GrafTech International (GTI) manufactures and sells graphite and carbon based products worldwide. The company operates two segments, but the lion's share of the revenue and earnings come from Industrial Materials, which produces graphite electrodes necessary in the production of steel. Shares of the company have been bludgeoned over the last year due to the decline in steel prices and demand. However, GrafTech will be solidly profitable this year and is now trading at under 10 times earnings, providing a great entry point for long term investors looking for value, growth, and long term competitive advantages.
Graphite electrodes are essential for the production of steel in electric arc furnaces (EAF). EAFs have increased in popularity over the past few decades due to their lower capital costs, energy requirements, and higher flexibility compared to traditional blast furnaces. They now account for over 30% of worldwide steel production, and with the adoption of EAF' in developing countries like India and China, that share is expected to rise. On the most recent conference call, GrafTech CEO Craig Shular noted the Chinese government is initiating the switch to EAF', and that usage is expected to grow nicely in the next decade. Exhibit 1 shows the increase in steel production, EAF share, and graphite electrode demand over the past 35 years.
GrafTech's Competitive Advantages
Warren Buffett once likened a competitive advantage to a moat around a castle. To Buffett, the castle is the business and the moat is the business' competitive advantage. When Buffett invests, he looks for companies with unbreachable moats. GrafTech has two such moats that should ensure the health of the business over the long-term.
First, the graphite electrode market has an oligopoly market structure. There are seven producers of electrodes world-wide and only two (GrafTech and SGL Carbon) are capable of competing on a global scale. Combined, the two companies control about 60% of production capacity. Additionally, the barriers of entry for new market participants are high. Only one new graphite electrodes facility has been built since 1977, a new site by SGL Carbon that was commissioned in 2011. The power of the market structure can be seen by examining quarterly results over the past few years. GrafTech has churned out a profit for the last 21 quarters despite being in a very cyclical business. Even during the doldrums of 2008-2009, when the company was running facilities at 40% capacity, GrafTech continued to report quarterly profits.
Second, GrafTech has positioned itself to be the low-cost producer of electrodes by acquiring needle coke maker Seadrift Coke LP. Needle coke is a petroleum based product and the main component of a graphite electrode. Approximately 40% of electrode cost is derived from needle coke. Graphite electrode producers have long been plagued by the rising cost of needle coke due to the market's similar oligopolistic structure. The Seadrift acquisition even prompted Russian graphite electrode producer Energoprom to file a formal objection to the US Justice Department. Energoprom argued the limited number of needle coke producers (only 4 world-wide including Seadrift); the high barriers to market entry, the lack of substitute products, and low elasticity of demand for needle coke would give GrafTech market advantages over competitors. The complaint was largely ignored by the US Justice Department, and GrafTech was only forced to make minor concessions on its needle coke supply contract with Conoco Phillips in order to gain regulatory approval.
Long-term investors who believe in the future of steel and graphite electrodes should consider buying shares for GrafTech at these depressed prices. As steel producers continue to move toward lower cost EAFs, the demand for graphite electrodes will continue to rise. Oligopoly market structure and vertical integration of needle coke supply provide durable competitive advantages that competitors are unlikely to match. With these advantages, GrafTech should be able to outperform their industry competitors and market over the long-term.