Battered Graftech Is A Value Investor's Dream

Summary

• GrafTech has significant competitive advantages thanks to vertical integration and the reliance on long-term take-or-pay contracts.
• The company has a target of returning 40%-50% of free cash flow to shareholders.
• Results during Q1 2020 were weak, but the global steel industry is expected to recover over the rest of 2020 and in 2021.

Introduction

I’ve covered South Africa-focused manganese ore miner Jupiter Mines (OTC:OTC:JMXXF) several times on SA and I think it’s an undervalued company which is returning a significant amount of free cash flow to shareholders through dividends. I’ve been looking for similar companies and I think I’ve found one which is also in the same sector - graphite electrode maker GrafTech International (NYSE:NYSE:EAF) (both manganese ore and graphite electrodes are mainly used for the manufacturing of steel). The latter has a target of returning 40%-50% of free cash flow to shareholders, although this is done mainly through share buybacks. Between June 2018 and the end of 2019, GrafTech reduced its share count by 11% and its debt by 18% to $1.81 billion. The reason I’m focusingon data from Q4 2019 is because Q1 2020 was impacted by COVID-19, thus making the preservation of capital key.

(Source: GrafTech International)

GrafTech’s business and its competitive advantages

GrafTech is involved in the manufacturing of ultra-high performance graphite electrodes used in electric arc furnaces (EAFs) that produce steel.There isn’t a substitute for graphite electrodes in the EAF steelmaking process and they account for between 1% to 5% of production costs.EAF steel production is a growing industry as it’s environmentally friendlier compared to traditional blast furnace production. China has a goal to move to 20% EAF steel production by 2025 from 12% in 2018.

One of the two main competitive advantages that I thinkGrafTech has is that it’s the only player in the industry that is vertically integrated into petroleum needle coke, which is the main ingredient in the production of graphite electrodes. The company’s Seadrift facility produces around two-thirds of its long-term needle coke needs. This is a crucial advantage as needle coke demand is set to rapidly increase in the next few years due to the increasing market share of electric vehicles.

(Source: GrafTech International)

The other main competitive advantages that I think GrafTech has is that it’s the only company in the industry to sell its production through three- to five-year fixed-volume, fixed-price take-or-pay contracts. These typically account for 60-65% of its production capacity and allow GrafTech to lock in good spot prices as well as get strong revenue visibility. These are high-margin contracts and come with significant termination payments of 50% to 70% of remaining contracted revenue.

Graftech’s turnaround and Q1 2020 troubles

Back in 2015, GrafTech was struggling financially due to declining demand for graphite electrodes, lower end-market demand in certain steel-consuming sectors and continued high Chinese steel exports. Brookfield Asset Management (BAM) stepped in and bought the company for $700 million at a time the latter was generating some $45 million of EBITDA and revenues of around $530 million on annual basis.

Brookfield implemented a significant restructuring plan which resulted in more than $100 million in annual cost savings. In just three years, GrafTech reduced the number of its electrode production facilities from six to three while production per facility was boosted from 34,000 metric tons to 67,000 metric tons. Also, take-or-pay contracts were implemented, product quality was improved, headcount was halved, and the manufacturing process at Seadrift was optimized. By 2018, GrafTech was generating adjusted EBITDA of $1.2 billion and free cash flow of $768 million.

(Source: GrafTech International)

However, Q1 2020 results were significantly impacted by the outbreak of COVID-19 with sales declined by a third compared to a year earlier.

(Source: GrafTech International)

While GrafTech has locked in more than 450,000 MT of production between 2020 and 2022 at prices close to $10,000 per ton, the issue is that several customers with long-term take-or-pay contracts have filed for bankruptcy or are experiencing financial difficulties. Also, the spot price averaged just $6,500 per ton in Q1 2020.

I think a significant part of the reduced production volumes in Q1 2020 are due to deferrals, but it’s hard to predict how much sales will recover over the over the remainder of 2020 as the COVID-19 crisis subsides and steel production picks up. Expectations for next year look bright though. According to the World Steel Association, global steel demand is seen falling by 6.4% to 1.65 billion tonnes in 2020 and increasing to 1.72 billion tonnes in 2021.

Conclusion

I think that just like Jupiter Mines, GrafTech is an undervalued free cash flow machine that is focused on returning value to shareholders. Using 2019 financials, GrafTech is currently valued at an EV/EBITDA multiple of just 3.8x.

Having its own needle coke production gives Graftech a significant competitive advantage and the reliance on long-term take-or-pay contracts protects the company from fluctuations on the spot market.

Results for Q1 2020 were weak but this is due to the impact of COVID-19 and the rest of 2020 as well as 2021 are shaping to be better for the steel industry. Overall, I think Graftech is undervalued and should be worth at least $16 per share.

Analyst’s 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.

I am not a financial adviser. All articles are my opinion - they are not suggestions to buy or sell any securities. Perform your own due diligence and consult a financial professional before trading.