HEG: A Smarter Way to Ride the Rally in Steel Stocks 

Hi guys, this is Aditya Vora here. Hope you guys are doing good.

In today's video I am going to talk about a very volatile sector.

Now, to start with I am sure you must have read about Chinese economy reopening and the Chinese government abandoning their Zero Covid policy.

Imagine, a major part of calendar year 2022 up till October, where China followed a strict Covid policy and demand as well as supply was muted.

However, as we approach the Chinese New Year in February where millions of Chinese travel to their hometowns and are on vacation... travel and shopping dominate the country during the end of January and February. Basically, to put it in simple words, it is the Diwali of Chinese people in February.

I am sure you don't need me to tell you that China is the biggest producer as well as consumer of almost everything.

Right from Steel to aluminium, copper, rubber to rare earth metals... China accounts for anywhere between 40-80% share in global metals production and consumption.

The reason why the metals sector underperformed in 2022 was on account of muted demand from China due to the lockdowns along with moderation in global demand.

So, if China is reopening and a lot of global recession fears are there in the price, why shouldn't we play the metal sector at least for the short term?

Also, a lot of central banks are already more than halfway through in raising rates and could stop increasing rates soon as economies enter recession.

I started looking at the steel sector but on seeing the price performance of stocks, I wasn't comfortable at these levels.

I mean look at JSW steel or Tata Steel, most the of the steel stocks are near their 52-week high.

Basically, they have run up over the past 2-3 months. I don't deny the fact that they could go higher but why not focus on sectors where there is greater margin of safety.

In that case I started looking at a proxy to steel sector which also had an element of structural tailwind in it.

I am talking about the graphite electrodes sector and the company which I am going to talk about is HEG.

Before I talk to you about the graphite electrodes, let me give you a brief on where this product is used and why it is dependent on steel.

So to start with steel is produced either in an electric arc furnace or a blast furnace.

If you look at the current steel production process, about 26% steel is made through Electric Arc furnace and the remaining 74% in a highly polluting blast furnace.

From a country perspective about 70% of steel is made through electric arc furnace in USA and 55% in India. The European union has about 42% share of steel production coming from electric arc furnace while China the largest steel producer which accounts for half of global steel production barely has 10% coming from electric arc furnaces.

So the question is ... why is the world shifting to electric arc furnaces?

Well, a) Relatively lower production costs & capex requirement. You know the average cost per tonne to construct a blast furnace is about 1100 dollars while the average cost per tonne to make an electric arc furnace is 300 dollars. That's huge reduction in capital cost. Besides, the operating costs are at least 10-15% lower and b) the most important point, electric arc furnace generates 70% lesser carbon emissions as compared to a blast furnace.

Graphite Electrodes are consumed in an electric arc furnace.

To give you more details,

a) An electrode typically lasts for 22-30 batches or 10 hours and demand is driven by the production of steel through the Electric arc furnace method.

So technically, more number of hours the electric arc furnace is used, the more the number of graphite required. In short it is directly related to steel production.

Let us also look at the graphite electrodes industry.

There are 5 major players ex of China which account for 75% of the worlds production with Indian companies like graphite and HEG accounting for 14% production capacity each.

Being a capital and technology intensive sector, the barriers to entry are extremely high.

Now that the basics are sorted, let me give you the rationale and triggers why this sector can re rate and why HEG is better than Graphite.

The first trigger is the shift to electric arc furnace from blast furnaces.

Let me give you some numbers.

USA where 30% of steel production still happens via the blast furnace route has decided to replace it with electric arc furnace.

A total of 20-25 million tonnes of new capacities are likely to come up over the next 2-3 years, of which 6.5 million tonnes of capex is expected to start over the next 1 month, another 11.5 million tonnes in 2024 and the remaining in 25.

Besides this, even Europe plans to replace about 16 million tonnes starting from 2023.

China where electric arc furnace accounts for 10-12% of steel production is expected to take it to 20% over the next few years.

This is going to be the biggest trigger for the graphite industry.

I am not even betting on increase in steel production, I am just saying this incremental demand over the next 2-3 years is likely to come from replacement demand.

Just imagine the growth which can come. And trust me with environmental concern this is likely to happen sooner than later.

Also, the cost of capex is 30-40% as compared to a blast furnace.

Now my second point is a short-term trigger over the next 6-9 months.

Graftech, the largest manufacturer of graphite electrodes, recently closed their Mexico plant which accounted for 30% of the company's production and 10% of world production (ex-China) due to some issues.

Now, when a graphite electrode which is used for 8-10 hours in the process needs to be replaced you require a pin to add another electrode. The pin is just 4% of the weight and is sold with a pair of electrodes.

Normally large companies who have more than one location for producing electrode. They have this tendency of concentrating their pin production at one place and then they air freight the pins to their other locations to sell electrodes and pins together.

In Graftech's case unfortunately, the Mexico location where all its pins were produced for dispatch to other plants is shut for 2 months and is expected to remain shut for may be 6 months.

Going forward as the pin inventory keeps coming down in the Mexico plant, it will start to affect the entire graphite electrode production.

This is likely to benefit the other 4 major players.

These were the structural industry tailwinds.

Let us shift focus to HEG.

Let me get straight to the point and talk about the rationale for investing in HEG and why it is preferred over Graphite India, the other player.

Exports accounted for 70% of revenues for HEG.

Now, while Europe is a problem due to rising costs, the share of exports to Europe from HEG is only 8-10% as compared to graphite India which has a subsidiary in Germany and had to shut operations as rising costs made it economically unviable.

USA and Middles East account for 20% and 27% of total exports for HEG. Massive capex is likely to be seen in these countries as they shift to electric arc furnaces.

Secondly, HEG has undertaken a 20,000-tonne capacity expansion which takes its capacity to 1 lac tonnes of graphite electrode. This technically makes it the largest player in India surpassing its Indian competitor graphite India.

Now here is the big trigger for HEG. The company is entering into Manufacturing of Graphite Anodes for Lithium-ion cells through the incorporation of a subsidiary company.

The plant would be made in two phases, spending Rs.1,000 cr in phase 1 over the next 3 years and another Rs 1000 crore in the second phase post commissioning of phase 1 in FY25.

To put it in simple terms, on a conservative basis, the demand for graphite anode annually would be 50000 tonnes in India by 2025 which would mean 10 lakh EV cars or 1 lakh buses.

This phase one will give HEG a capacity of 10000 tonnes out of the conservative 50000 tonnes of demand in FY25.

This means from end of FY25, the company at full capacity could generate an incremental revenue of Rs 1000 crore by sale of anodes for lithium-ion cells. Also from the raw material front, the raw material is needle coke which is the same raw material for graphite electrodes which the company is making currently. All this incremental revenue will give a higher realisation along with a higher margin.

To end this let me also talk about valuations and debt.

The valuations are relatively cheap as the company is trading at book value. That is the price to book value is 1 time. Also, the P/E multiple is barely 7 times and mind you, the steel industry declined in FY22 and is expected to be under pressure over the next 2 quarters.

HEG has a cash balance of Rs 935 crores as on Sept-22 and a net cash position of 985 crores with investments.

Such companies should be looked at during such turbulent times and low valuations.

So, friends, while I am bullish on the metal sector as China reopens and recession effect across the globe wears out, playing proxies like HEG and Graphite in the electrodes sector which have a structural tailwind apart from other factors is a better way in my opinion.

While 2023 is likely to be difficult in terms of strong growth in steel demand, the important point is to look beyond the first half of 2023 as markets discount things much well in advance and companies like these having a net cash position available at book value should not be missed.

Thank you for watching my video.