HEG: Buy

Investors with a two to three-year perspective can consider buying the stock of HEG (Rs 213), a leading manufacturer of graphite electrodes. Our recommendation is underscored by the management’s decision to hive-off its steel business and increase focus on the graphite and power businesses, which enjoy higher profitability. The decision appears positive, given that the steel business was incurring a loss and was a drag on the company’s profitability.

With an increased focus on its core operations, HEG is likely to benefit from expansion in its margins. In this context, the healthy demand outlook for graphite electrodes lends confidence.

At the current market price, the stock trades at about nine times its likely FY-09 per share earnings on a fully diluted basis. Investors can, however, consider buying the stock in lots given the volatility in the broad markets.

Revenue growth will hinge on the performance of the graphite division. In this context, a healthy order-book position, with about 80 per cent of the graphite electrode capacity pre-booked at 20-22 per cent higher realisation lend visibility to the division’s revenue growth. Moreover, with additional capacities expected to be operational by the last quarter of FY-08, revenues could get a further fillip.

HEG is also likely to benefit from the proposed setting up of a 33 MW captive thermal power plant, given its energy-intensive operations. Notably, the project cost for this plant, pegged at about Rs 80 crore, is at a significant discount to the industry benchmark. HEG could credit this discount to the setting up of sufficient infrastructure support when it had commissioned its previous plant.

The hive-off is also likely to benefit HEG by way of improvement in overall margins and profitability. The steel unit had, for the year ended FY-07, incurred a loss of about Rs 4 crore at the PBIT level (profit before interest and tax). Also, given that traditionally the unit has only enjoyed margins of about 6-8 per cent, as against the graphite and power divisions, which operate at about 23-28 per cent and 45-48 per cent margins respectively, overall margin expansion appears likely. This apart, with sale proceeds from the steel unit intended for retiring debt (about Rs 100 crore); the company could also gain from the strengthening of its balance sheet. This move, apart from getting the debt-to-equity at optimum levels, will also lead to a significant dip in interest cost.

Another notable advantage of the divestment is the lower susceptibility of HEG towards volatility in steel prices. While the volume growth in steel production through the EAF route (electric arc furnace) will continue to drive demand for graphite electrodes, steel price volatility is less likely to influence the overall earnings.
Robust performance

The company has reported strong numbers for the quarter ended June 2007. While sales grew by about 22 per cent on a year-on-year basis, earnings, helped by ‘other income’, grew more than two-fold to about Rs 28 crore.

While there was a 1.5 percentage point expansion in margins, there was a six-fold increase in ‘other income’ contribution due to forex fluctuations.

In the light of a volatile rupee outlook and given that the ballooning of ‘other income’ was mainly due to rupee appreciation, contributions from this segment could remain uneven. Earnings, however, could get a lift from a better business mix, a stable input cost scenario and the likely reduction in interest cost.