HEG Ltd Q2 FY26: Strong Profit Surge Masks Valuation Concerns

The September quarter marked a decisive turnaround for HEG, which had struggled through a challenging FY25 that saw annual net profit plummet to ₹97.00 crores from ₹230.00 crores the previous year. The latest quarterly performance demonstrates the company's ability to capitalise on improving industry dynamics, with net sales reaching an all-time quarterly high of ₹699.22 crores, representing sequential growth of 13.34% and year-on-year expansion of 23.19%.

However, the impressive headline numbers come with important caveats that warrant careful investor scrutiny. The company's elevated valuation metrics—trading at 50.95 times trailing twelve-month earnings and classified as "Very Expensive" by traditional measures—raise questions about sustainability and future return potential. Additionally, the significant contribution of non-operating income to profitability, accounting for 64.08% of profit before tax in Q2 FY26, highlights the quality concerns that temper the operational narrative.

Financial Performance: Revenue Growth Drives Margin Expansion

HEG's Q2 FY26 financial performance reflects a company hitting its operational stride after navigating a difficult FY25. Net sales of ₹699.22 crores represent the highest quarterly revenue in the company's recent history, surpassing the previous peak and demonstrating strong demand recovery in the graphite electrode market. The 13.34% sequential growth and 23.19% year-on-year expansion underscore improving pricing power and volume uptake across key markets.

Operating profit before depreciation, interest, tax and other income (PBDIT excluding OI) reached ₹118.35 crores in Q2 FY26, translating to an operating margin of 16.93%—remarkably stable compared to 17.09% in Q1 FY26 but significantly improved from the 6.77% recorded in Jun'24. This margin consistency despite volume growth indicates effective cost management and favourable input cost dynamics. However, the margin remains below the 25.10% achieved during the commodity super-cycle peak in FY23, suggesting the company is still operating below its optimal profitability potential.

The profit after tax margin of 20.50% in Q2 FY26 represents a substantial improvement from 16.99% in the previous quarter and a dramatic recovery from the loss-making Mar'25 quarter. This margin expansion stems from multiple factors: improved operating leverage as fixed costs get absorbed over higher revenue, stable interest costs at ₹8.92 crores, and consistent depreciation charges of ₹53.75 crores. The effective tax rate of 18.20% in Q2 FY26, lower than the historical average, also contributed to bottom-line expansion.

A critical observation emerges when analysing the composition of profitability. Other income surged to ₹112.29 crores in Q2 FY26 from ₹66.92 crores in Q1 FY26, accounting for 64.08% of profit before tax. This heavy reliance on non-operating income—likely comprising treasury income, dividend receipts, and gains from investments—raises questions about the sustainability of reported earnings. Operating profit before other income stood at just ₹62.94 crores, highlighting that core business profitability, whilst improving, remains modest relative to the company's scale and invested capital.

Operational Challenges: Weak Returns on Capital Employed

Despite the encouraging quarterly numbers, HEG continues to grapple with fundamental operational challenges that constrain long-term value creation. The company's average return on capital employed (ROCE) stands at a meagre 3.52%, whilst the latest ROCE has turned negative at -0.91%—a concerning indicator of capital productivity. For a capital-intensive manufacturing business operating in a cyclical industry, these return metrics fall substantially short of investor expectations and the cost of capital.

The average return on equity (ROE) of 6.61% tells a similar story of underwhelming capital efficiency. Whilst higher ROE generally signals superior management effectiveness in generating profits from shareholder capital, HEG's single-digit ROE indicates the company is struggling to generate adequate returns for equity holders. The latest ROE of 2.58% has deteriorated further, reflecting the challenging operating environment the company navigated through FY25 and early FY26. This weak ROE becomes particularly problematic when juxtaposed against the premium valuation multiples at which the stock trades.

