Refractory Sector- A Boiling Hot Theme!

Introduction

We initiate coverage on refractories, to capture and capitalise on the current boom in the steel industry. The said research is done to extensively read and understand the commodity cycle and the metals and refractory sector.

Refractories are insulation bricks which are used to resist heat and pressure (exceeding 1200 Celsius). They are used for high temperature insulation and are made from non-metallic minerals. Usually used in large hot boilers and furnaces. Now the inside of the container, is usually at a very high temperature, and to resist this heat from transferring to the outside part of the container, these refractory bricks are lined and insulated in the lining of the boiler.

The fortunes of this sector lie in the hands of the steel industry as almost 75% of the refractories produced are consumed in the steel industry. With the start of the capex cycle in India led heavily with the PLI Scheme we expect tremendous growth and potential in the construction, automobile, infrastructure, and power sectors, which in turn would generate demand for refractories.

Since 75% of the production of refractories are used in the steel industry, most of the plants of refractories are within the vicinity of the steel and metal plants.

Refractories are traditionally made from naturally occurring minerals such as bauxite, magnesite, fireclay etc. Lately man-made materials have also been used to produce these insulation bricks such as brown fused alumina, silicon carbide etc.

Refractory plays a dynamic and important role not only for metals and steel, but also in the glass, ceramic, and cement industry. There are more than 100 refractory producing companies, out of which 14 are major manufacturers, 30 are mid-sized and rest are relatively smaller in volumes. Steel plants in India consume 8-10 Kg of refractory per tonne of steel, which can go as high as 15 kg.

Current Market Size and Growth of The Industry

India’s steel capacity is targeted at 300MT by 2030, production of the same is expected to grow at 230MT by that time from 118MT in FY 22. And the cement industry is also expected to grow at 12% against a CAGR of 6% historically. This gets us to the point that this gap needs to be addressed and filled by the refractory industry.

In the past, India’s cement and steel industries have relied heavily on imported refractories, primarily from China. China produces 65% of the world's refractory and has God given luck within house raw materials present in abundance, this gives China a tremendous cost and strategic advantage, India on the other hand has a fragmented refractory industry producing lower end refractory.

With the onset of the China+1 mindset and deleveraging their dependency on China, this has created a significant opportunity for India to step in and fill in the needs of other customers throughout the globe.

Concurrent investments need to be made in R&D, India still relies on Europe’s technology and since after China we are the No.1 steel and cement producer, it is important we work on our technology and create an eco-system between users of refractory, manufacturers, and the raw material suppliers.

Steel production in India as of FY21 has been declining in the last two years and is still at FY18 levels of 103 million Tonnes, mainly due to the pandemic and a slump in consumption of steel.

Scope of expansion

With the year 2021 being comparatively steady with lockdowns being lifted off and economy reviving faster with pent up demand from real estate and infrastructure projects, we see good demand for steel.

India has an ambitious target of being a US 5 trillion Dollar economy by FY25, further accelerating spending on infra projects to drive this growth.

As of now, India is the lowest at the rate of per capita steel consumption, at 64.2 kgs.

According to the National Steel Policy the ministry of steel has set a target of reaching 160 kgs per capita steel consumption by 2030 with steel production of 255 kgs, focusing on an 8% CAGR.

Demand for refractory starts 3-4 months prior to commercial production at new steel plant.

Steel exports are expected to structurally rise, which in turn would drive demand for refractories. India has never in a big way been an exporter of steel until after the pandemic, when supplies were diverted to export markets due to low demand in domestic markets.

India’s steel exports have already covered 70% of FY21 exports in first half of FY22, this structural shift is due to short supply from other countries like China.

Refractories- Proxy Play to Investing in Steel Companies

Investing in refractories also acts as a proxy play to investing in metal cos. Since metals are cyclical in nature, all their return ratios will likewise be cyclical, producing a range of varied results over the course of time.

Refractories, on the other hand, are a key supplier to the metal industry. As a result, they are price insensitive, because they only represent 2-3% of the total plant cost, and their return ratios and quarterly growth rates are often consistent.

· Revenue

Now when we look at the revenue of refractories, we can notice that it has more revenue growth % than steel companies. The reason being that refractories depending on the demand of steel need to be replaced every 2-3 weeks to 2 months.

· Gross Margins

We clearly see a trend that unlike a steel company, refractory companies do not have high volatility. If at all there are high raw material costs, it can get easily passed on since steel companies as already mentioned, are price insensitive to refractory costs, thereby demanding a higher valuation multiple. As can be understood from the above picture, gross margins remain short range bound over long term. Orient Refractories/RHIM- 40-45% and IFGL Refractories- 45-50%

· Consistent FCF generation unlike a commodity company due to low debt and working capital requirements

According to my analysis, a refractory business is more comparable to a consumer manufacturer because they have higher margins and are less cyclical when compared to a commodity business like metals. RHI Magnesita has time and time again proved its superior business model with high EBITDA margins when compared to peers and stable FCF generation.

Current scenario of Refractory Companies

The refractory sector witnessed hard times with surge in freight rates, Raw material cost, inflation, currency headwinds and demand uncertainty, the best way to play out in these testing times is to invest in refractory companies who have lower dependency on exports and strong book order with respectable steel companies. The demand for steel has been shaky which is a new challenge for refractory players.

