Materials (Steel): Prospects look up for graphite electrodes

Graphite electrodes are used in steel production via EAF, and thus have a high correlation with steel demand. Indian metal stocks have entered an upgrade cycle after ~2 weak years. Steel demand and pricing have improved sharply
q-o-q. Also, needle coke prices (key input cost for electrodes) have softened in Q2FY21. We raise FY22-23e EPS for GRIL and HEG by 16-40%. Despite a 25-60% rally in a month, valuations stay undemanding (~2x EV/Ebitda on FY23e). B/S stays strong. BUY

Global Industry: The global commodity outlook and prices seem to be improving, aided by Chinese macro data and positive vaccine news. Steel demand has improved sequentially. Over July-Sept, according to the World Steel Association, most countries increased steel production on a q-o-q basis, although the pace of recovery depended on the severity of the pandemic.

Domestic Industry: The Indian steel industry saw a strong sequential rebound, with Q2FY21 steel production up +73% q-o-q to 27.1mn Mt (flattish y-o-y), driven by improvement in industrial activity and higher exports. Spot prices for Indian HRC flat (steel) are now 28-29% above Q2 average. Better steel demand typically augurs well for electrodes. GRIL mgmt remains cautiously hopeful that the downcycle of the electrode industry seems to be bottoming out. With an uptick in economic activity, GRIL expects growth in the medium term.

Upgrade Cycle: Indian metals witnessed ~2 yrs of earnings downgrades over mid 2018 to 2020. However, the earnings cycle seems to have bottomed out. Graphite electrodes are used to make steel; thus improved steel demand (both domestic and global) augurs well for electrode ASPs.

Estimates: Factoring in current industry dynamics and corporate commentary, we revise our key assumptions: (i) FY22-23e electrode ASPs up +4-8%; FY22e: $6.5k/MT; FY23e: $7.3k/MT; ASPs still 40-50% below upcycle peak of FY19. Also, companies are indicating softening needle coke prices (key RM) in Q2FY21. We cut our NC prices for FY22-23e by 8% to $2.3k/MT. These revisions lead to 16-40% increase in FY22/23e EPS. However, we expect FY21e EPS to decline, due to (COVID) demand disruption, inventory losses in H1FY21 and higher-cost needle coke inventory, which could take a few more quarters to liquidate.

Balance sheet, capex: GRIL and HEG continue to exhibit robust B/S. As of Sept’20, GRIL’s net cash+investments stand at Rs 24 bn, HEG’s at Rs 7.6 bn. While GRIL has no capex plans on the anvil (capacity at 98K MT), HEG is expanding capacity by 20K MT (80K MT now); expected to commission in next 2 years.

Reiterate Buy: Despite the sharp uptick (25-60%) in GRIL & HEG over the past month, they still trade at undemanding valuations (EV/Ebitda of ~3x/2x on FY22/23e). Retain Buy with revised DCF-based PT for GRIL at Rs 340, for HEG at Rs 1,400. Key risks: Slowdown in EAF production, lower utilisation/ASPs, higher NC cost.