Welcome to the fifth issue of the Safal Niveshak StockTalk.
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This time I delve deeper into a small-cap company, Graphite India Ltd. (GIL). GIL, despite being a small company, is India&#;s largest manufacturer of &#;graphite electrodes&#;, one of the most important components used while manufacturing steel using the electric arc furnace (EAF) route.
Before we dive deeper into GIL, here is a brief overview of the sections of this report&#;
GIL is India&#;s largest manufacturer of graphite electrodes, which are utilized in electric arc furnaces (EAF) in which scrap is recycled to produce steel.
Graphite electrode demand is primarily linked with the global production of steel in electric arc furnaces. Between the two basic routes for steel production &#; (1) Blast Furnace and (2) Electric Arc Furnace (EAF) &#; the EAF route to steel production has increased over the last two decades from 26% to about 32% at the global level.
The share of EAF is expected to grow further in years to come due to its inherent favourable characteristics of (a) an environment friendly and less polluting production process; (b) low capital cost; and (c) faster project commissioning time. (Click here for a simple explanation of graphite electrodes and EAF)
Another factor that is driving the EAF route to steelmaking is the increasing prices and unavailability of key blast furnace raw materials like iron ore and coking coal. Thus, while graphite electrodes account for just 2-3% of the cost of making steel, these play a major role in the steel manufacturers&#; profitability.
Here is a simple model I&#;ve created to showcase what all goes into the creation of free cash flow for GIL. Free cash flow, as you know from our past discussions, is what ultimately creates shareholder value.
This chart will help you understand the working of GIL and also serve as a helpful tool in analyzing other similar companies.
Keeping in mind the simplicity aspect that is otherwise missing in other company analysis reports you would come across, I&#;ve analyzed GIL by answering 20 important questions that span its:
Here is the complete 20-point checklist with my explanations.
Before we move ahead, here are the symbols that I&#;ve placed against each checklist point and that will tell you at a glance whether I have a positive or negative view on that particular point.
Indicates my positive view
Indicates my negative view
Let&#;s get started.
A. Business
1. Can I, in one sentence, say exactly what the company does?
Yes. GIL manufactures graphite electrodes that are a very key component in the manufacturing of steel using the electric arc furnace (EAF) route.
2. Does the business have high uncertainty?
GIL&#;s business is dependent on the steel manufacturing industry, which is cyclical in nature. So yes, cyclicality in steel industry is what defines the uncertainty in GIL&#;s business. The uncertainty however gets reduced due to the rise in steel production using the EAF route, where GIL&#;s product (graphite electrode) is used.
3. Has the business got an enormous moat?
GIL is one of the very few small companies in India that can boast of a moat &#; competitive advantage that largely restricts the entry of new players in the market.
The moat is created by the restricted supply of needle coke &#; the key raw material used in the manufacturing of graphite electrodes. With there being a handful of suppliers of this raw material globally, it has been impossible for new players to enter the graphite electrode market. Currently, only about 8-10 players globally manufacture this product and no new player has entered the industry over the past 30 years.
This competitive advantage is clearly visible in GIL&#;s realization (revenue per unit sold) over the past few years. As you can see from the chart below, despite some volatility in volume sales over the past few years, GIL&#;s average realization has improved consistently on a year-on-year basis, except for a drop in FY11.
The management expects realization to improve again in the current financial year (FY12), which I believe is a good possibility given the increase in volume sales that global graphite electrode manufacturers (including GIL) have reported recently.
4. Does the business generate strong free cash flow?
Yes. Despite the cyclicality in its business, GIL has consistently seen a good growth in its free cash flows (except the FY05-FY07 period when the company expanded its capacity). A combination of good operating margins and decent working capital management has led to this consistent rise in free cash flows in the past.
GIL depends on a few suppliers for its requirement of needle coke, which is the most important raw material used in the production of graphite electrodes. Thus, it doesn&#;t enjoy any bargaining power here, and generally has to pay up the price demanded by the suppliers of needle coke.
