia in India, weak global steel industry (excluding China), decline in graphite electrode realisations and rising inventory. Not surprisingly, some of the largest global electrode manufacturers reported losses.

The same aspect was highlighted by the credit rating agency, India Ratings in its April 2015 report of HEG Ltd:

Revenue declined 9.6% yoy in FY14 and around 13% (provisional) in FY15, led by lower volumes and realisations in the graphite electrodes (GE) business due to overcapacity and a slowdown in the steel sector, which drives GE demand. The capacity utilisation decreased to 70% in FY14 and remained at the same level in 9MFY15 (FY13: 78%).

Further advised reading: Credit Rating Reports: A Complete Guide for Stock Investors

In such a situation, it does not come as a surprise to the investor when she reads that a few graphite electrode manufacturers shut down their manufacturing capacities.

FY2014 annual report, page 15:

Two global electrode majors announced capacity closure, virtually removing 90,000 TPA of capacity from the marketplace. Going ahead, we are optimistic that this evacuation will correct the industry oversupply, improve realisations and encourage competitive players to aspire for higher growth.

The pain of the downturn in the business cycle of the graphite manufacturing industry extends further and the prices decline to such a level that any production of graphite electrodes becomes a loss-making affair for the manufacturers. In such times, closing down of the manufacturing capacity seems to be the best alternative to many producers.

FY2018 annual report, page 25:

In the recent years, electrode prices fell to unviable levels as cheap iron ore and coking coal made BOF route cheaper as compared to EAF steel, hitting the EAF steel mills who chose to re-roll blast furnace-produced semis, or utilise merchant pig iron. For every electrode they made, western producers lost money, and consequently shuttered capacity as a survival strategy. About 200,000 TPA of electrode manufacturing capacity was closed over the last 3-4 years in the western world

On the face of it, an investor may feel that such cyclical turn of events in the cyclical industries is predictable. An investor would believe that the events are following a predictable pattern of player announcing capacity expansions during good times. The capacities become operations in 2-3 years. However, by then, the industry cycle has taken the downturn. As a result, the industry faces a situation of oversupply, which leads to lower sales volumes as well as the lower sales price. Therefore, players report losses and then shut down capacity.

Such turn of events may seem highly predictable. However, predicting the timing of such events is not predictable. Even the promoters/managers who earn their livelihood by operating in these cyclical industries day and night, many times get their predictions wrong.

In the case of HEG Ltd, an investor would appreciate that the timing of going ahead with the capacity expansion of 14,000 TPA, which was completed in FY2012, may not be the best. On the similar lines, in FY2014, the management of the company expected that the troubled times for the industry are over in FY2014 and things should improve going ahead.

FY2014 annual report, page 15:

My assessment this time is that we have hit the trough and hereon we should see a recovery, albeit a slow and steady one. We were back to the wall, fighting all these factors and the entire team at HEG showed exceptional resilience and a resolve to do better. Adversity invariably brings out the best in the brave.

However, looking at the financial performance of the company in the coming years of FY2015, FY2016 and FY2017, an investor would notice that the worst was not behind the company in FY2014. The worst was yet to come in future years.

Further advised reading: Steps to Assess Management Quality before Buying Stocks

FY2015 annual report, page 15:

The international graphite electrodes industry was affected by overcapacity despite 1,20,000 tonnes per annum capacity going off the market during the year under review, indicating the grimness of the industry position.

FY2016 annual report, page 11:

The steep reduction in EAF steel production affected the demand and prices of graphite electrodes. In the past two years, graphite electrode manufacturing capacities reduced by about 200,000 MT. Despite these capacity closures the current capacity utilisation of the electrodes industry is still close to 70% showing continued pressure.

HEG Ltd reported losses in its graphite electrode business in FY2016 and FY2017 and it reported losses on the consolidated level in FY2017.

FY2017 annual report, page 15:

HEG FY2017 Losses In Graphite Electrode Business In FY2016 And FY2017

Further advised reading: Understanding the Annual Report of a Company

The management acknowledged in FY2017 annual report that the last five years (FY2012-2017) have been very tough for the graphite electrode industry.

FY2017 annual report, page 4:

HEG FY2017 Downturn In Graphite Electrode Industry

In light of the above analysis, an investor would appreciate that the graphite electrode industry like its customer (steel industry) is a cyclical industry in which the event tend to alternate with good and bad phases. In good phases, the companies go for capacity expansion, which later on leads to overcapacity. The oversupply, later on, leads to lower sales and prices resulting in losses for manufacturers, which then shut their plants.

Thereafter, the oversupply situation corrects itself by way of the closure of plants by the manufacturers and the manufacturers find that the demand for their products is increasing. This increased demand is an indication of the return of good times and the manufacturers see the sales volume and sales prices increasing. This increase in demand for the products leads to the next phase of capacity additions by the manufacturers and thereby start of a new business cycle.

When an investor analyses the current turn of events for graphite electrodes manufacturing industry, then she notices that in the current good times, HEG Ltd has already announced new capacity addition, which it plans to complete over next 2.5 years.

