In my limited investing history, I have had some success with "low-risk, high-uncertainty" situations. These situations can occur for any number of reasons, but one common scenario is to find a company operating in a cyclical industry that either has a diversified business or a particularly low-cost operating model. Essentially, you want a company that can stay afloat in the bottom of the cycle (low-risk), flourish whenever the cycle turns (the timing being highly uncertain), and to be able to buy it in the midst of a negative cycle when investors are most uncertain about the timing of a recovery. I believe this type of investing can produce satisfactory results over the long term and is well suited to investors who would list patience as their competitive advantage.
When I first came across GrafTech International (EAF), I thought I had stumbled upon one of these low-risk, high-uncertainty situations. The company operates a niche business in a growing but cyclical industry, controls its own means of production, and offers a high-quality product. EAF has signed longer-term contracts that have locked in about 70% of their business and guarantees some level of stability over the next few years. Unfortunately, the company also carries a substantial debt burden and I have some doubts that they would be an appealing investment under average market conditions. I would say that at its current share price, EAF is more of a 'medium-risk, medium-uncertainty' situation.
Understanding The Business
EAF's business might sound complicated at first, but after some light research understanding their operating model becomes relatively simple. EAF starts with something called petroleum needle coke, which is created from decant oil via various refining processes. The company uses this needle coke as a raw material to produce graphite electrodes, which are then sold to steel producers that operate electric arc furnaces. Graphite electrodes are a key component in the science behind electric arc furnaces and are consumed as part of the steel-making process, so if there are a lot of steel companies operating a lot of electric arc furnaces, there will be strong demand for graphite electrodes. The key variables to EAF's success are thus limited to the cost to acquire needle coke and the general market price for graphite electrodes, which is impacted indirectly by the price of steel.
There are some key numbers and data points that help provide additional context for EAF's operating environment. First, plants operating electric arc furnaces currently produce about 46% of total steel output globally (excluding China, which I will discuss more later in this piece) and are the fastest-growing segment of steel production, growing roughly 3.5% per year over the last 30 years. Secondly, EAF estimates that replenishing graphite electrodes makes up about 1-5% of the cost of operating an electric arc furnace, so while the electrodes are necessary for steel production they are a small percentage of a plant's total costs. Third, EAF is one of the two largest graphite electrode producers outside of China, with about 24% total market share. Finally, it is important to know that historically the market price of graphite electrodes has averaged between $4,000-$4,500 per metric ton, looking back over the last 20+ years: (Source: EAF 10-K)
On the qualitative front, EAF possesses numerous strengths:
- Perhaps most importantly, the company internally produces about 70% of the needle coke needed to run their operations, via fully-own subsidiary Seadrift. This is important both because it keeps their input costs relatively stable and because the price of needle coke has increased dramatically in recent years, due to it being a key component of lithium-ion battery production.
- EAF has developed a strong reputation in the industry for the quality of its electrodes and its reliability in delivering them on time. The company has been in business since the late 1800s and is one of the largest producers in the world, giving them benefits of scale and the ability to adjust their output to take advantage of market pricing opportunities.
- EAF is indirectly benefiting from the slide in electrode prices that began in 2013 due to high inventory levels and a slowdown in global steel production. While EAF's earnings have suffered, many smaller competitors were not able to stay afloat at all (especially with the rise of needle coke prices) and as a result EAF estimates that 20% of global production capacity has been permanently closed or repurposed since 2014, reducing competition and supply in the marketplace for graphite electrodes.
- EAF has benefited from a 2018 spike in graphite electrode prices, allowing them to reduce their debt burden, pay a dividend, and sign longer-term supply contracts with their customers, locking in selling prices just under $10,000/MT for over 70% of their production capacity thru 2022.
(Source: EAF 10-K)
Combining different pieces from above, we can see that EAF is able to source about 70% of its raw material needs internally and that about 70% of their output is already spoken via long-term contracts. One could think of the company as running two different businesses; a stable, fixed-rate business where they are able to control 100% of their input and output costs, and a variable business wherein they must purchase petroleum needle coke at a variable market rate and then sell their graphite electrodes at a variable market rate. Presumably EAF can ratchet variable production up or down based on market conditions, so this side of the business might be thought of as an option to produce electrodes when the price is favorable and abstain when the economics of production don't make sense.