However, GIL&#;s lack of bargaining power on the suppliers end gets converted into a good bargaining power against its buyers. This is because since EAF-based steel manufacturers must use graphite electrodes to keep their factories running, and that there are few electrode manufacturers worldwide, they have to pay the price asked by companies like GIL. Moreover, since graphite electrodes form just around 2-3% of a steel manufacturer cost, they don&#;t mind paying a higher price for the product.
B. Financial Performance
6. Does the business have a consistent sales and profit growth history and is there room for future growth?
Yes. GIL has grown its consolidated sales and net profits at an average annual rate of 18% and 24% over the past 9 years, which is a good pace of growth. As for the future, I see the company maintaining a good growth rate &#; largely led by rising demand for graphite electrodes on the back of rising EAF-based steel manufacturing worldwide and in India.
Yes. GIL&#;s average operating margins over the past 10 years have been around 20%. This gives the company a lot of leverage to spend greater money on sales and marketing to grow its business over the long term.I have a neutral view here. Owing to a weak inventory management, GIL&#;s operating cash flow has suffered in the past, and has been lower than its net profits for 4 of the past 10 years. But this isn&#;t a big worry for GIL given that its inventory levels are largely defined by the steel cycle, which in itself has been volatile during these years.Yes. GIL&#;s debt to equity ratio currently stands at just 0.2 times. While this ratio was high at 1.3 times five years back, GIL has done well to gradually pay off its debt to bring the ratio down to a very comfortable level as of now.Yes. GIL&#;s average current ratio has been 3.7 times over the past 10 years, which is a comfortable number and shows an overall good working capital management.
As a general rule, a current ratio of 1.5 or greater suggests that a company can meet its short-term operating needs sufficiently. However, a higher current ratio can also suggest that a company is hoarding assets instead of using them to grow the business. While this is not the worst thing in the world to do, it is something that could affect long-term returns.
11. Does the company have a good dividend history?
Yes. In terms of dividend payout (amount of dividend paid as percentage of net profit), GIL has averaged around 27% over the past 10 years. This is a comfortable level from a shareholder&#;s point of view. What is more, GIL&#;s current dividend yield (dividend per share divided by current stock price) is around 4.2%, which is attractive for investors.
What this implies is that if you buy the stock at the current price and GIL continues to pay Rs 3.5 per share as dividend in the future (the amount it paid last year), you will earn a minimum return of 4.2% per year from the stock even if the stock price does not move or even if it falls.
12. Is the Altman Z score > 3?
Yes. It&#;s at 3.1, which makes GIL safe against any possible bankruptcy. Read more on the Altman Z-Score.
13. How capital intensive is the business?
It&#;s highly capital intensive, thanks largely to the high inventory levels that the company maintains. On an average, GIL has employed Rs 11.7 billion of capital per year over the past 10 years. Its FY11 sales were Rs 14 billion. So the sales to capital ratio is around 1.2 times, which makes it a highly capital intensive business.
14. Has it got a high and consistent return on capital and return on equity?
While GIL&#;s average return on equity has been around 20% over the past 10 years, it has been marred by high volatility. However, given the cyclicality of the business, I would expect the number to revert to a higher level once the demand situation improves going forward.
15. Is the management known for its capital allocation skill and integrity?
GIL&#;s management has guided the company well over the past few years, so the track record in terms of integrity seems fine. As far as the capital allocation part is concerned, well, the company has been hit owning to the cyclicality of the steel business. It has however still done better in terms of free cash flows, which have been rising year after year. So, overall, I&#;m comfortable with the company&#;s management and its capability to guide the company in the future.
Also, the fact that the GIL&#;s promoters have increased their stake in the company consistently over the past few years raises my confidence.
Not substantial, but yes, over the past 6 years, GIL&#;s equity capital base has risen by around one-third (33%). This has been largely owing to the conversion of its FCCB (foreign currency convertible bonds) into equity.
17. Are management&#;s salaries too high?
No, GIL&#;s top management compensation has been under reasonable levels in the past.
18. What has management done with the free cash in the past?
GIL has reinvested a lot of free cash back into the business. A good part has also been doled out to shareholders as dividends.
