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Buy Graphite India, one of the world’s largest producers of graphite electrodes, on price declines…

Graphite India Ltd. (GIL) is among the world’s largest producers of graphite electrodes, accounting for 6.5 per cent of total global production. It is also India’s largest producer of graphite electrodes.
During the 44 years of its existence, GIL has supplied graphite electrodes to the country’s top steel manufacturers. Its clients include Tata Steel, SAIL, JSW, Jindal Steel, Essar Steel and Ispat Industries. India accounts for around a third of GIL’s production (by volume); Middle East for 28 per cent; and Europe for 25 per cent. This geographical diversification helps the company minimise the impact of a slowdown in any one part of the world.
Graphite electrodes are used in steel production using the electric arc furnace (EAF) method. This process is gaining ground over the traditional blast furnace method on account of its advantages: lower energy requirement and flexible production cycles.

Strengths and opportunities
High entry barriers. The global electrode industry is oligopolistic in nature with a handful of players controlling the majority of the world’s requirements. The top six players in this industry account for over 70 per cent of global capacity.
Technology also plays a significant part in preserving their advantage. Only the top players (including GIL) have the technology to produce high quality ultra-high power (UHP) electrodes. Add to this the strong referral-based supply model and the high cost of setting up a greenfield plant and you know why players like GIL enjoy an edge.
Improving demand. Demand for graphite electrodes is improving despite global EAF steel manufacturers clocking sluggish growth. What explains this? Electrodes are an essential requirement for manufacturing EAF steel. Earlier, steel manufacturers had large inventories of these electrodes. Now their stocks are running out, and this has created incremental demand.
Also keep in mind that the fortunes of the graphite electrode industry do not depend upon fluctuations in steel prices. Rather the industry is affected by the volume of steel produced (through the EAF method). EAF accounts for 30 per cent of global steel production currently but is slated to account for 50 per cent by 2020.
Higher volumes. Volume growth for electrodes has increased smartly. GIL reported volume growth of 33 per cent (y-o-y) in the most recent June 2010 quarter. While its domestic sales were up 55 per cent y-o-y, exports rose 19 per cent y-o-y.
Higher capacity utilisation. GIL’s capacity utilisation zoomed to 79 per cent in the June 2011 quarter (Q1FY12). A year ago its utilisation level stood at only 59 per cent. For the financial year FY12, GIL is targeting consolidated capacity utilisation of 85-90 per cent.
What is reassuring is that this increased capacity utilisation is not restricted to GIL alone, nor is it a single-quarter phenomenon. Graftech, the world’s second-largest graphite manufacturer, expects its utilisation level to jump from 70 per cent in the June quarter to 90 per cent by the fourth quarter of this year. Back home, HEG, GIL’s closest domestic competitor, also reported a high utilisation level of above 80 per cent in the June quarter.
Price increase next? Graphite industry leaders Graftech and SGL Carbon SE have both announced that they will hike prices from January 2012. Their moves provide confidence that prices are likely to remain firm for at least the next few months.
Indian graphite manufacturers have not hiked prices so far. In fact, GIL reported a 4 per cent decline in electrode prices (y-o-y) in the June quarter. Any price hikes are likely to be undertaken in the next calendar year only after current orders have been executed by the end of this year.
Capacity expansion. GIL has used the recent lull in business to focus on expanding its domestic capacity by 20,000 MT to 98,000 MT at its Durgapur (West Bengal) unit. The additional capacity is expected to come on-stream by Q4FY12. It requires a total capex of Rs 255 crore. Till June 2011 GIL had invested Rs 144 crore on this expansion project.
Lower labour cost. GIL’s labour cost is lower than that of its global peers. Its employee cost as a percentage of revenue amounted to 9 per cent in FY11. For SGL, the world’s largest graphite electrode manufacturer, whose plants are located in the US and Europe, this cost stood at 27 per cent of revenue in CY10. GIL has traditionally passed on a part of this advantage to its customers to gain market share. But with global market shares now stabilising, GIL’s low-cost advantage is now expected to get reflected in its bottom line.
Healthy balance sheet. GIL has managed to reduce its debt from Rs 616 crore in FY06 to Rs 341 crore in FY11. Net debt stood at Rs 73.3 crore as on March 2011. Consequently the debt-equity ratio has fallen from 1.22 (FY06) to 0.22 (FY11).
High dividend yield. The average payout ratio for the company stands at 26.5 per cent. At its current price, GIL trades at an attractive dividend yield of 4.55 per cent.

Weaknesses and threats
Fortune depends on steel industry. Graphite producers’ fortunes are inextricably tied to the demand for steel. To illustrate this point, in 2008 world steel output fell for the first time in two decades. This had a cascading effect on graphite manufacturers. GIL, which had reported a compounded annual revenue growth in the region of 35 per cent in the preceding five years, saw revenue growth decline to 12 per cent (FY09) and tumble further into negative territory (-11 per cent in FY10). It was only in FY11 that revenue growth revived to 8 per cent. This dependence will remain graphite producers’ Achilles heel.
Margins yet to improve. Till the June quarter, domestic players had yet to see an improvement in realisations. Higher prices of crude and coal have further compounded their problems by reducing their margins. In the June quarter, GIL’s electrode division’s margin declined 350 basis points (y-o-y) to 18.8 per cent. Higher raw material prices (calcined pet coke and furnace oil) and increased cost of power shaved off margins further. On a quarterly basis, though, the decline in margin was lower (a sign that the situation may be stabilising) at 68 basis points.

Financials
Over the past five years GIL has clocked an annualised revenue growth of 13.4 per cent. PAT grew at a higher rate of 22.6 per cent over the same period. ROCE (currently at 16.5 per cent) has averaged 20.8 per cent over the last five years.
The company utilised the good years to whittle down its debt. Hence its interest coverage ratio has improved from a mere five times in FY06 to a comfortable 36 times its FY11 Ebit.
In the most recent quarter, EBITDA margins saw a decline of 371 basis points (y-o-y). This was primarily caused by the fall in electrode prices and higher input costs. Other raw material prices including power costs have gone up. Lower generation from its captive hydel power plant added to the margin decline. However, EBITDA increased by 3.4 per cent (y-o-y) and 4.6 per cent (q-o-q) owing to higher revenue during the quarter, which was up 23.3 per cent (y-o-y) and 5.1 per cent (q-o-q).
Interest cost, which saw a marginal decline of 5.4 per cent (q-o-q) in the June 2011 quarter, was up 407 per cent y-o-y at around Rs 3 crore (interest cost amounts to 5 per cent of Q1FY12 Ebit).
In a bid to rein in power costs, the company had earlier signed an agreement with KSK Energy to acquire low-cost power for its Nashik plant. Supply is expected to commence from the second quarter of the current financial year.

Valuations
Graphite India’s stock is currently trading at a P/E of 7.42. This is higher than its five-year median PE of 6.12. Over the last five years, the stock’s earnings per share (EPS) has grown at a compounded annual growth rate of 15.78 per cent. This gives it a price-earnings to growth (PEG) ratio of 0.47.
Graphite India’s improved business outlook, the capacity expansion it is undertaking, and low debt levels will keep the company in good stead. Investors looking for attractive dividend yields in the current tumultuous market can look at this stock with a minimum three-year investment horizon. Buy whenever the price of the stock declines.