BSE announcement by HEG Ltd dated November 26, 2018:

HEG FY2019 Expansion Plans

Further advised reading: How to Monitor Stocks in your Portfolio

Such turn of events in the cyclical industries has been playing out in sequence year after year. However, it is highly difficult for investors to predict the timing of these events. We notice that at times, even the promoters/managers who have spent their lives working in these industries get their timings wrong. However, these cyclical events keep on repeating year after year.

Every time, there are different events, which act as catalysts for the turn of cyclical events. In 2008, the good times in the steel industry as well as the graphite electrode industry ended due to the housing credit crisis in the US, which percolated to most of the developed world. Similarly, in 2018, the recovery of the graphite electrode industry seems to be the result of the Chinese crackdown on polluting basic oxygen furnace (BOF) steelmaking plants in the country, which has led to the increase of electric arc furnace (EAF) steelmaking plants. However, investors should remember that in cyclical industries, the fortunes of industry players keep on changing in business cycles. Every time, there are different triggers, which mark the start or the end of different phases of business cycles. However, the above-mentioned business phases keep on repeating one after another.

Therefore, an investor would appreciate that the recent good performance of all the graphite electrode manufactures including HEG Ltd is an expected turn of events in the complete scheme of industry business cycles. The alternating turnout of good and bad times has taken place multiple times in the cyclical industries in the past and may take place multiple times in the future as well.

Therefore, while analysing any cyclical industry including graphite electrodes, an investor should analyse the long-term financial performance to understand how the business performance plays out under different phases of the cycle. Investors should not extrapolate performance over a short period of a few years into the future. Investors should always keep in mind that in the cyclical industry, bad times follow good times and vice versa.

To understand more about the impact of industry cycles on the companies, investors may read the analysis of the following companies:

Operating Efficiency Analysis of HEG Ltd:

i) Net fixed asset turnover (NFAT) of HEG Ltd:

When an investor analyses the net fixed asset turnover (NFAT) of HEG Ltd, then she notices that the NFAT of the company has witnessed a continuous decline over the years from 2.21 in FY2013 to 0.94 in FY2017 before increasing to 3.19 in FY2018.

The decline in the NFAT coincides with the period when the graphite electrodes industry hit the downturn soon after HEG Ltd completed its capacity expansion of 14,000 TPA in FY2012. The sales decline of FY2013-17 witnessed the NFAT decline from 2.21 to 0.94. The cyclical recovery of the company in FY2018 witnessed the sales as well as NFAT improve.

Further advised reading: Asset Turnover Ratio: A Complete Guide for Investors

ii) Inventory turnover ratio of HEG Ltd:

An investor would note that over the years, the inventory turnover ratios (ITR) of the HEG Ltd has been ranging from 2.2 to 2.7, which is low considering other manufacturing industries. Low inventory turnover of HEG Ltd is a result of the long manufacturing process of graphite electrodes.

Moreover, as per the website of HEG Ltd, it holds a lot of inventory in its warehouses around the world so that it may deliver the electrodes to its customers “just in time”.

Warehousing: HEG has warehouses throughout world. We are able to hold inventory and deliver just in time.

An investor would appreciate the decision of the company to hold inventory in its own warehouses near customer locations increases the needs for investment in inventory by the company and in turn decreases the inventory turnover of the company.

In the recent year (FY2018), the inventory turnover has increased to 7.1. However, this improvement is not a result of any technological advance, which might have decreased the manufacturing time drastically. This improvement in the ITR is a result of a sharp increase in the sales price of graphite electrodes, which has resulted in a significant increase in the numerator in the ITR calculation formula used by us (Sales/average inventory for the year).

Advised reading: Inventory Turnover Ratio: A Complete Guide

iii) Analysis of receivables days of HEG Ltd:

An investor would notice that over the years, receivables days of HEG Ltd has been ranging from 120 days to 150 days indicating that the customers of the company demand significant credit period. An investor would notice that the customers of graphite electrode manufacturers are steel manufacturers, which usually are very large corporates. These large customers usually have a lot of negotiating power and therefore, demand high credit period from the suppliers. Therefore, in the graphite electrode industry including HEG Ltd, the receivables days tend to be high.

While looking at the overdue details of the receivables of HEG Ltd in the FY2018 annual report, an investor notices that almost 25% of the receivables of the company are overdue with the customers failing to pay them at agreed-upon dates. Some amount of receivables are due for more than 2 years from the time these were to be paid by the customers to HEG.

FY2018 annual report, page 198:

HEG FY2018 Overdue Receivables

The working capital intensive nature of the graphite electrode manufacturing business is also highlighted by the credit rating agency, India Ratings in its report for HEG Ltd in Dec 2018:

HEG’s business is working capital-intensive because graphite electrode manufacturing involves a large processing period and a moderate to long credit period to customers. This is inherent in the graphite electrode manufacturing space.

The recent improvement in the receivables days in FY2018 to 89 days seems to be a result of the newly found negotiating power in the graphite electrode manufacturers, which is due to the recent increase in the demand for their products.

Further Advised Reading: Receivable Days: A Complete Guide

Moreover, when an investor analyses the receivables days along with inventory turnover, then she notices that despite low ITR and long receivables days, HEG Ltd has been able to keep its working capital requirements stable and under control. The working capital position of the company has not deteriorated over the years. It means that HEG Ltd has been able to convert its profits into the cash flow from operations without the money being stuck in working capital. An investor observes the same while comparing the cumulative net profit after tax (cPAT) and cumulative cash flow from operations (cCFO) of the company for FY2009-18.

