Seeking Alpha
Long/short equity, special situations, value
Profile| Send Message| ()  

Shares of GrafTech International (GTI) jumped up on Monday following the release of its third quarter results, which were accompanied by a new program to boost the efficiency and effectiveness of the business.

While I can only applaud GrafTech's rationalization plans, I remain cautious and stay on the sidelines. This is based on a fair valuation of through-the-cycle earnings.

Third Quarter Results

GrafTech generated third quarter revenues of $303.1 million, down 5.5% on the year before.

The company reported a $7.6 million loss compared to a $29.6 million profit a year ago. The fall in earnings was on the back of $14.6 million in rationalization costs as well as negative sales leverage.

CEO Craig Shular commented on the third quarter results, "We remain in a difficult operating environment, particularly for our Industrial Materials segment. We have announced initiatives today designed to significantly improve our competitiveness, allow us to better serve customers and position our Industrial Materials business well when global economies and steel demand recover."

Rationalization Plan

To combat the fall in earnings, GrafTech aims to reduce its annual costs by some $75 million, of which $35 million is targeted in 2014. Note that the plan will cost some $105 million of which just $30 million will result in cash outlays.

As part of the program 20% of the workforce will lose their jobs as supply chain efficiencies will yield a $100 million in inventory improvements. Some 600 workers in Brazil, Russia and South Africa will lose their jobs following plant closings in those countries.

Looking Ahead

As a result of the poor performance and circumstances, full year EBITDA is now seen between $145 and $155 million, compared to a previous guidance of $145 to $165 million.

Valuation

GrafTech ended its third quarter with $11.5 million in cash and equivalents. The company operates with $576.5 million in total debt, for a net debt position of around $565 million.

Revenues for the first nine months of the year came in at $858.2 million, down 2.2% on the year before. Net profits of $89.0 million last year, shrank to merely $1.0 million. At this pace, annual revenues of around $1.2 billion should be attainable as the company will most likely report a full year loss on a GAAP basis

Factoring in gains of 15% on Monday, shares are trading around $11 per share, valuing the company at $1.5 billion. This values operating assets at 1.2 times annual revenues.

GrafTech does not pay a dividend at the moment.

Some Historical Perspective

Long term holders in GrafTech have seen a great deal of volatility, but no real returns. Shares rose from merely $5 in 2005 to highs of $25 in 2008. Shares corrected back to lows of $5 in 2008 to see shares recover to levels in their low twenties in 2011.

On the back of the deteriorating operating performance shares fell to lows of $6 by March of this year. Following Monday's news, shares have recovered to levels around $11 per share, for year to date gains of 15%.

Between 2009 and 2012, GrafTech has increased its annual revenues by a cumulative 90% to $1.25 billion. Earnings rose from $16 million to $118 million after peaking at $175 million in 2010. Note that the outstanding share base increase by little over 10% in the meantime.

Investment Thesis

GrafTech has grown in recent years, notably on the back of the acquisition of C/G Electrodes LLC and the remainder of the shares of Seadrift Coke LP for a combined $692 million, expanding access to raw materials.

Besides this, GrafTech continues to operate in a long term growth industry as more and diverse end users continue to use graphite. Despite this, Graftech still relies on major steel customers including Arcelor Mittal (MT), Steel Dynamics (STLD) and ThyssenKrupp (GM:TYEKY), among others.

For now investors are not impressed. Trading around $11 per share, the market values GrafTech's enterprise around $2.0 billion, including the assumption of debt. This is not surprising given the fact that adjusted EBITDA came in at $247 million for 2012, valuing the business at around 8 times adjusted EBITDA.

Note however that the valuation is not cheap as EBITDA is seen around $150 million for this year, valuing the business around 13 times EBITDA. Given the prospects for synergies, operations should improve going forwards. On the back of sales leverage and a next potential upturn, Graftech sees the potential for peak EBITDA of $500-$600 million annum. This compares to peak EBITDA of around $369 million in 2008, prompting shares to peak around $26 per share that year.

While such a spike in EBITDA could occur going forwards, this will most likely result in a renewed share price jump upwards, possibly to levels far above $11 per share. Yet after applying through the cycle EBITDA of $300-$400 million per annum, which seems generous, shares are still valued around 5.7 times annual EBITDA.

At this point in the cycle I'll pass on the shares given the volatility of the operations and the reasonable valuation based on through the cycle earnings. That being said, shares could easily be squeezed higher in case of a renewed tightness in the market, but I don't see such a scenario materializing anytime soon.

I remain on the sidelines.

Source: GrafTech International - Investors Applaud The Rationalization Plans