Shares of graphite electrodes manufacturer HEG Ltd have risen 28-fold since early 2017. Peer Graphite India Ltd’s shares have risen about 13-fold in the same period. And in a strange turn of events, this massive rally has been accompanied by a huge compression in their price-earnings (P-E) ratio. A year ago, HEG traded at a P-E multiple of 67 times, based on its trailing 12-months earnings. Now, its P-E multiple stands at merely six times.
In other words, the rally has been accompanied by a mammoth increase in earnings. Note that the multiples above use trailing earnings, and not forward projections.
But the low valuations also point to the uncomfortable truth that not many investors are willing to jump on this bandwagon.
Analysts at Bank of America Merrill Lynch (BofA-ML) have said in two separate notes to clients that HEG and Graphite India trade at the lowest multiples globally. Valuations are attractive as the market seems yet to have recognized the story, and investors’ lack of conviction in the strength or longevity of the cycle, added the analysts.
Graphite electrode is a key component for electric arc furnaces (EAFs) that turn scrap into steel. Their manufacturers came into the limelight following China’s policy to curb pollution that was introduced in late-2016. The policy was seen as the trigger for a multi-year demand upcycle for electrodes as it required blast furnaces to be replaced by environment-friendly EAFs.
The surge in demand from China led to a spike in price realizations, which in turn has resulted in profits of ₹ 2,635 crore in the 12 months till September in the case of HEG, compared to losses of ₹ 50 crore in the year till March 2017.
The all-important question is if this rosy scenario will continue. After all, what if new capacity comes on stream to take advantage of the supply shortage? This seems to be one reason some fund managers are staying away.
According to an analyst, these companies have reached the peak of their earnings cycle and this supernormal growth in profitability may not sustain going ahead.
Besides, achieving this kind of profit growth could be challenging, given some potential headwinds.
As the production process of graphite electrodes is fairly long (three-six months), the full impact of higher cost needle coke will come in with a lag from the second half of FY19 onwards, which would remain a key monitorable, ICICI Direct said in a report. Needle coke is the raw material required for making graphite electrodes.
Apart from rising needle coke costs, a weak dollar also poses risks to their earnings performance. These companies derive a large part of their revenue by exporting graphite electrodes and were seen as beneficiaries of a weak rupee.
In the past two years, the graphite electrodes industry saw an extraordinary windfall gain from global industry consolidation and environmental curbs in China, translating into extraordinary profits, but there is limited clarity on this industry’s prospects beyond a year or two, said another analyst.
In sum, some investors are just plain scared of becoming part of the latest fad. In such cases, better safe than sorry seems like a wise approach.