Whitemonk Heg Equity Research Report

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HEG

BUY

November 4, 2009 Dominant market share coupled with positive outlook of domestic steel sector makes it an attractive stock Country INDIA EXECUTIVE SUMMARY Sector Electric Equipment  Electrode and Graphite Sector: Each tonne of steel requires Category Large Cap Market Cap 11443.21M about 2.5 kg of graphite electrodes and thus demand for Enterprise Value 18129.11M graphite electrodes depends on steel production. The total size FY09 Statistics of domestic markets is estimated to be 26000-27000Tonnes per Revenue 10990.9M Net Profit 1070M annum. HEG's market share within domestic market is around Operating Margin 26% 42-43%. The World crude steel production for the month July Net Profit Margin 10% 2009 stood at 103.9 million metric tons which is 11% lower ROE 18% ROA 6% when compared with corresponding period last year. The world PE 10.88 crude steel production despite being a lower when compared Sector PE 9.2 P/BV 1.98 with July 2008 figures, was the highest monthly production 52- WEEK RANGE figure during the calendar year 2009.Overall outlook for steel High INR284 sector is positive. Low INR94 Beta .53  Company: HEG (BSE: 509631), is a large cap firms with market Return Analysis cap of 11443.7MN, manufactures graphite electrodes, which are One Month Return 4.49% used to produce steel from scrap by electric arc furnace (EAF) Three Month Return 20.47% One Year Return 76.46% technology. The Company exports over 80% of its production to more than 25 countries worldwide. The Company's operations *1 US$ = INR46.52 are organized into three business segments: graphite, HEG PERFORMANC CHART (Price, Volume and steel/sponge and power. During the fiscal year ended March 31, Volatility) 2009 (fiscal 2009), the production of graphite electrodes was Volume Data 50,226 million tons. The company has a number of respected 3 – Month Avg. Daily Volume 26087 3-Month Avg. Daily Volume(in INR) 7130881 steel manufactures as clients such as ArcelorMittal, POSCO, US Steel, and Nucor 3-Month Avg. Daily Volume .06%  Performance Analysis: Due to global slump and lower demand of total Market Cap for steel resulted in revenue growth of 8%, significantly lower than FY08 revenue growth of 13%. Its margins has also declined especially net profit margin from 15% in FY08 to 10% in FY09.  Valuation Summary: HEG is currently trading at INR 246.9, The Fair value of the share is INR272, representing a minimum 10% of upside potential. Valuation Summary Relative Valuation P/E EV/EBITDA Earning Power Valuation(EPV) Fair Price Current Share Price

Equity Structure Promoters Holding :52.66% FII :10.45% MF :.2.64% Public :14.77%

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

Price

Weight

273.644 506.77 251.3 272.22 247

7.5% 7.5% 85.0%

Recommendation: We recommend “BUY” at current share price of INR247.

Company Research Report

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Company Research Report – HEG

WHY HEG IS A GOOD IN VESTEMENT

Key Performance Analysis Any Loss in last Five Year

No

Operating and Profit Margins Debt Exposure

Good

Revenue Growth(5 years) ROE ROA Cash in Hand

22% 18% 6% 64MN

The company has achieved revenue growth of 8% in 2009; In last five year overall revenue growth was 22%. Overall management has efficiently managed working capital and increased capital expenditure on a regular basis for capacity expansion. Its current ratio of Capex with respect to revenue is 13% which is highest in last three years and signifies that firms expect more demand in near term. In latest quarter, Management was able to drive down the expenses by 1.8% which resulted in significant PAT growth.