An investor would notice that over FY2009-18, HEG Ltd Limited has reported a total cumulative net profit after tax (cPAT) of ₹1,748 cr. whereas during the same period, it reported cumulative cash flow from operations (cCFO) of ₹2,593 cr indicating that it has converted its profits into cash. The cCFO of HEG Ltd is significantly higher than its cPAT primarily because of high depreciation and interest expenses, which are deducted while calculating PAT, while these are added back to PAT when calculating CFO.

It is advised that investors should read the article on CFO calculation mentioned below, which would help them understand the situations in which companies tend to have the CFO lower than their PAT and the situations when the companies tend to have CFO higher than their PAT.

Further advised reading: Understanding Cash Flow from Operations (CFO)

Margin of Safety in the Business of HEG Ltd:

i) Self-Sustainable Growth Rate (SSGR):

Further advised reading: Self Sustainable Growth Rate: a measure of Inherent Growth Potential of a Company

Upon reading the SSGR article, an investor would appreciate that if a company is growing at a rate equal to or less than the SSGR and it is able to convert its profits into cash flow from operations, then it would be able to fund its growth from its internal resources without the need of external sources of funds.

Conversely, if any company attempts to grow its sales at a rate higher than its SSGR, then its internal resources would not be sufficient to fund its growth aspirations. As a result, the company would have to rely on additional sources of funds like debt or equity dilution to meet the cash requirements to generate its target growth.

An investor would notice that HEG Ltd has witnessed an SSGR ranging from -1% to 10% over the years. The SSGR has increased recently because of a sharp increase in the profit margins in recent years. However, as discussed above, the recent sharp increase in profitability might not be sustainable as it is a result of the cyclical uptrend in the business cycle of the graphite electrode manufacturing industry.

The sales growth achieved by the company over the years is 10-12%, which is higher than its SSGR. Therefore, investors would expect that the company would have to raise debt from additional sources to fund its growth.

However, in the SSGR article shared above, we have highlighted a situation (Case C), where companies that have SSGR less than the current growth rate but still manage to reduce debt over the years. In such cases, efficient working capital management ensures that the company has a significant amount of CFO, which is not stuck in the working capital needs of the company. As a result, the cash is available from the internal sources for the capital expenditure needed for growth and reduce debt.

An investor is able to observe this aspect of the company’s business when she analyses the cumulative cash flow position including free cash flow for the company over the last 10 years (FY2009-18).

ii) Free Cash Flow Analysis of HEG Ltd:

While looking at the cash flow performance of HEG Ltd, an investor notices that during FY2009-18, the company had a cumulative cash flow from operations of ₹2,593 cr. However, during this period it did a capital expenditure (capex) of ₹740 cr. As a result, it had a free cash flow of ₹1,853 cr. (2,593 – 740).

Further advised reading: Free Cash Flow: A Complete Guide to Understanding FCF

While analysing the past annual reports of HEG Ltd, an investor would notice that the company has used this FCF in various manners:

  1. Dividend payments to the shareholders: The company has used the FCF to pay a dividend of about ₹521 cr. (excluding dividend distribution tax) to the shareholders.
  2. Reduction of debt: HEG Ltd used the FCF to reduce its debt by ₹585 cr over the years from ₹882 cr in FY2009 to ₹297 cr in FY2018.
  3. Buyback of shares: HEG Ltd did two rounds of buyback of equity shares in the past 10 years (FY2009-18).
    1. The first buyback was done in FY2009 for ₹48.5 cr.
    2. The next buyback of shares was done in FY2011-2012 for ₹67.5 cr. (Read: Share Buyback: An Investor’s Guide)
  4. Investment in group companies/associates: Over the years, HEG Ltd has made about ₹120 cr of additional investments in associates/promoter group companies like Bhilwara Energy Ltd and Bhilwara Infotechnology Ltd, which is currently visible as a part of the cash & investments of ₹250 cr available with the company.

Free cash flow (FCF) is one of the main pillars of assessing the margin of safety in the business model of any company.

Further advised reading: 3 Simple Ways to Assess “Margin of Safety”: The Cornerstone of Stock Investing

Additional aspects of HEG Ltd:

On analysing HEG Ltd, an investor comes across certain other aspects of the company:

1) Management Succession of HEG Ltd:

While analysing the annual reports of HEG Ltd, an investor notices that apart from the chairman of the company, Mr. Ravi Jhunjhunwala (age 63 years), another member of Jhunjhunwala family, Mr. Riju Jhunjhunwala (age 39 years) is present in the board of directors as a non-executive director. As per the annual report of the company, Mr. Riju Jhunjhunwala is the managing director of RSWM Ltd and Bhilwara Energy Ltd and is a relative of Mr. Ravi Jhunjhunwala. However, the annual report of HEG Ltd does not clearly specify the relationship between Ravi and Riju Jhunjhunwala.

When an investor analyses the notice to the 2016 AGM of RSWM Ltd (click here), page 7, then she notices that Riju Jhunjhunwala is the son of Mr Ravi Jhunjhunwala.

