Graphite India Limited (GRAPHITE) is the largest manufacturer of graphite electrodes (90% of the revenue). It also provides impervious graphite equipments and GRP/ERP pipes and tanks (10% of revenue). It end customers, and applications are in metallurgical (ferrous & nonferrous), chemical and process, and aerospace industry.
This is small cap which has potential in my long term buy and hold because it operates in niche market with high entry barriers. I want to understand its financial management and whether it meets my buying criteria.
The whole reason for any business to exist is to generate sales revenue and make more profits. At a minimum, the parameters listed below should have continuously increasing trends. All the data below is from 2000 to 2009.
- Revenue: Increasing trend since 2001 with average growth of 31% (SDev. 47%). Neutral observation.
- Earnings per share: Historically increasing trend, but flat for last three years. Average growth of 53% (SDev. 96%). High variability and has possibility of negative growth. Neutral observation.
- Net cash flow from operations: Increasing trend prior to 2004. Reduced until 2006, and now again increasing trend. Neutral observation.
- Profit/Loss from operations: Overall increasing trends in profits from its operations since 2001. Good observation.
- Reported net profit: Overall an increasing trend since 2001 and increase trend. Good observation.
- Gross margins: Current GM of 23.8% is higher than historical average of 17.3% (stdev. 3.01%). Good observation.
- Operating margins: Current OM of 26.8% is higher than historical average of 19.1% (stdev. 3.68%) and increasing trend. Good observation.
Quality of Dividends
In this part of my analysis, I am trying to understand dividend growth rate, consistency, and ability of the corporation to demonstrate sustainability. In is also an indirect way to gauging management’s policy vis-à-vis sharing of profits with common shareholders.
- Dividend per share: Chart 3 shows very slow growth until 2006 and then good growth onwards. Neutral observation.
- Payout factor: This has been less than 30%. Good observation.
- Dividend growth rate: The dividends have not grown at sustained year-on-year basis. i.e. there has been a high level of variability. Overall, on the basis of last nine years, the dividends have grown at an average of 37% (std dev. 61%) which is less than overall EPS growth rate of 53% (std. dev 96%). Good observation.
- Ratio of cash from operations to reported net profit: It had been more than 1.0 prior to 2005. This could be due to the funding for growth plans. Has been improved since then. Good observation.
- Ratio of profits from operations to reported net profit: This ratio is more than one. Good observation.
- Ratio of Cash from operations to total debt: This ratio was trending upwards prior to 2005. But here also, the debt funding for growth reduced it. It trending upwards. Neutral observation.
Dividend Cash Flow vs. Risk Free Savings Cash Flow
Why should I take risk if I can get a same or more cash flow by putting my capital into any risk free savings, fixed deposits, or any such risk free accounts? Therefore, I try to understand how dividends will affect my cash flow in 10 years of time period. The baseline assumptions are (1) the stock’s dividend yield is 3.6% at current price of Rs 84.00; and (2) savings interest rate is 7%.
- Best case scenario: considering average dividend growth rate of 26% for last nine years, the dividend cash flow will be 2.22 times the cash flow from savings interest at the end of 10 years.
- Worst case scenario: considering low end of the expected dividend growth of 15%, the dividend cash follow will be equal to the cash flow from savings interest at the end of 10 years.
- So at current pricing of Rs 84 and assuming the dividend growth rate of 15%, the cash flow from dividends is equal to savings cash flow.
Projected Beta-based Expected Return
I measured Beta for this stock’s risk (or price movement) relative to the S&P CNX NIFTY (or index movement). Here, I am trying to understand how a stock price behaves relative to the market and how to factor in the capital appreciation into my expected returns.
- The stocks three year Beta value is 0.18. This means this stock has low volatility w.r.t. S&P CNX NIFTY index.
- The expected return is 8.5% relative to market index.
- Now factoring in 8.5% of expected return into the worst case dividend growth of 15% and current yield of 3.9%, the total cash flow is 3.6 times the savings interest rate.
Fair Value Calculation
The next step is to estimate the fair value so that we can understand return characteristics for this investment.
- NPV price based on 15 year DCF: Rs 101.23
- Average high yield price calculated based on past 9 years: Rs 50.6
- Pricing relative to 9 year average PE ratio: Rs 78.5
- Pricing based on PE ratio of 12: Rs 138.0
- Graham number: Rs 131.8
The range of fair value is calculated as Rs 81.7 to Rs 100.
- Graphite is one of the only two companies in this domain in India. Another one is HEG.
- The market in which Graphite operates has high entry barrier for technology and capital intensive. This provides it an edge.
- It seems to have completely executing its growth plans. It has used both organic and inorganic strategies for growth. I has increased internal capacity in India for organic growth. The inorganic growth comes from acquiring German company to remain export competitive in European markets. The debt is being reduced faster than I would expect in any other businesses.
- It has also initiated some product diversification (on industry diversification) within its domain of graphite expertise. However, it revenue from this segment is still only 10%.
- It has steady increasing margins, although I believe it will get capped at certain point. When that will happen? I do not know.
- There are two reasons for which I preferred Graphite over HEG (1) operational cash flow for HEG is less than net profit; and (2) for similar level of revenues HEG has higher debt. Even though its margins and dividends are higher, it seems Graphite has better balance sheet management.
- The downside risk is related to operating in the relative niche markets. Majority of its product is supplied to steel industry, which is expected to remain slow for some more time (probably another 2 years?). It remains to be seen how its product diversification helps its profitability and margins.
I would expect Graphite to provide potential capital appreciation over long term and slow dividend cash flow. I believe it will have near term challenge of maintaining its earnings and dividends. However, long term it is very well positioned as being one of the only two suppliers of graphite electrodes and related products. At present, the shares are trading within my fair value range. I will add shares of Graphite as per my allocation levels.
Disclosures: Long on Graphite India Limited.
Disclaimer: This analysis is in the context of my long term buy and hold investment philosophy. It is in accordance with my investment objectives and my personal risk profile. If you intent to use this analysis for your own investment decision, then please make sure it meets your own objectives and your own risk profile.
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