GrafTech: (Still) Great Profits

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About: GrafTech International (EAF)
by: The Value Investor
Summary

GrafTech continues to see fat profits.

Higher production in 2019 might boost earnings power to even greater levels as the current earnings power is around $3 per share.

Earnings look very compelling, as I continue to hold a modest long position.

Concerns about long-term pricing and risks related to long-term contracts and debt make that I am withholding from buying a larger position.

GrafTech (EAF) has been an intriguing investment story, as the company is enjoying very strong profits, with investors wondering how long this huge earnings momentum can be maintained, especially as the company is still saddled with a great amount of debt as a result of its history in the hands of private equity firms.

In spite of great earnings, with the company producing an earnings yield close to 20% at the moment, I feel that despite hedges and "structural" factors, it is too simple to assume that profits can last forever or many years to come from here. Nonetheless, the cheapness argument warrants a modest long position.

The Company, The Thesis

GrafTech makes graphite electrodes for EAF steelmakers (electric arc furnace). These electrodes are key in the production of EAF steel. Not only is this electrode crucial as input material (with no real substitutes), the cost of that in relation to total production costs is limited as well. This creates a near perfect condition for those supplying this furnace to charge premium prices.

EAF steel production is responsible for roughly half of total steel production outside of China, with key advantages being that it is cheaper to produce, as it relies on scrap availability and is more environmentally friendly as well.

The company furthermore claims that fat profits can be maintained not just by very high replacement cost of manufacturing sites, but more so because critical knowledge to set up these operations is hard to come by. That seems a bit of an exaggeration, although the company claims that with the exception of China, no new capacity has been added for some 3 decades by now.

The price of these electrodes has exploded in recent years which caused a windfall for GrafTech, as the company has "secured" a great deal of these profits by locking in long-term contracts with users. In fact, the company has locked in more than 600,000 MT of production between 2018 and 2022 at prices close to $10,000 per ton, for >$6 billion in contracted revenues. This compares to prices averaging just $2,500 in the first half of 2017 before the boom in prices took place.

Earnings Power Is Great, Market Is Sceptical

GrafTech was acquired by private equity firm Brookfield which bought the firm in 2015 in a mere $700-million deal. A spike in prices urged Brookfield to bring the company public again almost a year ago. Underwriters aimed to sell shares at $21-24 per share, yet demand was soft as investors were sceptical and were more comfortable with a $15 per share valuation. Despite the big shortfall, the enterprise value still came in at $5 billion, creating a true windfall for Brookfield and associated parties.

The $5-billion valuation still looked very high based on 2017 results which revealed revenues of $551 million and $96 million in EBITDA. Yet this was based on production of 166,000 MT of EAFs with pricing averaging at just $3,000 per ton, as prices spiked to $10,000 per ton in early 2018. These higher prices drove a boom in first-quarter sales to $452 million. Revenues rose to $456 million in Q2 and were stable at $455 million in the third quarter, with pricing having ranged at roughly $10,000 per ton.

Fourth-quarter sales were very strong at $533 million, as the company reported steep net earnings of $230 million, or $0.79 per share for the final quarter as the sequential improvements in sales were much driven by higher volumes, with pricing being flattish compared to recent quarters.

Despite the strong earnings power, which trended at $2.80 per share for all of 2018, investors have been sceptical. Shares initially rose from $15 to levels in the low $20s following the IPO, but now trade at just $13 per share, up from a recent low around $10. This makes that shares trade at just 5 times earnings, even as the backlog of future profits remains very high.

Concerns

One key concern for shareholders is a $2.1-billion net debt level, as full-year adjusted EBITDA comes in at $1.2 billion, or $1.3 billion based on the Q4 numbers. These earnings are pretty steep, but investors fear that net debt has to come down in case earnings fall, as that would automatically result in a jump in leverage ratios.

While the current $0.085 per share quarterly dividend is not too high and allows for deleveraging, progress was limited in Q4 as the company paid out a special dividend of $0.70 per share last quarter.

The other concern is that of the sustainability of the premium pricing, although the company indeed claims to have locked in big profits for years to come through long-term contracts. Reality is that while these profits are "guaranteed," realisation of these cash flows will take time, as customers might even go bankrupt if spot markets revert to much lower prices of course.

Other risks include cash flows associated with hedging, certainly if GrafTech itself faces production outages or spot prices rise further and counterparts requite additional collateral. Thus there are very real risks to those profits if prices either rise further or fall, even as long-term contracts are in place!

Concerns about falling prices could be invoked by the company itself as production is on the increase. Production for the year rose from 166,000 to 179,000 MT as it has been performing debottling projects at its plants, while production is set to rise to 202,000 MT in 2019. Costs associated with this expansion are seen at just $1,200 per ton, while greenfield developments are pegged at a cost of $12,000 per ton.

We might be on the verge of new production coming online as average sales prices came in at around $10,000 per ton, while management claims spot pricing by peers already stands at $12,000-15,000 per ton. In fact, it sold limited quantities on the spot markets as well in the fourth quarter at the upper end of that range. Roughly two-thirds of future production is now locked in, with contracts currently representing $6.2 billion in value with a total size of 636,000 MT.

The company remains very bullish, pointing towards the continued shift to EAF steel-making as well as long-term demand for steel and other applications such as electrical vehicle battery demand. The company furthermore benefits from vertical integration of the business with key ingredient petroleum needle coke (used for EAF production) being largely produced in-house, creating a key advantage over peers.

Following the release of the third-quarter results, I was cautious despite that shares traded at just 6 times annualised earnings power, on the back of concerns about price volatility, high leverage, and some softness in spot pricing at the time, in combination with higher input costs, as well as potential impact of more capacity coming online. Before adding to a tiny long position (held as a monitoring tool) I would like to see further deleveraging to drive appeal.

Disclosure: I am/we are long EAF. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.