High, over 50% asset financed by Debt

Latest Quarter Results VS. FY08 Quarter Revenue Growth

Decreased by 2.15%

PAT

Increased by 41.85%

Total Expenses

Decreased by 1.8%

EPS

Increased by 41.94%

We believe the company has higher financial risk; its debt is 50% of total asset and has lower interest coverage of 4.1. It is significantly higher than its peer’s leverage ratio which stands at 21.11%. The company‘s key financial performance is as given below:

2009 Sales Growth

8%

Operating Profit Margin

26%

Net Profit Margin

10%

ROE

18%

ROA

6%

Current Ratio

6.5

D/E

1.5

D/A

0.521

A/R Turnover Days of sales outstanding Inventory Turnover

3.2 113.9 1.7

Inventory Turnover days

213.1

Operating Cash Flow growth

-24%

Capex as % of Sales

13%

Cash in Hand

6.4

Debt as % of (Expense + Capex)

91%

Debt as % of Revenue

80%

Interest Coverage

4.1

What We liked:  HEG enjoys significant Market share in Electrode and Graphite sector along with good client base.  Good revenue growth in current economic downturn  Management has decreased the expense by 1.8% resulting in a significant PAT growth of 45%.

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Company Research Report – HEG

HEG’S PERFORMANCE COMPARISON WITH INDUSTRY We have compared HEG‘s Return on Deployed Capital, Profitability, Asset Utilization and Financial Leverage with industry data. We believe HEG has been giving superior returns on Equity and Deployed Capital so far. HEG’s profitability in latest FY is superior then overall Industry average of profitability metrics. HEG is lagging behind on Liquidity and Financial leverage front. HEG is more leveraged in comparison with overall Industry. RETURN ON DEPLOYED CAPITAL

PROFITABLITY ANALYSIS

ASSET UTILIZATION

FINANCIAL LEVEARGE

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Company Research Report – HEG

EPS AND DIVIDEND ANALYSIS In 2009, EPS stood at INR24.04, 23% lower than 2008 EPS which was INR31.34. On an average EPS grew at 24% per annum in last five year. Due to economic and current slowdown, the company experienced negative growth in EPS. Following graph depicts EPS growth from 2004-2009.

EPS % Growth(2005-09) 100%

89% 79%

80% 60% 40% 20% 0%

-20%

2005

2006 -6%

2007

2008

-20%

2009 -23%

-40%

Company has been paying dividend since 1991. In FY09, management has declared total INR27.43 dividend which was lower 37% then FY08. Since 2001, Company has proven history of paying regular dividend with CAGR of 16.54%. The Dividend details are as given below: Year End 2009 2008 2007 2006 2005 2004 2003 2002 2001

DividendAmount 27.43 43.75 20.16 12.09 12.09 12.09 8.87 7.26 8.06

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Dividend Yield (%) 6.88 3.76 3.01 1.76 2.09 3.33 8.35 6.99 6.78

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Company Research Report – HEG

LIQUIDITY AND VOLATILITY ANALYSIS It is a liquid stock. Below is liquidity analysis of the stock for last two years (2007-09)

Open Price Minimum 94.5 Average 237.9 Maximum 582.9

High Price 97.8 245.5 609

Low Price 94 230.5 555.3

Total Volume 987 40393.9 747646

Close Price 94.5 236.6 575.05

No. of Trades 13 732.2 8593

On average over 40 thousands stocks are trading which shows that there is a good market sellers as well as buyers. The stock’s beta is .53 which makes it a highly stable stock. VALUATION SUMMARY We have valued HEG at share price of INR295.9, implying a minimum upside potential of 10% for its current share price of Rs246 as of on 04 November 2009.The stock value has been arrived based on weighted average of the price determined through Relative valuation and value investing methodology (Assuming 15% and 85% weight respectively). Valuation Summary Relative Valuation P/E EV/EBITDA Earning Power Valuation(EPV) Fair Price Current Share Price

Price

Weight

273.644 506.77 251.4 272.22 247

7.5% 7.5% 85.0%

Summary 10% Downside 105% upside 2% Upside

VALUATION DETAILS 1. Relative Valuation: Following PE based approach; HEG is valued at INR 273.64, on the basis of 2010 EPS of INR67.4 and PE of 4.06. Forecast Earnings Earnings per share (in INR) PE(x) Dividend per share (in INR) Dividend Yield Source*Reuters

% 2009(e) 2010(e) change 48.5 67.4 39% 5.65 4.06 -28% 6.5 10 54% 2.37% 3.65%

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Company Research Report – HEG Relative PE valuation HEG EPS 2010PE(x) Target Price

2010 4.06 67.4 273.644

2. EV/EBITDA Based Valuation Based on EV/EBITDA approach, we have valued HEG at INR506.77, on the basis of 2010 EBITDA of INR5972M and EV/EBITDA multiple of 3.04.

