by Suhani Adilabadkar

Graphite India (which is in 21 stock screeners) had its day in the sun. The cyclical uptrend that lasted for one and a half years transformed Graphite India and HEG into multibagger stocks with informed value investors assimilating wealth as both Indian twins gave phenomenal returns, roughly 1300% and 2600% respectively by the end of August 2018. Though the party seems to be over - Graphite India is now down 62% from its 52-week high last year - the Graphite Electrode sector, after emerging from the unknown realms of stock market, cannot be completely written off.  

Quick Takes:

• Graphite India Limited with its12% global market share is the third largest GE manufacturer in the world.
• High dependency on global steel demand and rising raw material costs are major key risk factors.
•  Graphite electrodes, an indispensable industrial consumable product is utilised in production of steel through EAF method.
• Anti-dumping duties implemented by the Trump administration in the US, cheap Chinese imports and restrictions on exports halted the Indian GE rally.

Graphite India

Started in collaboration with erstwhile Great Lakes Carbon Corporation (GLCC) USA  in 1967, Graphite India Limited (GIL) is the largest producer of Graphite Electrodes in India and one of the largest globally as per capacity. The company’s manufacturing prowess is spread over three plants at Durgapur and Nashik in India and Nurnberg in Germany with total capacity of 98,000 tpa. Apart from Graphite Electrodes (GE), GIL also boosts strong product profile comprising Calcined Petroleum Coke, Impervious Graphite Equipment, Glass Fibre Reinforced Plastic Pipes and High-Speed Steel. Exports account more than half of its revenue basket with GIL’s products servicing auto, aerospace, chemical, pharmaceutical, metallurgical and machine tool industries. Mainstay business for GIL is its Graphite Electrode business with 12% global market share, making it the third largest GE manufacturer in the world.

A sobering March quarter

The analyst community appears to be have sobered down on Graphite Electrode sector as the multibagger theme of 2017 isn’t paying off anymore. Though analyst forecasts have not been met, GIL has done fairly well in a tough milieu with rising raw material costs, lower volume and changing regulatory scenario. Revenue grew 28% YoY at Rs. 1693 cr against Rs. 1323 cr same period previous year with sequential de-growth of 9% in Q4 FY19. EBDITA grew 20% YoY reported at Rs. 864 cr compared to Rs. 720 cr corresponding quarter previous year but also with sequential decline at the same rate coupled with EBDITA margin declining 339 bp YoY and 735 bp QoQ mainly on account of lower volumes and rising cost of its major raw material (needle coke). PAT exhibited mild YoY growth of 4% at Rs. 564 cr with quarterly fall of 26% in Q4 FY19. Though the annual numbers look strong with 229% growth in PAT and 140% revenue jump in FY19, they much lower than FY18 growth rates when revenue doubled, and profitability jumped 14 times YoY. In contrast, its immediate peer, HEG, exhibited 18% de-growth in PAT with mild revenue jump of 4% along with sequential decline of 28% and 40% for Revenue and PAT respectively in Q4 FY19. Though HEG has played the cyclical card well over the past one and half years, GIL has emerged as a relatively stronger player during the past 6-7 months. 

Graphite Industry Analysis

There has been a lack of consistency in GIL numbers over the past five quarters. March, June and September quarters exhibit an uptrend in sales and profitability whereas growth seems to have tapered off from December quarter. To understand this declining cacophony, we need to first understand the original score.

The Graphite Electrode Industry is highly dependent on global steel production, and woke up to a highly environmentally friendly and protectionist world in 2016. GE being an indispensable industrial consumable product available in two forms, UHP (ultra-high power) and non UHP, utilised in production of steel through Electric Arc Furnace (EAF) method which is considered environmentally friendly and less polluting.

Manufacturing one tonne of steel requires approximately 2 kgs of GE. The environmental measures adopted by the Chinese authorities in 2016, with large scale shutting down of polluting factories led to the closure of roughly 300 million tonnes of steel capacity which was mainly produced via highly polluting BOF method. Consequently, Chinese exports also came down, roughly by 30% in 2017 opening the doors for other global players to garner higher market share in the global steel industry, which was earlier saddled with higher cheap Chinese imports. Another catalyst to this whole steel equation was the US administration’s trade barriers on Chinese steel. This worked favourably well for countries like India both with respect to domestic Steel industry and Graphite Electrode players as nearly 42-45% of global steel manufacturing facilities excluding China produces steel via EAF method using Graphite Electrodes.

EAF being the preferred route for steel manufacture, these moves opened the profitability doors for Graphite companies worldwide. Indian twins, HEG and GIL grew with robust numbers reporting phenomenal quarterly and yearly numbers in 2018 and stock prices rallying ahead of benchmark indices multiplying investor wealth several times over the past two years.

The Reversal

Informed value investors with an understanding of the cyclical trends of the global economy made hay when the steely sun was shining on the GE market, as Chinese stopped imports and trump trade barriers took effect. These investors exited as global slowdown alarm bells started chiming by the end of October 2018. With respect to Indian scenario, removal of anti-dumping duty on GE imports in September last year, higher non UHP GE imports from China, lower UHP GE prices impacted by weak steel prices and adding to the trouble list, halting GE exports to Iran amidst US sanctions took its toll on Indian GE producers.

But the worst stroke was from rising cost of its primary raw material, Needle Coke which also has alternate high demand from Electric Vehicles market, which is expected to grow at a CAGR of 30% in the next 3-5 years. EVs are expected to garner 5% market share in the next 3 years and require Needle Coke for manufacturing carbon anode of their lithium batteries.  Thus, tight supply of basic raw material, as Needle Coke has only five suppliers globally along with lower steel prices driven by slow economic activity impacted operating margins for all GE producers.

Needle coke costs have risen dramatically for GIL, roughly 40-50% YoY constituting more than 50% of total cost mix by the end of FY19. No doubt margins have come down heavily more than 700 bp sequentially. GE industry is riddled by raw material constraints, lower capacity additions due to high capital and technology requirement and high dependency on cyclical EAF steel industry which utilizes 90% of its total supplies.  Consequently, companies like GIL with strong balance sheet with debt equity ratio of just 0.07, robust net consolidated cash flow of Rs. 2577 cr with 12% global market is valued as per global steel industry movement which has grown just 3.3% YoY and declined 3% sequentially in March quarter FY19.

So for investors to ride the next GE wave, wait for the next steel boom.