D. Competition
19. Does the business face high competition?
Not really. In India, GIL&#;s biggest competition is HEG, which is also a large player in the graphite electrode industry. But as we discussed above, due to bottlenecks on the supply of needle coke, no new player has entered the industry over the past 30 years. So competition remains limited for GIL. And whatever it is, it hasn&#;t impacted the company&#;s business at all.
20. Has the management focused on market share or profitability in the past?
A combination of both, which is good.
Before I move into calculating the intrinsic or fair value range for GIL, let me make one thing very clear.
Intrinsic value isn&#;t a definite figure but just a &#;calculated&#; value. In fact, the calculation of intrinsic value of a business mostly throws up a highly subjective figure. And this figure changes as estimates of variable like future cash flows are revised (given that the future is unknown).
Anyways, what I have done here is rather than arrive at a single intrinsic value figure for GIL, I have calculated the value using 5 different methods and then arrived at a &#;fair value range&#; for the stock.
1. Net present value based on a 2-stage 10-year DCF
The discussion about the calculation of net present value using a discounted cash flow model (DCF) can be found in the 7th lesson of my free course on investing &#; Value Investing for Smart People.
I have done a 2-stage DCF analysis for arriving at the intrinsic value for GIL.
If you want to learn more, please visit our website Graphite Electrodes supplier.
But as a reference, here is the formula for calculating the NPV:
Where:PV = present valueCFi = cash flow in year ik = discount rateg = growth rate assumption in perpetuity beyond terminal yearTCF = the terminal year cash flown = the number of periods in the valuation model including the terminal year
I have calculated GIL&#;s future cash flow for the next 10 years, assuming 2 different rates of growth in cash flows of 10% (years 1-5), and 8% (years 6-10).
As for the discount rate, I&#;ve assumed it at 15% assuming the average cost of capital for the company. My expected terminal growth rate for the company&#;s cash flows &#; expected growth in cash flow after 10 years and till eternity &#; is 2%.
Based on these numbers and after reducing the net debt (debt minus cash), the present or discounted value of future cash flows for GIL is coming at Rs 213 per share, which is also the stock&#;s intrinsic value using this method.
2. Earnings Power Value (EPV)
After DCF, the second most reliable measure of a firm&#;s intrinsic value is the value of its current earnings. This method is known as &#;Earning Power Value&#; or EPV. This value can be estimated with more certainty than future earnings or cash flows, and it is more relevant to today&#;s values than are earnings in the past.
The formula for EPV of a company is:
Here, &#;R&#; is the cost of capital.
GIL posted an average adjusted EPS (earnings per share) of Rs 12.5 over the past five years (I have taken the average EPS of last 5 years given that this is sort of a cyclical business).
Now, if GIL&#;s profits were to stagnate and remain at Rs 12.5 per share going forward, and applying the EPV formula here, I multiply Rs 12.5 with 1/15% (15% is the approx. cost of capital for the company).
This gives me a value of Rs 83 per share, which is GIL&#;s intrinsic value as per the EPV calculation.
3. Pricing relative to 10 year average P/E ratio
True value investors, as Graham has prescribed, won&#;t pay a price based on the stock&#;s latest P/E or the company&#;s latest earnings. They will take a much longer term view&#;as long as 10 years.
Here, I have attempted to estimate the intrinsic value of GIL using the company&#;s last 3 years average earnings, and last 10 years average P/E ratio. So the formula is:
GIL&#;s average P/E ratio for the past 10 years has been around 7 times, while its last 3 years&#; average EPS has been Rs 13 per share. Based on the formula, GIL&#;s intrinsic value is coming to Rs 90 per share.
4. Graham number
Graham number is the formula Ben Graham used to calculate the maximum price one should pay for a stock. As per this rule, the product of a stock&#;s price to earnings (P/E) and price to book value (P/BV) should not be more than 22.5 i.e., P/E of 15 multiplied by P/BV of 1.5.
But why did Graham specifically used a P/E of 15 and P/BV of 1.5? Why didn&#;t he use some other numbers?