HEG RSWM Ltd Riju Jhunjhunwala Is Son Of Ravi Jhunjhunwala

It indicates that the company/LNJ group has put in place a management succession plan in which the new generation of the promoter family is being groomed in business while the senior members of the promoter family are still playing an active part in the day-to-day activities.

Presence of a well thought out management succession plan is essential in case of promoter run businesses as it provides for a smooth transition of leadership over the generations and provides continuity in the business operations of any company.

Further advised reading: Steps to Assess Management Quality before Buying Stocks

2) Proposed capital expenditure for the upcoming manufacturing capacity expansion:

On November 26, 2018, HEG Ltd announced to the stock exchanges that it plans to execute an expansion of its manufacturing capacity by 20,000 TPA. The company highlighted that the expansion would cost about ₹1,200 cr and would be completed in 30 months i.e. in 2021.

HEG FY2019 Expansion Plans

While analysing the past annual reports of HEG Ltd, an investor notices that in FY2012, the company has completed its last capacity expansion of 14,000 TPA at a cost of ₹225 cr.

FY2012 annual report, page 9:

We expanded our capacity by 14,000 TPA for an investment of ₹225 crore.

An investor would notice that if she assumes inflation of about 6% on the capital costs from the last capacity expansion in FY2012 to the proposed completion of newly announced capacity expansion in FY2021 (i.e. 9 years = 2021 – 2012), then the proposed expansion should cost about ₹543 cr. [calculation = (225 * 20,000/14,000)*(1.06)^9 = 543]

Therefore, by a simple assessment, it seems that the estimated cost of ₹1,200 cr for the proposed capacity expansion of 20,000 TPA to be completed in 2021 seems high when compared to the expansion projects completed by HEG Ltd in the past.

An investor may seek clarification from the company in this regard to understand the reasons for the significant increase in the cost of capacity expansion over and above the normal expected inflationary increases of about 6% per year.

Further advised reading: How to Identify if Management is Misallocating Capital

3) Management of foreign exchange fluctuations by HEG Ltd:

While analysing past annual reports of the company, an investor notices that HEG Ltd has suffered large losses to the tune of hundreds of crore rupees due to foreign exchange (forex) fluctuations over FY2008-18.

FY2009 annual report, page 47: HEG Ltd classified forex losses in the administrative and other expenses:

HEG FY2009 Foreign Exchange Losses

From FY2012 onwards, HEG Ltd started classifying forex losses under “Exceptional Items”.

FY2013 annual report, page 102: Exceptional forex losses in FY2012 and FY2013:

HEG FY2013 Foreign Exchange Losses

FY2015 annual report, page 118: Exceptional forex losses in FY2014 and FY2015:

HEG FY2015 Foreign Exchange Losses

Further advised reading: Understanding the Annual Report of a Company

An investor would notice that the exceptional item of foreign exchange losses has started to appear regularly over FY2012, FY2013, FY2014 and FY2015.

Overall, during FY2008-18, HEG Ltd reported losses of ₹327 cr due to foreign exchange fluctuations in its profit and loss statements. The net impact on the profits after factoring in the forex gains of total ₹47 cr during some years during FY2008-18 was a loss of ₹280 cr on account of foreign exchange fluctuations.

HEG Losses Suffered Due To Foreign Exchange Fluctuations In FY2008 18

An investor may note that the above analysis of the impact of net foreign exchange losses of ₹280 cr is only considering the amounts disclosed in the profit and loss statement (P&L) of HEG Ltd over these years.

In addition to the forex fluctuations disclosed in the (P&L), HEG Ltd has capitalized a significant amount of foreign exchange fluctuations in the fixed assets by way of capitalization of pre-operative expenses in the capital work in progress (CWIP) and other fixed assets. An investor would note that the amounts, which are capitalized during any year, do not reflect in the profit & loss statement in the year.

Advised reading: Understanding Capitalization of Interest & Other Expenses

FY2013 annual report, page 111:

HEG FY2013 Foreign Exchange Fluctuations Capitalised In CWIP

FY2015 annual report, page 125:

HEG FY2015 Foreign Exchange Fluctuations Capitalised In CWIP

FY2017 annual report, page 123:

HEG FY2017 Foreign Exchange Fluctuations Capitalised In CWIP

FY2018 annual report, page 195:

HEG FY2018 Foreign Exchange Fluctuations Capitalised In CWIP

During FY2012-2018, HEG Ltd seems to have capitalized the impact of foreign exchange fluctuations of about ₹192 cr in fixed assets as part of CWIP, building and plant & machinery.

Considering the above significant amount of losses incurred by HEG Ltd including the ₹327 cr disclosed in the P&L during FY2008-18, an investor would expect that the company should improve its foreign exchange management practices by adopting better hedging policies so that such large amount of forex losses may be avoided. This, in turn, would lead to value addition to the equity shareholders of the company.

Further advised reading: How to Identify if Management is Misallocating Capital

4) High barriers to entry did not help the graphite electrode manufacturers in tough times:

While analysing the graphite electrodes industry, an investor notices that multiple sources highlight it as an industry with high barriers to entry.

