Indian Graphite Sector

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Graphite sector in India

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<ul><li><p>March 24, 2010 </p><p>ICICIdirect.com | Equity Research </p><p> Initiating Coverage </p><p>In a global outperformance phase The Indian graphite sector is currently going through a phase of global outperformance in a technology intensive industry on the back of cost competitiveness and sound operations of domestic graphite producers. Graphite demand has started improving globally. An improvement in steel production and robust product prices have led to a fine performance by Indian graphite players in 9MFY10 leaving global peers far behind. Capacity expansion is underway and low cost operations are ensuring better margins as compared to global peers. Hence, we expect Indian graphite companies to continue their outperformance over international players and increase their share in the global graphite market from ~13% in 2009 to ~18% in 2012E. We are initiating coverage on the graphite sector with a STRONG BUY rating on HEG Ltd and an ADD rating on Graphite India Ltd (GIL). </p><p>Bounce back in steel production to propel graphite electrode demand </p><p>Steel demand suffered a sharp drop from Q4CY08 and through much of 2009. This was on account of the global financial crisis that led to a severe drop in EAF steel production and the resultant graphite electrode demand. With the recovery in steel production growth firmly in place, we expect graphite demand to increase by ~17% YoY in 2010 on the back of steel production scaling back to pre-crisis levels. </p><p>Ongoing capacity expansion ensures economies of scale Indian graphite manufacturers enjoy competitive operating advantages with low manpower costs, captive power feeds and strategic location benefits. Brownfield capacity expansion (ranging from 13% to 21%) at existing locations being carried out by both Indian graphite producers would lead to further cost savings with economies of scale. </p><p>Low cost structure ensures highest capacity utilisation, margins globally Indian graphite producers have operated at higher capacity utilisation rates (45-75%) as compared to global peers (35-55%) even during recessionary periods (CY09) due to their low cost structure. Production cuts in response to a drop in demand have been more pronounced for high cost producers in the developed world. Domestic players have weathered the storm better. With the low cost structure being further improved upon, domestic players are expected to enjoy better margins (higher by 500-1000 bps) as compared to global peers, going forward. </p><p>Outlook and recommendation Indian graphite players have remained at the forefront of the recovery in graphite electrode demand globally. Apart from operating at higher capacity utilisation levels and achieving better profit margins as compared to global peers in the last few quarters, they have also announced capacity expansion plans recently. Despite possessing strong business models, the current valuations of domestic players are at a steep discount to global peers and leave room for upside. We are initiating coverage on the graphite sector with a positive view. HEG Ltd is our top pick in the space on account of its single location advantage, higher margins and value accretive investment in Bhilwara Energy Ltd. </p><p>Indian Graphite Sector Financials &amp; Rating Grid </p><p>HEG Limited (HEG) STRONG BUYCMP Rs 338TP Rs 466Upside % 38%Market Cap Rs Cr 1380</p><p>FY09 FY10E FY11E FY12ENet Sales Rs Cr 1029.0 1069.7 1155.9 1352.4EBITDA Rs Cr 274.7 380.9 369.3 431.6EBITDA % % 26.7 35.6 31.9 31.9PAT Rs Cr 107.0 181.6 155.6 191.6EPS Rs 25.1 44.5 38.1 46.9P/E x 13.4 7.6 8.9 7.2EV/EBITDA x 8.1 5.4 5.5 4.8</p><p>Graphite India Limited (CAREVE) ADDCMP Rs 88TP Rs 95Upside % 8%Market Cap Rs Cr 1740</p><p>FY09 FY10E FY11E FY12ENet Sales Rs Cr 1501.0 1294.9 1443.4 1766.8EBITDA Rs Cr 307.6 359.3 295.3 366.7EBITDA % % 20.5 27.8 20.5 20.8PAT Rs Cr 235.5 205.6 166.4 207.6EPS