Graphite India: Mix of businesses with little synergy
Mixing too many businesses under one roof and acquiring siblings for the sole purpose of bragging rights does not quite rub off from the investor viewpoint
The graphite electrode top dog
Graphite India is the largest producer of graphite electrodes in India. It also claims to be one of the largest producers of graphite electrodes globally. Its first plant to manufacture electrodes was set up in 1967 in West Bengal with technical and financial collaboration of Great Lakes Carbon Company of the US. The foreign promoters still hold 4.9% of the piddling outstanding equity capital of Rs 391 m, but apparently it is today reduced to a figure head holding or some such. The Indian promoters, the Bangurs of Kolkata, control another 57.3%, for an aggregate promoter holding of 62.2%. Almost the entire Indian promoter's holding are held by four group companies.
Presently the company makes do with a number of diverse businesses including the manufacture of graphite electrodes, calcined petroleum coke, manufacture of turnkey plants for graphite equipment, glass reinforced plastic pipes and tanks, generates in-house power, and makes high speed steel and alloy steel from facilities that it acquired from GKW, another Bangur controlled entity. Old timers may remember GKW as Guest Keen Williams, the manufacturer of press tools and fasteners etc, and the erstwhile subsidiary of the English parent, Guest Keen and Nettlefolds. With so many disparate undertakings under one roof it makes do with 11 manufacturing facilities spread across the states of West Bengal, Maharashtra, Karnataka, Orissa, and Bihar. It also boasts of an R&D facility in Bangalore.
Capital Market magazine lists the names of three companies in the graphite electrode segment. Besides Graphite India, there is HEG and Panasonic Carbon(formerly Indo Matsushita Carbon Company). Heading the list- sales wise for 2011-12 - is Graphite India with revenues of Rs 16.7 bn followed by HEG (formerly Hindustan Electro Graphites) with revenues of 14.2 bn. But the revenues of Graphite India include sales from other categories too. Presumably the revenues of the other two likewise include such other income too. Whatever, Graphite India generated manufactured sales income of Rs 16.7 bn, service income of Rs 191 m, and other operating income of Rs 456 m. Services income includes installation charges, while other operating income includes export entitlement and royalty. Top of the pops is graphite electrodes accounting for 80% of all manufactured sales. This is followed by high speed steel and alloy steel with 5.8% of revenues and plastic pipes with another 5.2%. Bringing up the rear are graphite plant equipment, and calcined petroleum coke with 3.9% and 3.4% respectively. There are miscellaneous other sales too.
The product lines
For those readers who are not well versed, graphite electrodes are used in electric arc furnace based steel mills for conducting current, and it is a consumable item for the steel industry. The company states that world steel production through the electric arc furnace (EAF) based route has increased from 26% to about 32% at the global level in the last two decades. (That adds up to a very slow percentage rate of increase by any yardstick.) The share of EAF is expected to grow steadily it adds. However elsewhere in the copy the company states that steel production through the EAF route today is estimated at around 28%. It is indeed amazing that one of the largest producers of graphite electrodes does not even have its facts right in the matter, as both figures can be wrong but both figures can't be right at the same time. But let that be.
The calcined petroleum coke (CPC) division is one of the backward integration projects that it undertook. CPC in short, is the raw material for the manufacture of graphite electrodes, and also used in ferro alloy smelters and submerged arc furnaces as linings. In other words some part of the production is internally consumed, while the rest is flogged in the market. This material seems to be some sort of a crucial factor in the wellbeing of the company. In any event the company has booked sales income of Rs 571 m from CPC, and Rs 262 m as sales income from carbon paste. The inventory value of CPC at year end was a phenomenal Rs 4 bn against Rs 2.8 bn in the preceding year. As a matter of fact the inventory value of CPC accounts for over 91% of the total value of all raw material inventories, and 47% by value of all inventories! The consumption value of CPC during the year amounted to Rs 4.1 bn, and on the face of it the inventory value appears to be out of proportion. (Consider for example the consumption value of pitch at Rs 1 bn, but a closing inventory value of only Rs 97 m). Consequently, the total inventory value of all products at year end relative to gross sales was as high as 50%, against an even higher 59% previously!