The credit rating agency, India Ratings, in its report of HEG Ltd in April 2015, highlights the advantages for existing players in the industry:

Barriers to Entry: The ratings are underpinned by HEG’s position as one of India’s leading GE manufacturers, its diversified customer base and its 100% self-sufficiency in power. The entry barriers, in terms of capital and technology, remain high which gives an edge to existing GE manufacturers.

Further advised reading: Credit Rating Reports: A Complete Guide for Stock Investors

The management of HEG Ltd has discussed the factors leading to the high barriers to entry in detail in the FY2018 annual report:

FY2018 annual report, page 20:

Supply constraints: Most opinion makers are of the view that the law of equilibrium would catch up considering the sizeable opportunity at hand. Hence, supply, sooner than later, would catch up with demand.

But I hold a different view. Like I mentioned earlier, I don’t expect large additional volumes entering the graphite electrode market over the medium term as the Graphite electrode business is not an easy space to be in, for important reasons:

One, because the technology for manufacturing this product has been zealously guarded by a handful of players globally.

Two, it is a highly capital intensive business. It requires high investment to set up a unit and sizeable working capital requirement to run the facility.

Three, graphite electrodes are made out of needle coke, a crude oil derivative. This too is a technologically difficult product and its supply is controlled by very few companies across the globe. Hence, its availability has constrained any meaningful capacity expansion in our business….

Four, any new Green field plant of electrodes would take anywhere between four to five years to build and stabilise

As a result, the graphite electrode sector has seen no large capacity increase over decades.

The management of the company highlights the key factors like:

  1. Closely guarded technology to produce graphite electrodes
  2. High capital requirements to establish manufacturing plants
  3. Difficulties in getting the raw material, needle coke and
  4. A long time of 4-5 years to build and stabilize a graphite electrode manufacturing plant

have prevented a lot of new players to enter the manufacturing space of graphite electrodes.

An investor would notice that these claims of high barriers of entry to new players seem to give an impression that the space of manufacturing graphite electrodes is a very coveted place, where only a few selected players got access early on and now there is no entry for any new entrant. An investor would expect that such a closely guarded club of graphite electrode manufacturers would face very limited competition and in turn, would generate a significant amount of profits for their owners/shareholders in all business situations. This is because in the business situations of monopoly and oligopolies where there are only a few suppliers of a product, the existing players are able to charge their customers sufficiently high prices to generate good profits in all the business environments as there is no fear of new entrants/manufacturers entering the field and disturbing the equilibrium.

However, when an investor studies the graphite electrode manufacturing industry over the years, as has been discussed above, then she notices that the only phases of supernormal profits for the graphite electrode manufacturers have been the uptrends in the business cycle like FY2003-FY2007 and FY2018. In the other phases of the business cycle i.e. from FY2008 to FY2017, the graphite electrode manufacturing industry has witnessed:

  • high competition,
  • oversupply,
  • declining demand,
  • declining prices and
  • business losses just like any other industry, which does not have such high barriers to entry.

Further advised reading: How to do Business Analysis of a Company?

Therefore, an investor should appreciate that even though it might be very difficult for any new player to:

  • acquire the technology to produce graphite electrodes,
  • arrange for huge capital to establish the manufacturing plant,
  • get sufficient amount of needle coke to manufacture graphite electrodes and
  • wait for many years to see a return on its investments

still, the dynamics of this industry are such that it has been prone to intense competition, oversupply, dumping by players below-cost prices to hurt competition, periods of business losses just like any other industry.

An investor would notice that the high entry barriers to new entrants have not provided any sustained supernormal profit characteristic to the graphite electrode manufacturers. An investor may notice the following factors:

  • The main end-user of graphite electrodes is the steel manufacturing industry. In the phases of a downturn in the steel manufacturing business, the demand, as well as prices of graphite electrodes, fall sharply and then the manufacturers go bankrupt/close plants. This happens frequently after every few years whenever the business cycle enters a downturn.
  • Even though as claimed, no new entrant has entered the graphite electrode manufacturing space in the last 40 years, the industry dynamics are such that the existing manufacturers over time have created an oversupply. As a result, they have dumped their products in other markets below the cost of production. Therefore, frequently, the govt. of different countries have to put anti-dumping duties on imports. Consider the following examples:

2010-Dec-17, European Union puts an anti-dumping duty on import of graphite electrodes from India (Global Trade Alert):

HEG EU 2010 Antidumping Duty On Graphite Electrode Imports From India

2015-Feb-16, India puts an anti-dumping duty on imports (Source: Antidumping duty imposed on imports of graphite electrodes: Economic Times)

NEW DELHI: The government has imposed an anti-dumping duty of up to $922.03 per tonne on imports of a product used in steel plants, a step to protect the domestic industry from below-cost shipments.

2018-Aug-11, Russia extends anti-dumping duty on graphite electrodes imports from India (Steel Mint)

HEG Russia 2018 Antidumping Duty On Graphite Electrode Imports From India

Further advised reading: How to Monitor Stocks in your Portfolio

As a result, an investor would notice that despite high entry barriers to entry for new players, in the graphite electrodes industry, the existing players themselves have created a sufficiently tough environment that there is no guarantee of sustained good profits for the manufacturers. As discussed above, the graphite electrode manufacturers have generated supernormal profits for limited periods, which have coincided with the upturn in the business cycle like FY2003-FY2007 and FY2018.