HEG Net Sales EBITDA EBIT Net Income *Source: Reuter

% 2009e 2010e Difference 13,283,000 17,411,000 31.1% 4,606,000 5,972,000 29.7% 3,991,000 5,296,000 32.7% 2,168,000 3,110,000 43.5%

EV/EBITDA All figures are in INRM ,except per share data HEG EBITDA 2010 EV/EBITDA(x) EV Net Debt Market Value of Equity Shares Target Price

2010 5972.00 3.04 18154.88 8820.4 11443.21 41 506.77

3. EPV Valuation EPV valuation is as given below, Our EPV calculation represent 11% potential upside from its current share price. Valuation Summary Current Share Price 247 EPV* 312.137 Intrinsic Value 279.30 Entry Price* 251.37 *Please see Exhibit 1 for definitions www.whitemonk.in

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Company Research Report – HEG

4. Sensitivity Analysis We did different scenario analysis for various WACC, CA and safety margins. Our selected scenario is in black. Sensitivity Table WACC EPV* Safety Margin* CA* Intrinsic Price Entry Price*

9% 530.5 10% 0.75 497.6 447.9

10.00% 459.2 10% 0.75 426.3 383.7

11.00% 400.9 10% 0.75 368.0 331.2

12.00% 352.2 10% 0.75 319.4 287.5

12.97% 312.13 10% 0.75 279.3 251.4

13.97% 276.7 10% 0.75 243.9 219.5

14.97% 246.1 10% 0.75 213.2 191.9

15.97% 219.2 10% 0.75 186.4 167.8

*Please refer exhibits 1 for definitions RISK ANALYSIS



Overall revenue projections, profitability and forecasted EPS would depend upon the sustained demand from steel sector, Revenue growth may remain modest if economy recovery (growth in GDP and steel sector growth) is lower than forecasted growth which will result in longer time to realize upside potential in share price.



Historically, HEG has managed its debt well and has brought it down from 61% of total assets in FY07 to 52% of total assets in FY09. At present Indian market is highly liquid but interest rate hikes are expected in first quarter of FY10 by RBI (Reserve Bank Of India), which may result in added financial burden to HEG. If we compare D/A ratio with industry average, Industry D/A ratio stands at 21.11% which is significantly lower than HEG’s D/A ratio of 52%.

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Company Research Report – HEG

RECOMMENDATION



We recommend HEG to investors as “BUY” at current price of INR247.



Please consider your position carefully ,once asset price appreciates by 25%-30%



In case share price falls, Please consider buying more so that your average cost of ownership goes down.



Please diversify your portfolio, you may get less return in the short term, but it is always a better and positive investing strategy to minimize overall market risk and maximize the returns



Please discuss your investment strategy with your financial advisor before making investment decisions

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Company Research Report – HEG

EXHIBITS

EXHIBITS 1: ABBREVIATIONS Abbreviations & Definitions

EPV

Earning Power Value

Intrinsic Value

NAV

Net Asset Value

CA

Competitive Advantage

Margin of Safety

Entry Price PBT

PAT

It is an estimate of the value of a company from its ongoing operations The intrinsic value (IV) of a potential investment is arrived at by comparing the results of the Net Asset Value (NAV) and Earnings Power Value (EPV) Replacement Value of the Assets, taking in to considerations of tangible and intangible assets such as customer relations, product portfolio and licenses. It is net difference between EPV per share and replacement value of asset per share It is the risk averse strategy in which, investor decides and apply a specific margin of safety to intrinsic value of the firm. Margin of safety depends upon firm revenue growth, management capability, and market share and risk appetite.

Profit Before Tax

It is the intrinsic share value with margin of safety This captures the income-operating and non operating but before Tax

Profit After Tax

This captures the income-operating and non operating but after Tax, Depending upon Industry, Tax Assets or Liability can affect overall profitability of the Firm

Operating Margin

It’s a ratio of operating income to Sales.