Rs 13.8 12.0 8.4 10.5P/E x 6.4 7.3 10.5 8.4EV/EBITDA x 6.0 4.3 5.5 5.0</p><p>Comparative return metrics 1M 3M 6M 12M</p><p>HEG 2.1 -11.4 28.9 238.2Graphite India 13.1 13.4 44.8 269.2 </p><p>Price Movement (Stock vs. Nifty) </p><p>050</p><p>100150200250300350400450</p><p>Mar-09 Jul-09 Nov-09 Mar-10</p><p>(In rs</p><p>)</p><p>0</p><p>1000</p><p>2000</p><p>3000</p><p>4000</p><p>5000</p><p>6000</p><p>(In u</p><p>nits</p><p>)</p><p>HEG GIL NIFTY </p><p> Analysts name </p><p>Pankaj Pandey pankaj.pandey@icicisecurities.com </p><p> Goutam Chakraborty goutam.chakraborty@icicisecurities.com </p><p>Abhisar Jain abhisar.jain@icicisecurities.com </p></li><li><p>Indian Graphite Industry </p><p>ICICIdirect.com | Equity Research Page 2 </p><p>Table of Content Page No Global graphite electrodes industry dynamics 3 </p><p>Technology intensive and oligopolistic in nature 3 Bounce-back in steel production to propel graphite demand 6 Graphite prices remain strong 9 Scarce availability of raw material remains a concern 10 Power a major cost, Indian players have captive advantage 11 Indian players operating at higher margins 12 </p><p>Risk &amp; Concerns 13 Financials 14 Valuations &amp; recommendation 16 Companies: HEG Ltd Investment Rationale 21 </p><p>Capacity build-up spree continues 21 Strong captive power base provides competitive edge 22 Low cost structure ensures better margins 24 </p><p>Financials 25 Valuations 27 Tables 29 Graphite India Ltd Investment Rationale 34 </p><p>Capacity expansion underway 34 Diversification benefits through other businesses 35 Realisation and cost of production to trend upwards 36 On competitive footing with global peers 37 </p><p>Financials 38 Valuations 40 Tables 42 </p></li><li><p>Indian Graphite Industry </p><p>ICICIdirect.com | Equity Research Page 3 </p><p>Global graphite electrodes industry dynamics </p><p>Technology intensive and oligopolistic in nature </p><p>The graphite electrode industry is characterised by a closely guarded technology with just a small bunch of producers globally. The replacement cost of a new greenfield plant is exorbitantly high and remains non-viable. The last greenfield project was set up by HEG way back in 1977 in India. The industry has oligopolistic competition because of the existence of only seven or eight players on a global basis. Graphite manufacturers are involved in the production of ultra high power (UHP) electrodes that find application in steel production through electric arc furnace (EAF) route. Exhibit 1: Industry structure Graphite electrode producers </p><p>Sr. No. Company Mid-1990's Current1 Graftech International, USA 5 200000 2200002 SGL Carbon, Germany 7 190000 2200003 Four Japanese producers 7 220000 2500004 Other Western producers 2 60000 350005 China 6 75000</p><p>Sub-total 27 670000 800000Growth 19.4%</p><p>6 HEG 1 20000 660007 Graphite India 4 25000 78000</p><p>Sub-total 5 45000 144000Growth 220.0%</p><p>Total - UHP Electrode 31 715000 944000Growth 32.0%</p><p>Production capacity (Tonne)No. of plants</p><p>Source: Industry data, ICICIdirect.com Research </p><p>Dependent on steel production growth through EAF route </p><p>Graphite electrodes are used as a consumable item in the steel production process through the EAF route. EAF steel plants, also known as mini-mills due to their relatively small size (1-3 MT) as compared to blast oxygen furnace (BOF) steel plants, typically consume one graphite electrode every 8-10 hours and require 1.5-2 kg of graphite electrode per tonne of steel production. </p><p>Exhibit 2: EAF steel share in global steel production rises smartly </p><p>283405 450 473</p><p>539691</p><p>803</p><p>3234</p><p>3328</p><p>2523</p><p>18</p><p>0</p><p>200</p><p>400</p><p>600</p><p>800</p><p>1000</p><p>1200</p><p>1400</p><p>1600</p><p>1975 1980 1985 1990 1995 2005 2011E</p><p>5</p><p>10</p><p>15</p><p>20</p><p>25</p><p>30</p><p>35</p><p>40</p><p>(%)</p><p>Total Steel Produced (MT) EAF Steel (MT)Graphite Electrode Demand('000 tonne)</p><p> Source: Industry, ICICIdirect.com Research </p><p>Graphite industry is technology intensive andconstituted by just a few producers globally </p><p>Graphite capacity expansion is possible mainlythrough the brownfield route. Indian players haveexpanded capacity at a much faster pace as comparedto their global peers </p><p>Graphite electrode demand is dependent on steelproduction through the EAF route and has grownsmartly due to the increasing share of EAF in worldcrude steel production </p><p>EAF Share (R.H.S)</p><p>700045</p></li><li><p>Indian Graphite Industry </p><p>ICICIdirect.com | Equity Research Page 4 </p><p>The demand for graphite electrodes has increased consistently on the back of strong growth in overall steel production and increasing share of steel produced through the EAF route over the last two decades (EAF steel share has increased from 25% to 34% over 1985-2005). </p><p>EAF route enjoys strategic advantages over BOF method </p><p>EAF route method of producing steel is continuously increasing its share in the worlds total steel production due to several advantages over the traditional blast furnace method. Some of these include: </p><p> Lower initial capital expenditure requirements and higher productivity </p><p> Smaller size leading to easy switch on and off options (can be done every two or three hours), which allows flexibility in production </p><p> Suitable for producing high-end special steel and batch process of production allows easy change in the product mix </p><p> Lower cost of production as compared to non-integrated BOF steel producers </p><p>Exhibit 3: EAF steel production cost break-up </p><p>ParticularsCost/unit </p><p>(US$/tonne) I/P Reqd/tonne Cost (US$)Steel Scrap (tonne) 375 1.13 424Power (KwH) 0.075 600 45Ferro Alloys (tonne) 1200 0.01 12Graphite Electrodes (Kgs) 5 1.8 9Transport 10 1 10Labour 20 1 20Others 10Total Cost/tonne 530</p><p>EAF Production</p><p> Source: Industry, ICICIdirect.com Research </p><p>Exhibit 4: BOF steel production cost break-up </p><p>ParticularsCost/unit (US$/tonne) I/P Reqd Cost</p><p>Iron Ore 90 1.7 153Coking coal 200 1 200Coke conversion 30 1 30Power (KwH) 0.075 500 38Scrap 375 0.1 38Ferro alloys 1200 0.015 18Other Raw Material 30 1 30Transport &amp; Others 30 1 30Labour 25 1 25Total Cost/tonne 561</p><p>BF Production</p><p> Source: Industry, ICICIdirect.com Research </p><p> EAF route more pronounced in the western world and Middle East </p><p>Against the share of ~31% on a global basis, the EAF route accounts for 40-50% of steel produced in the western world and ~85% in Middle East. This is due to better availability of scrap (major ingredient in EAF steel making) and higher demand of special/alloy steel that is produced mainly </p><p>EAF route of steel production enjoys strategicadvantages over BOF method like lower cost ofproduction and easy switch on and off options </p></li><li><p>Indian Graphite Industry </p><p>ICICIdirect.com | Equity Research Page 5 </p><p>through EAF route. Due to higher share of EAF produced steel, graphite electrode demand is driven largely from these markets. </p><p>Exhibit 5: EAF steel share -2008 (Country wise) </p><p>CountryTotal Steel </p><p>produced (MT)EAF Steel </p><p>(MT)EAF Share </p><p>(%)Europe (EU 27) 198 82 41.4USA 91 53 58.1Central &amp; South America 48 18 37.1Middle-east 16 14 87Asia 767 161 21Total 1323 405 30.6 </p><p>Source: IISI, ICICIdirect.com Research </p><p> Exhibit 6: EAF steel production break-up </p><p>Location</p><p>Crude Steel (MT)</p><p>EAF Steel (MT)</p><p>EAF Share</p><p>(%)</p><p>Crude Steel (MT)</p><p>EAF Steel (MT)</p><p>EAF Share</p><p>(%)</p><p>Crude Steel (MT)</p><p>EAF Steel (MT)</p><p>EAF Share</p><p>(%)EU(27) 198 82 41 139 56 40 151 60 40USA 91 53 58 58 35 60 72 43 60Middle-east 16 14 88 17 15 85 20 17 85Asia 767 160 21 795 159 20 830 166 20World 1323 405 31 1220 341 28 1329 399 30</p><p>2008 2009 2010E</p><p> Source: Industry, ICICIdirect.com Research </p><p> but supply of graphite electrodes has increased mainly from India Exhibit 7: Share in world graphite production </p><p>28 