The recent phase of high profits in the industry may also come to an end whenever the newly announced capacity expansions get completed and the temporary shortage of the electrodes resolves. There are already some signs indicating developments in this direction:

  • India has removed anti-dumping duty on imports of graphite electrodes in Sept 2018 (HEG Ltd, Feb 2019 results presentation, page 6):

India removed antidumping duties on graphite electrodes imported from China in September 2018 which has increased imports.

  • China is increasing the production of graphite electrodes and has in fact completed the capacity increase of graphite electrodes before the new electric arc furnace (EAF) steel plants, which are expected to use these new graphite electrodes could be completed. (HEG Ltd, Feb 2019 conference call, page 5-6). As a result, an investor would appreciate that there will a tendency of China to export the surplus graphite electrode production until the EAF steel plants become operational.

So what we believe is that there has been probably a mismatch where the capacities of existing non-UHP electrode making in China, those capacities have probably come maybe six months, maybe nine months earlier than the newly built Greenfield steel plants. So in a nutshell, what we are probably assuming is that the electrode capacities have come in earlier than the new steel capacities are coming in.

  • The management of HEG acknowledges that high profitability periods like FY2018 occur rarely and it expects that the profit margins may moderate going ahead as manufacturing costs and the raw material prices are increasing (FY2018 annual report, page 34):

Growth risk: Will the Company be able to sustain its performance of the current year, going forward?

Mitigation: The period 2017-18 was an incredible year from every perspective and such events happen very rarely in a Company’s journey. The Company was just fortunate that after two years of being in the red, 2017-18 happened which more than made up for the ills of the earlier financial years. Going forward, while demand is expected to remain robust, the cost of manufacture is expected to catch up (needle coke prices are expected to rise). This will rationalise margins to more sustainable levels.

The management informed the analysts in the Nov. 2018 conference call that in FY2019, the prices of coal tar pitch, which is a significant portion of the raw material for graphite electrodes has risen to 2.5 to 3 times of the prices in FY2018.

Nov. 2018 Conference call, page 6-7:

Rohan Shah: I would like to talk about our raw material required which is coal tar which I guess, so I wanted to understand about this raw material requirement of ours. I have read that about 40% of a graphite electrodes is may through coal tar pitch, so I just wanted to know that the pricing of coal tar pitch is also increased or what has been happening in the market?

Ravi Jhunjhunwala: Yes, what you are saying is right, we have two major raw materials in our mixing process, one is CPC and the other one is coal tar pitch and the ratio could be different between different companies, so 25, 30 whatever based on each company specs is what people use. Now, in terms of price trend of coal tar pitch, you are right there has been shortage of carbon material in the entire year of 2018-19 and we saw a jump in prices of coal tar pitch as well, so if we compare ‘17-18 with ‘18-19, coal tar pitch is at least 2.5 to 3 times of what it was in ‘17-18.

Further advised reading: How to Monitor Stocks in your Portfolio

Therefore, an investor would appreciate that the recent high-profit performance of the graphite electrode industry is a phase in the business cycle, which may give way to moderate profits as the new manufacturing capacities come up, imports increase, cost of manufacturing and raw material prices increase. We believe that while analysing graphite electrode manufacturers, an investor should keep in mind the impact of business cycles on their performance.

5) HEG Ltd: Claims of lowest cost producer do not reflect in business performance:

While reading the past annual reports of HEG Ltd., an investor notices that year after year, the company has claimed itself as one of the lowest-cost producers of graphite electrodes in the world.

FY2009 annual report, page 7:

Our single site location also adds advantage to economies of scale and we believe that we are one of the lowest cost producers of high grade graphite electrode products.

FY2011 annual report, page 10:

Cost advantage: At HEG, our competitive advantage is derived from our positioning as one of the world’s lowest cost graphite electrode manufacturers.

Investors expect that when an industry is faced with tough times, then the lowest-cost producers in the industry are able to perform better than their competitors do. Investors expect such manufacturers to keep generating profits while their competitors make losses as the sales volumes and sales prices decline because of their lowest costs of production.

However, when an investor observes the performance of HEG Ltd during the downturn phase of graphite electrode industry FY2016 and FY2017 and compares HEG Ltd.’s performance with its Indian competitor, Graphite India Ltd, then she expects that HEG Ltd would report profits and Graphite India Ltd would have reported losses. This is because HEG Ltd is supposed to be one of the lowest-cost producers in the world. However, the performance of HEG Ltd and Graphite India Ltd during FY2016 and FY2017 indicates that during this industry downturn, Graphite India Ltd reported profits and it was HEG Ltd, which reported losses in its graphite electrodes business.

HEG Ltd FY2017 annual report, page 115:

HEG FY2016 FY2017 Graphite Electrode Segment Losses

Graphite India Ltd FY2017 annual report, page 157:

Graphite India FY2016 FY2017 Graphite Electrode Segment Profits

Looking at the above comparative performance of the two Indian graphite electrode manufacturers, an investor notices that during the business downturn of the industry in FY2016 and FY2017, the claims of HEG Ltd of being one of the lowest-cost producers did not reflect in the comparative business performance.