Net Profit Margin

It’s a ratio of Net income to Sales.

Beta

It's measure of stock volatility against Stock market

Regression

Source Wiki:In statistics, regression analysis refers to techniques for modeling and analyzing several variables, when the focus is on the relationship between a dependent variable and one or more independent variables

Volatility

It is pace through which stock prices moves up or down

ROE

Return on Equity

It’s a ratio of net income to Equity of the firm

ROA

Return on Asset

It’s a ratio of net income divided to Total Asset of the firm

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Company Research Report – HEG EXHIBITS 2: RATIO ANALYSIS

Sales Growth Operating Profit Margin Net Profit Margin ROE ROA Current Ratio D/E D/A A/R Turnover Days of sales outstanding Inventory Turnover Inventory Turnover days Operating Cash Flow growth Capex as % of Sales Cash in Hand Debt as % of (Expense + Capex) Debt as % of Revenue Interest Coverage

2009 8% 26% 10% 18% 6% 6.5 1.5 0.521 3.2 113.9 1.7 213.1 -24% 13% 6.4

2008 13% 31% 15% 27% 10% 6.6 1.3 0.5 3.4 107.5 2.2 167.7 193% 5% 43.2

2007 55% 23% 9% 21% 5% 5.9 2.5 0.6 4.3 85.5 2.1 174.1 -166% 7% 103.3

2006 16% 22% 7% 12% 3% 6.7 2.5 0.6 4.5 80.8 1.9 190.7 -171% 23% 130.5

2005 18% 17% 9% 14% 5% 3.1 1.5 0.5 4.5 81.3 3.0 120.6 -22% 60% 20.3

91% 80% 4.1

95% 71% 5.7

121% 101% 3.7

135% 136% 4.3

68% 99% 8.1

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Company Research Report – HEG EXHIBITS 3: REGRESSION ANALYSIS

HEG VS SENSEX (1 YEAR RETURN ANALYSIS)

Heg Vs. Sensex 20%

y = 0.5439x + 0.0016 R² = 0.2564

15% 10%

-20%

-10%

5%

Heg

0%

Linear (Heg)

-5%

0%

10%

20%

-10% -15%

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Company Research Report – HEG EXHIBITS 4: INCOME STATEMENT

*All Figures are in INR-M

2009

2008

2007

2006

2005

INCOME : Sales Turnover Excise Duty Net Sales Other Income Stock Adjustments

10529.8 272.4 10257.4 171.5 562

9790 321.1 9468.9 337.5 251.5

8675.3 521.5 8153.8 281.7 353

5604 361.3 5242.7 99.1 565.3

4818.2 262.1 4556.1 64 -31.5

Total Income

10990.9

10057.9

8788.5

5907.1

4588.6

2686.3 1750 370.7 940.4 1235.6 1268.9 0 0 8251.9 0 2739 669.6 2069.4 455.5 1613.9 525.5 4.8 13.7 1069.9

2918.5 1835.4 351.8 658.3 1048.6 184.9 0 0 6997.5 0 3060.4 537.6 2522.8 450.9 2071.9 702.9 4.3 -98.9 1463.6

3054.2 1769.6 351.8 662.8 883.4 49.8 0 0 6771.6 0 2016.9 540.3 1476.6 476.4 1000.2 118.5 3.6 139.7 738.4

1959.2 1357.5 326.8 419.6 600.6 35.8 0 0 4699.5 0 1207.6 281.9 925.7 396.2 529.5 51.1 7.1 82 389.3

1350 1121.7 266.3 381.8 588.2 38.3 0 0 3746.3 0 842.3 103.6 738.7 243.2 495.5 61.2 0 22.8 411.5

EXPENDITURE : Raw Materials Power & Fuel Cost Employee Cost Other Manufacturing Expenses Selling and Administration Expenses Miscellaneous Expenses Less: Pre-operative Expenses Capitalized Total Expenditure Operating Profit Interest Gross Profit Depreciation Profit Before Tax Tax Fringe Benefit tax Deferred Tax Reported Net Profit

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Company Research Report – HEG EXHIBITS 5: BALANCE SHEET