The balance sheet reveals a company with substantial assets but challenged operational deployment. Fixed assets stood at ₹1,894.33 crores as of Mar'25, up from ₹1,770.37 crores the previous year, indicating ongoing capital expenditure. However, the sales to capital employed ratio of just 0.44x suggests these assets are not being sweated efficiently. Investments totalling ₹1,013.64 crores, whilst providing the non-operating income cushion, also represent capital that could potentially be deployed more productively in core operations or returned to shareholders.

On a positive note, HEG maintains a fortress balance sheet with zero long-term debt and net debt to equity of just 0.01. This financial flexibility provides the company with strategic options to navigate industry cycles, invest in capacity expansion or technology upgrades, and weather demand downturns without financial stress. The debt-free status also means that profit margins are not burdened by significant interest costs, with the minimal interest charge of ₹8.92 crores in Q2 FY26 likely relating to working capital facilities.

Industry Context: Graphite Electrode Market Dynamics

The graphite electrode industry operates as a critical enabler of steel production, particularly for electric arc furnace (EAF) steelmaking, which uses scrap metal as feedstock. HEG's performance must be evaluated within the context of global steel production trends, EAF adoption rates, and the competitive landscape shaped by Chinese capacity and pricing dynamics. The company operates the world's largest single-site integrated graphite electrode plant at Mandideep, Madhya Pradesh, providing scale advantages and operational efficiencies.

The industry experienced a dramatic boom-bust cycle between FY18 and FY23. Electrode prices skyrocketed during FY18-FY20 due to supply constraints following environmental crackdowns in China, enabling HEG to generate extraordinary profitability with operating margins exceeding 25%. However, the subsequent normalisation of supply and demand dynamics, coupled with the COVID-19 pandemic's impact on steel production, led to a sharp correction in realisations and margins through FY21-FY23.

The current recovery phase, evident in HEG's Q2 FY26 results, reflects improving steel demand globally and better capacity utilisation in the EAF segment. However, the company's operating margins of 16-17% remain well below peak levels, suggesting pricing power has not fully recovered to super-cycle highs. The sustainability of current margin levels depends on several factors: global steel production growth rates, the pace of EAF adoption (particularly in India and emerging markets), Chinese export policies, and raw material cost trends for needle coke—the primary input for electrode manufacturing.

Peer Comparison: Valuation Premium Without Profitability Edge

Comparing HEG against its industry peers reveals a valuation conundrum that investors must carefully consider. The company trades at a price-to-earnings ratio of 50.95x based on trailing twelve-month earnings, significantly above the industry average P/E of 37x. This premium valuation is not justified by superior profitability metrics, as HEG's average ROE of 6.61% trails several competitors and falls well short of double-digit return thresholds that typically warrant premium multiples.

The peer comparison highlights several noteworthy observations. Graphite India, HEG's closest competitor in the electrode segment, trades at a more modest 29.30x earnings despite comparable ROE of 4.68% and offers a substantially higher dividend yield of 2.04% versus HEG's 0.35%. Vesuvius India commands a higher price-to-book multiple of 6.49x, but this premium is justified by superior ROE of 14.29%—more than double HEG's return profile. Similarly, RHI Magnesita trades at 56.99x earnings but delivers ROE of 11.86%, providing better profitability credentials.

HEG's price-to-book ratio of 2.25x appears reasonable in isolation but becomes questionable when considering the weak ROE. A fundamental principle of equity valuation suggests that companies earning returns above their cost of capital deserve price-to-book premiums, whilst those generating subpar returns should trade at discounts to book value. With ROE of 6.61% likely below the company's cost of equity capital, the 2.25x P/BV multiple implies the market is pricing in substantial improvement in future return profiles—a bet that may or may not materialise.

The one area where HEG demonstrates clear superiority is balance sheet strength. With net debt to equity of 0.01 and zero long-term borrowings, the company maintains the strongest financial position amongst peers. This debt-free status provides significant downside protection and strategic flexibility, factors that partially justify the valuation premium. However, strong balance sheets alone cannot sustain elevated multiples indefinitely without corresponding improvement in operational returns and cash generation.

