KEY RATING DRIVERS
Bottoming Out of Credit Risk: HEG’s ratings are underpinned by an improvement in HEG’s credit metrics over FY14-FY15 despite a weak operating environment and revenue slowdown. The affirmation reflects the company’s ability to manage cash flow and resilience in profitability due to favourable raw material pricing and terms, coupled with the low cost of captive power generation.
Improved Profitability, Softer Revenue: EBITDA margins improved to 15.8% in FY15 from 15.1% in FY14 (FY13: 14.7%, FY12: 10.5%), led by lower forex losses as well as lower power and fuel costs, along with reduced crude prices. Revenue declined 9.6% yoy in FY14 and around 15.4% in FY15, led by lower volumes and realisations in the graphite electrodes (GE) business due to overcapacity and a slowdown in the steel sector, which drives GE demand. The capacity utilisation decreased to 70% in FY14 and remained at the same level in FY15 (FY13: 78%).
Softer Earnings Outlook: HEG’s revenue and earnings outlook have turned weaker in FY16 due to continued slowdown in steel sector. In 1QFY16, HEG’s revenue fell 28% yoy due to lower volumes as well as end product pricing. EBITDA margins was also lower at 9.3% in 1QFY16 (1QFY15: 16.2%), hit by INR130m of inventory loss in the backdrop of declining input (38% fall) and finished stock prices (15% yoy fall).
Fixed Raw Material Prices: HEG contracts majority of its raw material (needle coke, a crude oil derivative) for 12 months and hence could not benefit from the lower raw material prices October 2014 onwards. However, it sources some raw materials on a spot basis, which partly compensates the impact of fixed-price contracts. HEG has been able to contract needle coke for 2015 at a favourable pricing which is likely to support the margins.
Comfortable Liquidity: Significant working capital improvements led to positive cash flow from operations (CFO; FY14: INR7bn; FY13: INR538m) and free cash flow (FCF; FY14: INR4bn, FY13: negative INR1.36bn) in FY14. These were driven by a reduction in inventory days to 185 in FY14 from 199 in FY13, a reduction in receivables days to 130 from 135 and an improvement in payables days to 67 from 35. However, the net cash conversion cycle remained long at 248 days in FY14 (FY13: 298 days), due to the long production cycle for both electrodes and connectors, which is an industry-wide phenomenon and reflects working capital intensive nature of business. Also, HEG’s average use of the fund-based limits was 76.6% utilisation during the 12 months ended September 2015 and its interest coverage was comfortable at 3x in FY15.
Over the last two years, HEG’s raw material accessibility has improved with low end-use capacity utilisation leading to an oversupply situation and eventually a buyers’ market. Hence, the payables period also improved as payment terms eased.
Barriers to Entry: HEG is one of India’s leading GE manufacturers, and has a diversified customer base and 100% self-sufficiency in power. The entry barriers, in terms of capital and technology, remain high which gives an edge to existing GE manufacturers. The government of India’s recent notification (February 2015) of anti-dumping duty of up to USD922.03/t on the import of Chinese electrodes into India is likely to provide a level-playing field to domestic players.
High Financial Leverage: Financial leverage (total adjusted net debt/EBITDA), though improved to 4.6x in FY14-FY15 (FY13: 5.83x; FY12: 8.43x), remains high for the rating level. The leverage improvement was driven by a reduction in both long-term and short-term debt in FY15. Ind-Ra expects HEG’s leverage to reduce due to the measures taken to improve the working capital cycle and on the repayment of long-term debt.
Forex Risk: HEG remains exposed to fluctuations in foreign currency, given its exposure to exports, imports and foreign currency debt. HEG incurred a forex loss of INR222m in FY15 (FY14: INR254m). However, the company has a partial natural hedge due to both imports and exports.
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