Well, he thought that nobody should be willing to pay more than the AAA bond yield at that time. AAA bond yield at that time was 7.5%. Therefore, AAA P/E was arrived at 1/7.5 or 13.3, which was rounded up to 15. Similarly he thought that nobody should pay more than 1.5 P/BV for a stock.
Graham insisted that the product of the two shouldn&#;t be more than 22.5. In other words,
(P/E of 15) x (P/BV of 1.5) = 22.5
Put another way:
(P/E) x (P/BV) = 22.5
Price(sqr)/(EPS x BVPS) = 22.5
Price(sqr) = 22.5 x EPS x BVPS
Take the square root of both sides, and you get the equation for the Graham Number.
However, since GIL&#;s is a cyclical business, and thus will never command a P/E valuation of 15x, I&#;ve used a P/E of 8x and P/BV of 2x, to use &#;16&#; instead of &#;22.5&#; as prescribed by Graham in his formula.
As such, for GIL, the Graham formula will stand as such:
Applying this formula, GIL&#;s intrinsic value comes to around Rs 110 per share.
5. Dividend discount model
As we have discussed in the DCF method above, the value of a stock is worth all of the future cash flows expected to be generated by the firm, discounted by an appropriate risk-adjusted rate or discount rate. Now, as per the Dividend Discount Model or DDM, dividends are the cash flows that are returned to the shareholders.
Hence, to value a company using the DDM, you calculate the value of dividend payments that you think a stock will throw-off in the years ahead. Here is what the formula is:
The modified formula for valuing a company with a constantly growing dividend is&#;Given that GIL has paid higher dividends over the years, we use this &#;dividend growth&#; formula for calculating the stock&#;s intrinsic value.
Assuming a discount rate of 15%, dividend growth rate of 10%, and the latest dividend of Rs 3.5 per share, and inputting these numbers in the above DDM formula, I get to an intrinsic value of Rs 70 per share.
Fair Value Range
I have calculated 5 different intrinsic values for GIL using 5 different methods. So much for the &#;target prices&#; you hear on business channels every day as if these were the holiest numbers!
As you can see from the above calculations, the &#;target price&#; isn&#;t such a holy number and can differ based on the method used to calculate it.
Anyways, based on the above calculated intrinsic values for GIL, I can arrive at a &#;fair value range&#; for the stock. Here is how I calculate it:
High End of the Fair Value Range = [Average of above five intrinsic values] Low End = [(Average of above five intrinsic values) &#; (0.5) x (Std Dev)]
Based on this, the fair value range for GIL&#;s stock is Rs 85 to Rs 115.
Assuming a margin of safety of around 25% to the higher end of this range, I would be comfortable buying GIL&#;s stock at any price less than Rs 85.
Given that GIL&#;s current price is just around this level, if I have surplus cash to invest, I will be happy to buy the stock at the current levels.
Overall, I believe GIL fits the category of a &#;good investment available at the right price&#;.
If one is thinking of making a quick buck, this isn&#;t the right company. But if one has patience, the stock has the ability to give good returns over the long term.
The best things about GIL is that it is a focused business, is cost competitive, and operates in an industry with high entry barriers. What is more, the promoters believe in the story and have thus consistently increased their shareholding over the past few years.
So that was my take on Graphite India as part of theinitiative. I&#;ve tried to be as comprehensive in my analysis, while trying to keep the report very simple. Let me know what you think of this report and the improvements therein.
Do you think I&#;ve missed mentioning something specific here? Can the Safal Niveshak 20-Point Checklist be modified or expanded any further? Do you find this report simple enough for your understanding?
Your answers would help me in making the Safal Niveshak StockTalk report, and the entire initiative, more beneficial for you.
Also, if you want to see your choice of stock covered here, just send me your request using the following form. If you can&#;t see the form below, click here.
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Disclaimer: The author of this report, or any of his family members, does not own the stock(s) mentioned herein. The opinions in this report are for informational and educational purposes only and should not be construed as a recommendation to buy or sell the stock(s) mentioned or to solicit transactions or clients. The information in this report is believed to be accurate, but under no circumstances should a person act upon the information contained within. I do not recommend that anyone act upon any investment information without first consulting an investment advisor as to the suitability of such investments for his specific situation.