Valuation Analysis: Premium Multiples Challenge Future Returns

HEG's valuation metrics paint a picture of a stock trading at the expensive end of the spectrum across multiple parameters. The P/E ratio of 50.95x implies investors are paying ₹50.95 for every rupee of annual earnings, a level that demands either exceptional growth prospects or consistently high return on equity—neither of which HEG currently demonstrates convincingly. The company's PEG ratio of 50.95 (calculated by dividing P/E by five-year EBIT growth rate of 15.40%) further underscores the valuation challenge, as ratios above 2.0 typically indicate overvaluation relative to growth potential.

The enterprise value to EBITDA multiple of 44.50x represents another red flag for value-conscious investors. This metric, which accounts for the company's entire capital structure, suggests the market is valuing HEG's operating earnings at nearly 45 times, an extremely rich multiple for a cyclical manufacturing business. The EV/EBIT ratio of 496.58x appears distorted, likely due to the low base effect from recent weak operating performance, but nonetheless highlights the stretched nature of current valuations.

The company's overall valuation assessment of "Very Expensive" by traditional metrics reflects these stretched multiples. Historically, HEG's valuation grade has oscillated between "Expensive" and "Very Expensive" over the past year, with brief periods of "Risky" classification when fundamentals deteriorated sharply. The current valuation leaves limited room for error, requiring near-perfect execution and favourable industry dynamics to deliver satisfactory returns from current levels.

The dividend yield of 0.35%, based on the latest dividend of ₹1.80 per share, provides minimal income support to investors. The dividend payout ratio of 6.04% indicates the company retains the vast majority of earnings, presumably for reinvestment in operations or building cash reserves. Whilst capital retention makes sense for growth companies generating high returns on incremental capital, HEG's weak ROCE profile suggests retained earnings may not be creating commensurate shareholder value.

From a fair value perspective, applying a more reasonable P/E multiple of 25-30x to normalised earnings of approximately ₹10-12 per share (based on improved but not peak-cycle profitability) would suggest a fair value range of ₹250-360 per share. At the current market price of ₹553.85, the stock appears to be trading at a 35-55% premium to conservative fair value estimates, implying limited upside and potential downside risk if earnings disappoint or multiples compress towards historical averages.

Shareholding Pattern: Stable Promoter Base, Gradual Institutional Build-up

HEG's shareholding structure reflects a stable promoter base with gradually increasing institutional participation, a pattern that provides both confidence in management commitment and validation from sophisticated investors. Promoter holdings have remained rock-steady at 55.78% across the past five quarters, with zero pledging of shares—a strong positive indicator of promoter confidence and financial strength. The absence of pledged shares eliminates a significant risk factor that has plagued many Indian companies during market downturns.

Foreign institutional investor (FII) holdings have shown consistent upward trajectory, rising from 7.08% in Dec'24 to 7.96% in Sep'25, with a notable sequential increase of 0.66 percentage points in the latest quarter. This gradual accumulation by 111 FII entities suggests growing international investor interest in HEG's turnaround story and the broader graphite electrode opportunity. The steady FII buying also provides liquidity support and typically correlates with improved corporate governance and disclosure standards.

Mutual fund holdings at 9.33% represent meaningful institutional participation, with 20 domestic fund houses maintaining positions. The sequential increase of 0.41 percentage points in Q2 FY26 indicates domestic institutional investors are adding to positions following the improved quarterly results. However, the relatively modest mutual fund stake—compared to 15-25% holdings typical for widely-held large caps—suggests room for further institutional adoption if the company can demonstrate sustainable earnings improvement and better capital efficiency.

The non-institutional shareholding of 24.27%, which includes retail investors and non-institutional entities, has declined by 1.05 percentage points in the latest quarter. This reduction, coinciding with institutional buying, represents a healthy rotation from weaker hands to stronger, longer-term holders. The overall institutional holding of 19.95% (combining FII, mutual funds, insurance, and other DII) remains below levels typical for institutionally favoured stocks, indicating potential for further professional investor interest if fundamentals continue improving.