27</p><p>31</p><p>6</p><p>24 2427</p><p>13</p><p>21 2124</p><p>18</p><p>0</p><p>5</p><p>10</p><p>15</p><p>20</p><p>25</p><p>30</p><p>35</p><p>US Europe Japan India</p><p>(% S</p><p>hare</p><p>)</p><p>Mid-1990s Current 2011-12E</p><p>India's share increasing steadily</p><p> Source: Industry, ICICIdirect.com Research </p><p>While India has been increasing its market share (up from 6% to 13% in the last 10-12 years) of graphite electrode production steadily over the years (through brownfield expansion), the western world and Japanese share is steadily coming down. This is due to lesser capacity addition on account of higher operational and capital costs and lower cost competitiveness as compared to Indian players like HEG and GIL who enjoy lower power and manpower costs. </p><p>EAF share in steel production is ~58% in the US and~41% in Europe </p><p>Indias share in overall supply of graphite electrodeshas increased due to build-up in capacities by Indianplayers on account of better cost competitiveness andbrownfield expansion capability </p></li><li><p>Indian Graphite Industry </p><p>ICICIdirect.com | Equity Research Page 6 </p><p>Bounce-back in steel production to propel graphite electrode demand </p><p>Steel demand suffered a sharp drop from Q4CY08 and through much of 2009. This was due to the global financial crisis that, in turn, led to massive production cuts in the developed world on account of shrinking demand. This led to a severe drop in EAF steel production and the resultant graphite electrode demand. With the recovery in steel production growth firmly in place, we expect graphite demand to increase by ~17% YoY in 2010E. This will be on the back of steel production scaling back to pre-crisis levels of ~1330 MT and EAF steel production going up to 399 MT. </p><p>Exhibit 8: Strong bounce back expected in demand </p><p>SteelProduction</p><p>(MT) EAF Share</p><p>EAFProduction</p><p>(MT)</p><p>Implied UHP GraphiteElectrode Demand</p><p>('000 tonne)* Growth2005 1144 34% 389 7002006 1247 32% 393 707 1%2007 1346 32% 427 769 9%2008 1323 31% 405 729 -5%2009 1219 28% 341 614 -16%</p><p>2010E 1329 30% 399 718 17%2011E 1395 32% 446 804 12%</p><p>* Graphite electrode demand based on 1.8 Kgs reqd./tonne of EAF steel produced Source: Worldsteel.org, Industry, ICICIdirect.com Research </p><p>Significant EAF capacity additions planned in Asia and Middle East. </p><p>The advent of the global recession has led to significant demand destruction and production cutbacks in the developed world. However, Asia and Middle East have shown strong resilience. They have continued on their strong growth path with steel production growing over 13% in China and ~3% in India and the Middle East in 2009. EAF capacity to the tune of 110 MT is planned to be on stream in the next five to six years resulting in additional graphite electrode (UHP grade) demand of ~2 lakh tonne. </p><p>Exhibit 9: EAF capacity pipeline in the next five or six years </p><p>Location</p><p>New EAFCapacity</p><p>(MT)</p><p>Additional UHPGraphite electrode</p><p>demand ('000 tonne)Rationale for New EAF capacity </p><p>build-up</p><p>China 45 81Higher demand for special steel. Flexibility in production</p><p>India 10 18Better availability of captive power to run EAF plants</p><p>Middle-east 20 36Higher availability of cheap gas as a source of power</p><p>Sub-Total 75 135Other locations 35 63Total 110 198 </p><p>Source: Industry, ICICIdirect.com Research </p><p>The majority of the new EAF capacity (75 MT, which is ~68% of the total) is expected to be in the Asian and Middle East region. This will create demand for graphite electrode, which can be catered to easily by Indian producers due to close proximity. This is due to the fact that captive power availability remains strong in these regions and the requirement for special steel is on the rise. It is produced through the EAF route. We estimate an additional demand of ~1.35 lakh tonne of graphite electrode demand from these regions in the next five or six years. </p><p>The expected...</p></li></ul>