· Freight rates have corrected almost 25%, this has led to an advantage to certain players like RHIM in freight surcharge.

· Main advantage to them is that raw material issues related to China have resolved which was a matter of concern in 2021.

· Raw material costs have corrected by 20% from peak

· Margin contraction a source of worry- Reduction in export revenue (Euro depreciating) and appreciating rupee. Since RHIM get 20-25% revenues from Europe, a depreciating EURO is a source of concern, and as Raw material are purchased in dollar, depreciating Rupee also helps in reduction of the margins.

2HFY23 expected to be soft since headwinds from depreciating rupee has a direct effect on the RM cost inflation.

RHI Magnesita

Market Capitalisation- Rs. 10,583 Crores

RHI Magnesita is the leading supplier of high-grade refractory products which are indispensable for industrial high-temperature processes exceeding 1,200°C.

RHI entered the Indian market by acquiring a major stake in Orient Refractories. In January 2013, RHI purchased 43.6% of ORL and a further 26% by the end of April 2013 by open offer. RHI produced refractories in the name of Monofrax and Refel brands for glassmakers for our western counterparts such as Europe and the Americas for many years.

RHI recently merged its Indian entities- RHI India, RHI Clasil and Orient Refractories to create India’s largest refractory manufacturing and trading company RHI Magnesita India (RHIM). Merger got completed in May 2021, after approval from NCLT.

Benefits of Merger

A diversified portfolio which includes basic bricks and specialised refractories will help complete the full basket of products. Also benefit from the wide customer portfolio of the three entities and low input cost, recycling of raw materials and a common supply chain for all plants. Completion of expansion at Vizag facility and Cuttack facility is a step taken to substitute reliance on imports as 75% of magnesia bricks used in India are imported from China.

Customer portfolio of merged company- Jindal Stainless Ltd, JSW Steel, Gerdau, TATA Steel, Lafarge Holcim, Sunflag Steel, Birla Shakti Cement, SAIL etc.

· Focus on full line contracts for increasing market share

· Benefits of raw material sourced directly from parent

· An integrated business serving in Asia and Africa

· Increase in exports

· R&D Centre inn Bhiwadi

Superior Return Ratios

RHIM has consistently outperformed when compared to their peers when compared in terms of The Return on Equity and Return on Capital Employed. This shows better stable margins and returns when compared to their peers.

RHIM also has highest EBITDA margins among peers due to benefit of acquiring RM from parent directly and recycling of unused RM.

I believe RHIM has the best business among all other peers due to a diversified portfolio of products (magnesia bricks, specialised refractories from Bhiwadi), expanding domestic market share and leverage its R&D expertise.

Forward looking plans of the Management

RHIM has committed approximately Rs. 400 Crore of phased investment by FY2026 to expand production capacity in India. About Rs. 50 Crore was invested during FY2021-22 to expand their Vizag plant by almost 30%.

The investment would go towards brownfield expansion and automation in the plants at Bhiwadi, Vizag and Cuttack.

Large orders- An undisclosed entity trusts RHI Magnesita for refractory solutions to a steel maker with a total capacity of 28MTPA in India and USA. The steel maker commissioned its new Steel Melting Shop (SMS) II integrated plant in one of its facilities in southern India. With a capacity of 5 Million Tons Per Annum, the plant is the largest brownfield expansion in India – comprising two lines of Kanbara Reactor (KR) Hot Metal Processing, a Basic Oxygen Furnace (BOF), a Ladle Furnace (LF), a RH Degasser and a Twin Slab Caster. The equipment also boasts of the largest capacity in India, being able to heat 350 tons in a single heat. RHI Magnesita India successfully executed the commissioning of converter as the refractory partner for the project.

Financials

Technical Analysis

By observing the chart we get to know that RHIM has been in a strong bullish uptrend, and has consistently created wealth for their shareholders.

My analysis tells, every dip should be bought.

With good commentary from the management, in a relatively soft environment RHIM is expected to do better than their peers and the street’s expectations.

As it can be observed from the above chart, investing through refractories can be a better option than investing in a metals company, Say TATA Steel here, due to its deep cyclicality. Hence RHIM acts as a proxy to metals company, and investors would make steady stellar returns with lesser volatility.

Conclusion

RHI Magnesita and the refractories sector is poised to give stellar returns with respect to the benchmark index and can outperform and generate alpha for the investors. The price chart indicates that, keeping aside short-term headwinds, in the long term RHIM has made stellar returns. With the oncoming of the tailwinds for the steel sector, RHIM can indeed make very good wealth for the investors.

I would recommend investing in RHIM at a buy price of Rs. 520-550 levels and can reach target of 700-720+.

Source: Monarch Networth- https://www.mnclgroup.com/

Screener- https://www.screener.in/

Shivam M. Dave

23 September 2022- Update

RHI Magnesita India to acquire 100% stake in Dalmia Bharat Refractories Limited. The share consideration has a value of Rs. 1,708 crores.

This acquisition makes the already industry leader more bigger in size, reports suggesting it to gain >30% market share.

The investors have reacted in a positive way to the news. The day's high price being Rs. 835/per share.

It is a hold for the longer term, as we expect it doing very well in the quarters and years to come.

Peers are no where close to RHI Magnesita in terms of market share, making it more of an monopolistic postion in the refractory sector.