Further advised reading: Why We cannot always Trust What Management Claims

6) Investments by HEG Ltd in the promoter group companies/associate companies:

While analysing the past annual reports of HEG Ltd, an investor notices that the company has been investing in the promoter group companies/associates on a regular interval. An investor would notice that the company has invested money in the group companies even when it had debt outstanding on its books.

HEG Investments In The Group Companies In FY2009 18

Investing in the group companies when a company has debt outstanding may be interpreted as an alternative use of funds where a company believes that helping group companies with investments is a better option than increasing the value to the equity shareholders by repaying the debt of the company.

Investors may note that the enterprise value of any company accrues to lenders and equity shareholders. Therefore, whenever a company reduces the debt on its books, then the enterprise value accrues to the equity shareholders.

Investors may make an opinion about whether investing money in the group companies is a preferable option than repaying the debt of the company and increase value to the equity shareholders.

Moreover, while analysing the auditor’s report section of the FY2009 annual report of HEG Ltd, an investor gets to know that the company provided a helping hand to the promoter group company/associate by way of a short-term loan of ₹100 cr.

FY2009 annual report, page 38:

(a) The Company has granted unsecured loan during the year to one of its associate companies listed in the register maintained under section 301 of the Companies Act, 1956. Apart from this loan, the company has not granted any other loans, secured or unsecured, to companies, firms or other parties listed in the register maintained under section 301 of the Companies Act, 1956.

(b) The maximum amount outstanding during the year is Rs. 100 Crore and year end balance of such loan is Rs. Nil. In our opinion, the rate of interest and other terms & conditions of such loan are, prima facie, not prejudicial to the interest of the company.

In addition, while analysing the contingent liabilities of HEG Ltd, an investor notices that the company has given a guarantee to International Finance Corporation (IFC) for its investment in a group company M/s AD Hydro Power Ltd.

FY2018 annual report, page 132:

HEG FY2018 Financial Guarantee To IFC

The investor notices that the guarantee is outstanding for more than 10 years. In FY2010, the amount of financial guarantee was increased from ₹3.5 cr to ₹6 cr.

FY2010 annual report, page 48:

HEG FY2010 Financial Guarantee To IFC

An investor would appreciate that a financial guarantee may indicate that in case IFC does not make a return on its investment (if invested in equity) or does not get its interest and principal repayments (if it has given debt) from M/s AD Hydro Power Ltd, then IFC may ask HEG Ltd to pay it so that IFC can earn the return on its money.

It is advised that an investor should keep in mind these transactions of HEG Ltd in the group/associate companies while making her opinion about the company.

Further advised reading: How Promoters benefit themselves using Related Party Transactions

7) Error in the annual report of HEG Ltd:

There appears to be an error in the FY2013 annual report of HEG Ltd in the calculation of cash flow from operating activities (CFO).

FY2013 annual report, page 82:

HEG FY2013 Error In The CFO Calculation

While calculating net cash from operating activities by adjusting the tax payments done in the year, the tax payments are deducted from the cash from operating activities.

In the FY2012, HEG Ltd has correctly deducted the tax payments of ₹4.82 cr from cash from operating activities of ₹31.88 cr and arrived at the figure of ₹27.06 cr as net cash from operating activities. However, in the calculations for FY2013, there is a mistake as HEG Ltd should have deducted tax payments of ₹19.47 cr from the cash from operating activities of ₹134.70 cr and arrived at net cash from operating activities of ₹115.23 cr (= 134.70 – 19.47). However, erroneously, for FY2013, the annual report mentions the net cash from operating activities as ₹170.73 cr.

Further advised reading: Understanding Cash Flow from Operations (CFO)

8) Graphite electrode manufacturing produces pollution:

While reading about HEG Ltd and graphite electrodes production, an investor would notice that the production of graphite electrodes is a polluting process. An investor may find multiple instances of information regarding its polluting nature.

  • China in its crackdown on polluting industries closed around 300,000 TPA of graphite electrode manufacturing capacity. FY2018 annual report, page 25:

The shortage of electrodes was also attributed to shutting down of nearly 300,000 TPA of graphite electrode manufacturing capacity in China since the second half of 2016 (Source- CRU.)

The GIL plant on ITPL Main Road manufactures graphite electrodes, which causes high level of air pollution because of the graphite dust generated.

In light of the polluting nature of the graphite electrode production process, investors should be aware of the risks, which any non-adherence to the environmental norms by the company or social activism can bring for the company and in turn for its shareholders. An investor may remember that the copper production plant of Vedanta Ltd/Sterlite in Thoothukudi, Tamil Nadu, is lying shut since about a year and the company is losing about ₹5 cr per day because of the closed plant (Source: Losing Rs 5 cr daily due to Sterlite copper plant shutdown: Vedanta to HC,

Other queries:

  • HEG Ltd has its manufacturing plant in Mandideep, M.P. However, its corporate office is in Noida, UP, which is a part of NCR. The company may have chosen a Delhi based chartered accountant for audit due to closeness to its corporate office.

Margin of Safety in the market price of HEG Ltd:

Currently (March 9, 2019), HEG Ltd is available at a price to earnings (PE) ratio of about 2.78 based on the past four quarters’ standalone earnings. However, an investor would remember that even the management of the company has acknowledged that the current period of high profitability is a rare instance. There is no certainty that the high-profit margins will continue in future. Therefore, we are not able to provide any opinion about the valuation of the company based on the current share price and its recent business performance. Investors may take their own decision about the valuations of the company.