What I am interested in is estimating the net present value of the supply contracts that EAF has on its books for the next 3-4 years thru 2022. Breaking down the revenue side of the equation, we see a total of $5.24 billion being generated:
|Year||$/ton||Volume (000's MT)||Revenue ($ billions)|
Translating this total revenue into discounted earnings requires additional nuance. I think it is helpful to consider various scenarios with different assumptions to help get a clearer picture. In 2018, which was by far the most favorable year in the last twenty for EAF in terms of electrode pricing, the company had a net margin of 45%. While this margin applied over the entirety of EAF's financials, not just the portion of up-front contractual revenue, we can use it as a starting point. My default is to use a 10% discount rate when projecting future earnings. So, in this scenario where the company averages a 45% net margin and we use a 10% discount rate, we would get just about $2 billion in future earnings value:
$1,450 mil * .45 = $650 mil
$1,390 mil *.45 *.90 = $560 mil
$1,240 mil *.45 *(.90)^2 = $450 mil
$1,160 mil *.45 * (.90)^3 = $380 mil
Total: $2.04 billion
If one was more optimistic and thought that 2018's gross margin might be a better way to value the revenue (~60%) and that a 7% discount rate was more reasonable, you could run the same exercise and get an earnings value of $2.85 billion, or continue to use a 10% discount rate but assume that the variable portion of EAF's earnings inflated the net margin in 2018 and use a 30% net margin, for a value of $1.38 billion.
I prefer to think of the value being around $2 billion because it helps highlight the major black spot on EAF's balance sheet, its long-term debt burden. As of April 1st, 2019 the company had long-term debt of $2.02 billion, which is almost equal to an optimistic value of the company's stable earnings power over the next few years, having locked in prices more than double the historical average. If the company used these earnings to pay off the debt burden, the hypothetical debt-less company would still have a $3 billion market cap and would perhaps be facing electrode pricing more in line with historical averages (prior to 2018 the company had not had a net profit of more than $10 million since 2012). Essentially what I am saying is that at best the company's locked-in earnings from the pricing spike could get them back to a clean debt slate, but the company's enterprise value would still be unappealing given historical electrode pricing levels.
Along with EAF's competitive advantages there are also a number of risks to keep in mind. First and foremost, the Chinese steel market and their production of graphite electrodes seems to be a bit of a black box and a potential source of disruption. EAF's financial statements are filled with caveats that their market estimates (size of global market, market share, market growth, etc.) do not include China, and analyst questions about Chinese competition are met with best guesses and approximations. EAF is certainly not dependent on China for their revenue (the entire APAC region accounted for only 8% of 2018's revenue), but there seem to be rumblings that the country might begin to produce and export more graphite electrodes to the broader global market, adding supply and potentially depressing prices.
In a similar vein, EAF is indirectly impacted by the global supply and price of steel, as well as the ratio of electric arc furnace steel production to more traditional blast furnace production. If electric arc furnace steel producers face difficult market pricing environments for their steel due to global oversupply, it would stand to follow that production would decrease and there would be less demand for graphite electrodes. Looking at historical pricing for graphite electrodes is also fairly sobering. As seen in the graph earlier in this article, the price per metric ton of graphite electrode has rarely been above $4,500 over the last 23 years, meaning that current pricing is more than double historical averages and more likely to be an anomaly than the new normal.
Finally, it is worth noting that EAF is over 75% owned by private equity firm Brookfield Asset Management, which had acquired 100% ownership of the company in 2015 and then brought a percentage of the company public again in a 2018 IPO. While this could be seen as a positive, given that the company has a vested interest in EAF succeeding, it also means that Brookfield will have sole discretion as to how the business is run and there will be limited opportunities for dissenting shareholders to have a say. I think this is a small risk or maybe even a slight positive, but it is important to know about the relationship either way.
As I was researching EAF, I found myself wanting to be excited about the company. The company possesses many competitive advantages and appears to have made a number of prudent decisions in light of a surprise spike in graphite electrode prices. Unfortunately, it seems difficult to turn a profit in the graphite electrode industry under normal market conditions and so while EAF seems poised to deliver stable financial numbers for the next three years, I am less excited about investing in their stock with graphite electrode prices being so much higher than the historical average. With the right balance sheet or market cap I think EAF could still be intriguing, but the fact that the company has a large amount of debt and a $3 billion market cap make me less excited. As I stated at the beginning of the article, I think EAF is more of a 'medium-risk, medium-uncertainty' situation that might appeal to some investors, but at this level I am going to hold off on investing in the company.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. 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.
Additional disclosure: This article should not be taken as financial advice. It is only an expression of my own opinions as an individual investor