Buy HEG, target Rs 4400: Jefferies Group

Jefferies Group has a buy call on HEG Ltd. with a target price of Rs 4400.0 . The current market price of HEG Ltd. is Rs 3783.65 Time period given bythe brokerage is a year when HEG Ltd. price can reach defined target. HEG Ltd., incorporated in 1972, is a largecap company with a market cap of Rs 15569.88 crore.

Investment rationale by Jeffries

We hosted a non-deal road show in Mumbai with more than 20 investors meeting the HEG management. Key takeaways from discussion were: 1) Realisation to remain robust. 2) Phillips66 needle coke debottlenecking will help improve utilisation. 3) China’s graphite electrode (GE) quality not comparable with the UHP grade produced by other major players. 4) Demand for GE within China to increase. 5) Looking at different avenues within carbon space for cash utilisation.

Realisation to remain robust: Management highlighted they have booked volumes for the 1HFY19E at realisations higher than 4QFY18 realisation (~US$11,800/t). As perthe management, demand supply tightness continues and expect demand supply gap to further widen going forward leading to higher GE realisation. On the spot prices,management commented that it remains at elevated level of more US$17,000/t. Phillips66 debottlenecking to improve utilisation: As highlighted in our note, Phillips66 is increasing its production capacity by about 15-20%. As per the management, the debottlenecking process is expected to be complete by Oct- Nov 2018. However, thiswould help in improving the utilisation of the company but would not be enough for the capacity expansion. Some portion of the increased production is expected to be diverted to lithium ion batteries. Management mentioned currently they see 10-15% of needle coke is getting diverted to lithium ion batteries.

China’s GE – Not comparable: There were lot of concerns over China adding GE capacities which will lead to decline in GE realisations. However, management mentioned that Chinese GE producers don’t have the technical knowhow of producing UHP electrode and thus do not see them as a competition. As per our interaction with some of the industry experts, nipple is a crucial component as it holds the electrode vertically in Electric Arc Furnace (EAF). Majority of China’s producers don’t have the technology to manufacture high quality nipple which can hold heavy electrodes (UHP grade).

China increasing EAF share in steel production: Graftech in a SEC filing mentioned that they estimate at least 105 new EAFs totalling 66mn ton of steel capacity has been installed or has commenced construction in 2017. This would lead to sharp rise in the demand for graphite electrodes within China. We believe the reason China going for smaller size EAF is because they produce only low grade of electrodes and bigger size EAF needs UHP grade of electrodes which China cant produce.

Cash Utilisation Plans: As highlighted in our annual report analysis note, HEG is discussing capacity expansion of 20kt. Management expects the capex for this expansion will be ~US$100 mn and will take at least 2-2.5 years to come onstream. Apart from this expansion, the company is also looking at different avenues within carbon space like graphite micro fines used as anode material in lithium ion batteries. Management also indicated of at least maintaining pay-out ratio going forward.