It is also in the business of turnkey contracts and makes equipments which have a wide range of applications in the corrosive chemical industries such as pharma, agro-chemical, chlor alkali and fertilizer industries. The plastic pipes division makes and markets pipes and tanks which find customers in the power equipment sector. Power being a major constituent of graphite electrode production, it generates in-house power. The steel division makes high speed steel and alloy steel with an estimated current market share of 60%.
Bringing home the bacon
So which division is bringing home the bacon at the end of the day? Before we get to that, one must note that the company also has a large export market for its products. As a matter of fact almost 55% of its sales income in 2011-12 or Rs 9.1 bn came from exports, while the balance 45% or Rs 7.8 bn was tweaked in from the domestic tariff area. The percentage figures were quite different in the preceding year. What is not quite known is which items that it produces are also exported and the share of these items in the export basket. Besides, companies are not required to give a separate account of export income and the profits earned if any on such an exercise. What we do know however is that it realised total export income of Rs 9.1 bn during the year, and expended forex worth Rs 5.1 bn in the process. What we also know is that the cost of raw materials imported at Rs 4.4 bn amounted to 55% of all materials purchased during the year (imported raw materials consumed amounted to 52% of all raw materials consumption.) We also know that export sales included sales valued at Rs 1.5 bn to its German sibling Graphite Cova GmbH. The parent earned Rs 48 m as royalty fees from this sibling (what was the occasion?) and in turn purchased goods worth Rs 41 m from it.
What is also fairly clear is that the fall in the rupee value would have worked in favour of the company on the revenue side given that the exports were substantially higher than the imports, and the fact that it added value to the imports. But it was also caught in a straitjacket on another front. It suffers large long term forex borrowings. The fall in the rupee value had added to its gross block during the year, with no additional production benefits coming its way.
For segment reporting purposes the company segregates its operations under four heads of account - Graphite, Power, Steel, and Others. The graphite division earned a margin of 17% on sales, while the steel division earned a margin of 12%. The others division on its part roped in a margin of 19% on sales. But it is the power division which was a whopper. It earned a margin of 73% on sales of Rs 340 m (including inter-segmental sales of Rs 322 m) and that too on segmental assets of only Rs 565 m. Such a divisional margin really amounts to nothing at the end of the day given the extent of sales that it affects to its other divisions. One division's gain is another division's loss.
The cash flow generation
Irrespective of the margins that the divisions are logging in, the company does experience difficulty in drumming up cash flow from operating activities. In 2010-11 it registered a negative cash flow of Rs 180 m on this count, due in large part to increased commitments on trade receivables, inventories, and loans and advances. This and some other related factors like purchase of capital assets valued at Rs 968 m led it to borrow additional funds of Rs 1.86 bn. In 2011-12 it managed a turnaround and posted a positive cash flow of Rs 286 m from operating activities. As in the preceding year there was a sharp increase in inventories, trade receivables and, loans and advances. But the company still had to resort to additional borrowings of Rs 1.7 bn due to other exigencies. It is another matter that it also realised some serious cash by exiting from some non-current and current investments to the tune of Rs 301 m and Rs 754 m respectively. It sold a public limited foreign sibling based out of the Netherlands and sporting the name Carbon International Holdings. This is apparently a holding company and not a manufacturing company going by its nameplate. Against a cost price of Rs 5.6 m the sale proceeds tossed in Rs 301 m. That would amount to a neat return on investment. But more to the point what does this company do and why was it sold? There was also large expenditure on account of gross block addition which sucked away Rs 1.3 bn, and outlays in long term investments, including in a subsidiary, which made the company cashbox poorer by Rs 1 bn. The business appears to be capital intensive to boot. A gross block of Rs 10.5 bn churned out revenues of Rs 17 bn.
The interesting factor here is that there is a recurring expenditure on gross block addition on the one hand, and in the drastic churning of its liquid investment portfolio on the other. If the company is making money on the churning of its short term investment portfolio it is not showing up in the other income schedule. This schedule is in itself a hotch potch of incomes (liabilities no longer required written back, net gain on disposal of investments, foreign currency gain, guarantee fees - foreign currency losses are however accommodated in a schedule called Other Expenses) which cannot be called upon for a repeat performance in the following year. Other income is not very germane to the bottom-line generation accounting for a mere 12% of pre-tax profit. But, still, it has some effect.