Stock Performance: Strong Medium-Term Returns, High Volatility

HEG's stock price performance presents a tale of dramatic cyclicality and substantial volatility, characteristics inherent to commodity-linked equities. Trading at ₹553.85 as of November 11, 2025, the stock has delivered impressive returns across multiple timeframes, though these gains must be contextualised within the broader market environment and the company's operational volatility. The one-day surge of 6.95% following Q2 results demonstrates the market's positive reception to the earnings beat, with the stock substantially outperforming the Sensex's 0.22% decline on the same day.

The six-month return of 30.11% represents the strongest recent performance period, generating alpha of 25.20 percentage points versus the Sensex. This surge reflects the market's anticipation and validation of HEG's operational turnaround, with the stock rallying from the ₹332.20 52-week low touched earlier in the year. The one-year return of 28.91% similarly demonstrates substantial outperformance, with alpha of 24.06 percentage points, positioning HEG amongst the better-performing stocks in the small-cap universe.

However, the short-term performance reveals concerning volatility. The one-week return of -4.07% indicates profit-booking following the recent rally, whilst the year-to-date return of just 8.66% suggests the stock has been range-bound for much of the calendar year despite recent strength. This choppiness reflects the market's uncertainty about earnings sustainability and appropriate valuation levels for a cyclical business navigating industry recovery.

The longer-term returns tell a remarkable story of wealth creation for patient investors. The three-year return of 177.25% and five-year return of 289.15% reflect the complete cycle from the electrode super-boom through the subsequent bust and ongoing recovery. The 10-year return of 1,600.58% represents truly exceptional performance, though this largely captures the stock's rise from depressed levels during the 2014-16 period to the 2018-19 peak, rather than sustainable compounding.

The risk-adjusted return analysis reveals important nuances. With one-year volatility of 46.65%—nearly four times the Sensex volatility of 12.38%—HEG qualifies as a high-risk, high-return proposition. The risk-adjusted return of 0.62 versus the Sensex's 0.39 indicates the stock has delivered superior returns per unit of risk taken, but the absolute volatility level makes it unsuitable for conservative investors or those with short investment horizons. The beta of 1.35 confirms HEG's high-beta nature, amplifying both gains and losses relative to broader market movements.

Investment Thesis: Quality Concerns Temper Growth Narrative

Constructing a comprehensive investment thesis for HEG requires balancing encouraging operational recovery signals against persistent structural concerns about capital efficiency and valuation sustainability. The company's proprietary Mojo score of 70 out of 100, translating to a "BUY" rating, reflects this mixed picture—positive near-term momentum and technical strength offset by average quality metrics and expensive valuation.

The near-term drivers present a compelling case for continued momentum. The financial trend has turned decisively positive in Q2 FY26, marked by record quarterly sales, highest operating profit in recent quarters, and net profit reaching ₹143.33 crores. Key positive factors include operating profit to interest coverage at a robust 13.27 times, indicating comfortable debt servicing capacity despite minimal leverage. The technical trend classification of "Bullish" since October 29, 2025, with multiple indicators including MACD, moving averages, and KST showing bullish signals, provides additional confidence for momentum-oriented investors.

However, the quality assessment of "Average" highlights fundamental limitations that constrain long-term investment appeal. The five-year sales growth of 7.09% appears modest for a company trading at premium multiples, whilst the average ROCE of 3.52% and average ROE of 6.61% fall well short of wealth-creating thresholds. These weak return metrics suggest the company has not yet demonstrated the ability to generate attractive returns on the substantial capital employed in its operations, a critical requirement for justifying current valuations.

The valuation dimension presents the most significant challenge to the investment case. Classified as "Very Expensive" with a P/E ratio of 50.95x and PEG ratio of 50.95, the stock prices in substantial future improvement that may or may not materialise. The EV/EBITDA multiple of 44.50x leaves minimal margin of safety, requiring near-perfect execution and sustained margin improvement to deliver satisfactory returns from current levels. Any disappointment in earnings trajectory or compression in multiples towards industry averages could result in significant capital erosion.

Key Strengths & Risk Factors

Outlook: What to Watch in Coming Quarters