However, we recommend that an investor may read the following articles to assess the PE ratio to be paid for any stock, takes into account the strength of the business model of the company as well. The strength in the business model of any company is measured by way of its self-sustainable growth rate and the free cash flow generating the ability of the company.

In the absence of any strength in the business model of the company, a low PE ratio of the company’s stock may be signs of a value trap where instead of being a bargain; the low valuation of the stock price may represent the poor business dynamics of the company.

Analysis Summary

Overall, HEG Ltd seems a company operating in a cyclical industry. As a result, HEG Ltd has witnessed its business performance varying from very high profitability and losses in the past decade (FY2009-18). The company witnessed the impacts of cyclical upturn and downturns along with its industry peers. Graphite electrode industry started expanding capacity when the industry witnessed the previous upturn phase of 2003-2007 when its customer industry of steel manufacturing was in a boom phase. However, the business cycle turned with the onset of the global financial crisis of 2008.

Investors would notice that in cyclical industries, most of the manufacturing capacity announced during good times is completed after the good times are over. Similarly, in the case of the graphite electrode industry and HEG Ltd, its capacity expansion was completed in 2012 when the industry downturn had started. As a result, the graphite electrode industry found itself saddled with overcapacity. During the 2012-2017 period, the industry faced declining sales with lower prices due to oversupply. Many graphite electrode manufacturing plants became unviable and as a result, these plants were shut down during this period. During this period, HEG Ltd was not spared and it reported losses in its graphite electrode division in FY2016 and FY2017.

The reduction of supply by way of shut down of manufacturing capacity corrected the oversupply situation of graphite electrodes, which is a typical case with all cyclical industries. Therefore, when the demand revived in the ensuing upturn, the remaining graphite electrode manufacturers found themselves in a position of negotiating power. As a result, all the manufacturers including HEG Ltd earned very high profits in FY2018. In a standard template of responses of cyclical industries in the business upturn, the manufacturers of graphite electrodes (HEG Ltd.) have announced capacity expansion plans. It seems that the business cycle has turned a full circle from the last upturn of 2003-2007 to the current upturn of 2018.

It is anticipated as like any other cyclical industry and the response of the graphite electrode industry in its previous business cycle, the manufacturing capacity will increase and in future, the high profits will come down. The trend is visible by way of fast completion of graphite electrode plants in China even before the completion of steel manufacturing plants, which will use the graphite electrodes produced by them. As a result, China has started exporting graphite electrodes. Govt. of India has removed the import duty on graphite electrodes in Sept 2018. This increased supply along with an increase in the cost of raw material is expected to bring down the profit margins in future.

Such turn of events in cyclical industries, seem predictable in terms of a sequence of events/phases one after another. However, it is difficult to determine the timing of onset/completion of these phases with precision. As a result, many times, even the promoters/managers who earn their livelihood by working in these industries also get the timing of their decision wrong. Therefore, it is difficult to predict the exact time when the current upturn in the graphite electrode business cycle will end and the downturn will begin. However, these cyclical phases have worked one after another in the past and it is expected to follow this sequence in future.

Apart from the cyclical nature of its business, HEG Ltd is affected by less than optimal management of foreign exchange exposure. The company has reported more than ₹300 cr of forex losses in FY2008-18 in the P&L because of foreign exchange fluctuations. These losses do not include the amount of foreign exchange losses, which are capitalized and not deducted from the P&L in the year of their occurrence.

As mentioned above, HEG Ltd has announced a capacity expansion plan for ₹1,200 cr. This capital expenditure seems very high when compared to the inflation-adjusted cost of similar expansion undertaken by the company in the past.

It is advised that investors may seek clarifications from the company related to the seemingly high cost of capital expenditure plan, investments in the group companies/associates and guarantees given for third-party investments (IFC) in the associate company.

Advised reading: How should investors contact Companies/Management for clarifications or additional information?

Investors should be aware of the risks of investing in companies dealing with environmentally polluting manufacturing processes. Graphite electrode manufacturing is one such process, which has seen the authorities closing down plants in various countries like China (about 300,000 TPA shut in last 2-3 years) as well as India (Bengaluru plant of Graphite India Ltd closed down). Such risk of non-compliance with environmental norms as well as social activism poses a serious concern to investors and they should factor it while making an opinion about such companies.

Going ahead, investors should monitor the profit margins of HEG Ltd along with the progress of the capacity expansion project within cost and time limits. Investors should monitor the foreign exchange management by the company along with investments in associate/group companies.

Further advised reading: How to Monitor Stocks in your Portfolio

These are our views on HEG Ltd. However, investors should do their own analysis before making any investment-related decision about the company.

You may use the following steps to analyse the company: “Selecting Top Stocks to Buy – A Step by Step Process of Finding Multibagger Stocks

Hope it helps!


Dr Vijay Malik



Registration status with SEBI:

I am registered with SEBI as a research analyst.

Details of financial interest in the Subject Company:

I do not own stocks of the companies mentioned above in my portfolio at the date of writing this article.

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