Fine rates of borrowed funds
Though the company is piling on the debt burden it is able to get very fine rates on the interest that it pays out. At least this is what the interest paid schedule has to reveal. On a rough back of the envelope calculation the interest rate on the year end debt of Rs 4.6 bn would amount to 4% against an even lower 3.2% previously-on a year-end debt of Rs 2.7 bn. (The interest taken into consideration is the pre-capitalised figure and includes bank charges as it is not separately stated). O.K. the company has substantial foreign currency borrowings on which the interest payable is at Libor rates etc, but still, such fine rates appear to be a bit difficult to comprende'.
Though the debt holding has gone up sharply during the year, it is only fair to state that the company also held free liquid investments of the value of Rs 958 m at year end as non-current investments against a value of Rs 202 m previously. So, in a sense, some of the additional funds that the company raised found its way into liquid investments. Separately, the value of free liquid investments in current investments was lower at Rs 1.28 bn against Rs 1.80 bn previously. Thus the total value of liquid investments amounted to Rs 2.24 bn against Rs 2 bn previously. Why has the company given separate classifications for the same investment vehicle? Apparently the company also figures that the tax free dividends that it gets from these investments and the profit it can make on purchase / sale outweighs the interest that it has to pay on the higher level of debt.
Reason for the high debt levels
There is also another understated reason for the rise in debt levels. Namely, the high value of current assets at year end relative to the value of current liabilities. By the company's own calculation, the current assets at year end amount to Rs 15.6 bn, while the current liabilities weighed in at Rs 6.6 bn. If one were to tag on the value of liquid investments of Rs 958 m classified under noncurrent investments, then the situation becomes even more quirky. In my analysis of company annual reports I have found that market leaders have of late shifted to holding current assets only a shade above that of current liabilities, and in exceptional cases, the value of current assets is even lower than the current liabilities.
The company has investments of the value of Rs 1.1 bn in its siblings. It was not a beneficiary of any dividends in the latest accounting year. It has two direct siblings, Graphite International B.V. with an investment value of Rs 737 m and based out of the Netherlands, and Carbon Finance Ltd incorporated onshore. Then there are four siblings who are the offshoots of Graphite International and are all Germany based. But interestingly a company incorporated in the Netherlands is the godmother of these five companies. The parent has also issued corporate guarantees worth Rs 511 m on behalf of its offshore siblings.
Carbon Finance is definitely an oddball. It has a paid up capital of Rs 53 m, ample reserves of Rs 355 m, an investment portfolio of Rs 198 m consisting of liquid investments and very little else to show. That is to say it rustled up revenues of Rs 13 m and pre-tax profits of Rs 9.6 m. The purpose of existence of this company is difficult to fathom. The holding company Graphite International has an equity base of Rs 839 m (based on a different exchange yardstick), revenues of Rs 50 m (may well be royalty income) and a pre-tax of Rs 3.2 m. The biggest by far of the step downs is Graphite COVA with an equity base of Rs 677 m and revenues of Rs 4.2 bn. But it could only squeak out a pre-tax of Rs 17 m. The next in line, Bavaria Electrodes on the other hand rustled up revenues of Rs 1.2 bn on a capital base of a mere Rs 6.8 m and registered a pre-tax of Rs 26 m. The third biggie of sorts Bavaria Carbon Specialities similarly ran up revenues of Rs 402 m and engaged a pre-tax of Rs 16.6 m. The smallest of the four is an inconsequential entity. As stated earlier none of these worthies declared any dividend.
From the looks of it these companies appear to be around principally for the parent to do some twiddling, for matters of overall size, and the bragging rights that go with it, rather than any sane reason.
The company does not give one the right vibes either.
Disclosure: I do not hold any shares in this company, either directly, or under any non discretionary portfolio management scheme
This column Cool Hand Luke is written by Luke Verghese. Luke has been a business journalist, financial analyst and knowledge management head with a professional experience of more than 20 years. An avid watcher of the stock market, he has written extensively on stock market trends. His articles have featured in Business Standard, Financial Express and Fortune India amongst others. He has also been the Deputy Editor, Fortune India and the Financial Editor of The Business and Political Observer.