*All Figures are in INR-M

Inventories Sundry Debtors Cash and Bank Loans and Advances Total Current Assets Gross Block Less : Accumulated Depreciation Less: Impairment of Assets Net Block Capital Work in Progress Investments Miscellaneous Expenses not written off Deferred Tax Assets Total Asset

2009 409.73 328.54 6.38 162.69 907.34 853.46 289.44

2008 273.38 288.35 43.19 212.05 816.97 795.03 246.26

2007 280.89 203.13 103.25 131.21 718.48 917.33 267.49

2006 214.13 124.04 130.47 115.7 584.34 849.18 221.35

2005 104.35 107.27 20.32 66.49 298.43 551.53 184.11

564.02 134.23 83.54 1.39 3.75 1694.27

548.77 56.47 30.32 2.43 2.34 1457.3

649.84 23.14 56.46 3.47 3.51 1454.9

627.83 35.69 30.14 4.52 6 1288.52

367.42 210.8 30.14 0 3.6 910.39

Current Liabilities Provisions Total Current Liabilities Deferred Tax Liability Secured Loans Unsecured Loans Total Debt Share Capital Reserves Total Equity Share Warrants Total Shareholders Funds Total Liability

89.54 50.43 139.97 78.73 664.09 217.95 882.04 42.57 533.7 17.26 593.53 1694.27

88.89 35.48 124.37 75.96 617.45 94.32 711.77 44.32 483.44 17.44 545.2 1457.3

74.59 47.31 121.9 87 724.42 163.4 887.82 40.31 317.87 0 358.18 1454.9

65.98 21.51 87.49 75.52 669.05 135.93 804.98 40.31 280.22 0 320.53 1288.52

76.12 19.12 95.24 64.92 441.7 13.15 454.85 40.31 255.07 0 295.38 910.39

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Company Research Report – HEG EXHIBITS 6: CASH FLOW

*All Figures are in INR-M

Cash Flow Summary Cash and Cash Equivalents at Beginning of the year Net Cash from Operating Activities Cash Flow From Operating Activities Net Profit before Tax & Extraordinary Items Adjustment For Depreciation Interest (Net) Dividend Received P/L on Sales of Assets P/L on Sales of Invest Prov. & W/O (Net) P/L in Forex Fin. Lease & Rental Chrgs Others Total Adjustments (PBT & Extraordinary Items) Op. Profit before Working Capital Changes Adjustment For Trade & 0th receivables Inventories Trade Payables Loans & Advances Others Total (OP before Working Capital Changes) Cash Generated from/(used in) Operations Interest Paid(Net) Direct Taxes Paid Advance Tax Paid Others Total-others Cash Flow before Extraordinary Items Extraordinary Items Net Cash Used in Investing Activities Net Cash Used in Financing Activities

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2009

2008

2007

2006

2005

431.9 674.9 0 1613.9

1032.5 891.9 0 2072

1304.7 304.8 0 1000.7

203.2 -459.1 0 530.1

143.8 643.2 0 496.1

455.5 561.2 -1.8 -28.1 0 10.4

450.9 428.1 -0.3 -137.4 0 10.4

476.4 386.7 0 -0.9 0 9.9

396.2 237.6 -0.3 -6.2 0 7

243.2 93.2 -1.6 -0.6 0 10.6

17.8 1015 2628.9

-0.6 751.1 2823.1

0 872.1 1872.8

0 634.3 1164.4

0 344.8 840.9

-401.9 -1363.4 29.3 312.3 0 -1423.7 1205.2

-852.2 75.1 146.8 -593.6 0 -1223.9 1599.2

-790.9 -667.6 217.9 -204.8 0 -1445.4 427.4

-167.7 -1097.8 88.9 -388.2 0 -1564.8 -400.4

-111.8 -100.2 98.2 -22.1 0 -135.9 705

-530.3

-707.3

-122.6

-58.7

-61.8

-530.3 674.9

-707.3 891.9

-122.6 304.8

-58.7 -459.1

-61.8 643.2

-1550.2 507.2

413.8 -1906.3

-709.1 132.1

-1462.5 3023.1

-2376.1 1792.3

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Company Research Report – HEG

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