A Greenlight For GrafTech International

Summary

• GrafTech International Ltd. has been able to weather the pandemic thanks to long-term take-or-pay contracts that allowed it to generate well above spot market revenue.
• With many contracts due to expire in 2022, the company needs a turnaround in spot graphite electrode pricing – to realize favorable terms.
• With a ~77.8 million share overhang in the form of a private equity investor exit, strong cash generation, and a solid balance sheet, this busted IPO merited a deeper dive.
• A full investment analysis and recommendation follow in the paragraphs below.
• I do much more than just articles at The Busted IPO Forum: Members get access to model portfolios, regular updates, a chat room, and more. Learn More »

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Inflation is when you pay fifteen dollars for the ten-dollar haircut you used to get for five dollars when you had hair.”― Sam Ewing

Today, we take a look at an 'off the radar' name that should do well in an environment that is seeing rising inflation pressures. A full analysis follows.

Company Overview:

GrafTech International Ltd. (NYSE:EAF) is a Brooklyn Heights, Ohio-based manufacturer of graphite electrode products, necessary for electric arc furnace steel production, as well as other ferrous and non-ferrous metals. The company has operations in four countries (France, Spain, Mexico, and the U.S.) and accounts for approximately one-quarter of the graphite electrode production capacity in the world ex-China. Founded as the National Carbon Company in 1886, GrafTech was purchased by Union Carbide in 1917, three years after introducing the first 12-inch diameter graphite electrode. The company went public in 1995 and was subsequently acquired by private equity shop Brookfield Asset Management (BAM) for a total consideration of $854.3 million in 2015. Brookfield began its exit of the business with an initial public offering of 38.1 million shares at $15 in 2018 and has continued to reduce its stake in GrafTech, currently holding 29.1% of the 267.3 million shares outstanding. Those shares trade right at $11.50 a share, equating to a market cap slightly over $3 billion.

Source: May Company Presentation

Graphite Electrodes

Graphite electrodes – and more specifically the ultra-high power (UHP) ones manufactured by GrafTech – are anywhere from 10 to 30 inches in diameter and typically nine to eleven feet long, weighing up to nearly three tons. They act as conductors of electricity in a furnace, generating heat at temperatures high enough to melt iron ore, scrap metals, and other raw materials. They have the unique ability to both conduct and maintain intense heat for eight to ten hours – or ~1.7 kilograms per metric ton [MT] of steel production – at which point they need replacement. The UHP graphite electrodes are manufactured in a multi-month, multistage process that requires significant technical skill employing petroleum needle coke [PNC] as a raw material. A new graphite electrode plant, of which only one has been constructed since the 1980s outside of China, takes three to five years to become operational, creating a significant barrier to entry.

Electric arc furnaces, or EAFs – the source of the company’s ticker symbol – employ graphite electrodes and account for ~47% of the world’s steel production (ex-China), with blast oxygen furnaces (BOF) responsible for the balance. There are three major differences in the two production processes that now favor EAFs. First, BOFs use iron ore as its base raw material whereas EAFs employ scrap metal; and with the increasing abundance of high-quality scrap from China, the cost of production favors the latter. Second, EAFs emit ~25% of the CO₂ of its BOF counterparts. And lastly, the BOF steelmaking process requires an outlay equal to ~$1,100 per tonne of installed capacity versus ~$300 per tonne of installed capacity for a mini-mill utilizing an EAF. Due to these in-built tailwinds, EAF steelmaking ex-China has grown at CAGR of 3% since 2000 as opposed to 1% for the entire industry. Also owing to these advantages, China, whose steelmaking is currently 90/10 BOF/EAF, has stated its intention to be 80/20 by 2025, meaning further demand for graphite electrodes.

And due to its acquisition of PNC manufacturer Seadrift Coke in 2010, GrafTech is the only vertically integrated electrode source. PNC is a crystalline form of carbon derived from decant oil – a byproduct of gasoline refining – and is the vital feedstock of UHP graphite electrode manufacture that takes two to three months to create. GrafTech has 140,000 metric tons (MT) of PNC capacity – second-largest ex-China to Phillips 66’s (PSX) 420,000 MT capacity – the preponderance of which is specifically tailored for use in the production of graphite electrodes.

In addition to the current economic and environmental advantages of EAF over BOF operations, GrafTech is also the beneficiary of dynamics within the graphite electrode and PNC industries. Excluding China, graphite electrode production capacity has fallen ~20% since 2014 due to industry consolidation and rationalization, tilting the supply-demand equation in its favor. Second, PNC demand is surging due to its employment in electric vehicle lithium-ion battery anodes. The need for PNC is expected to grow substantially from over 200,000 MT in 2020 to over 700,000 MT in 2025. This undercurrent could cause either cost push inflation in electrode prices or at least provide vertically integrated GrafTech with a significant margin advantages over its competition. All these dynamics and China’s cessation of its steel dumping in the U.S. conspired to drive average spot prices for graphite electrodes from a historic low average of ~$2,500 per MT in 2016 to $9,937 per MT in 2018. Average prices did retreat about 25% in 2019.

Foreseeing most of these trends, Brookfield purchased GrafTech with an eye on increasing core production output and efficiency in 2015. It sold off non-core assets to focus on its UHP graphite electrodes business and removed bottlenecks with manufacturing footprint optimization programs at three of its plants, allowing the company to produce more from those three upgraded facilities than from the company’s six operational plants in 2012. Production capacity at the company (not giving effect to its (fourth) St. Mary’s, Pennsylvania facility) increased from 151,000 MT in 2016 to 202,000 MT by 2019. Annual savings from this repositioning totaled ~$100 million. Efficiency improved to the point that management believes it can produce electrodes at a cost $1,000 per MT lower than its lower capacity competition. These ‘savings’ were accomplished by loading GrafTech up with debt, which surged from $322.9 million in 2017 to $2.05 billion in 2018. It was debt capital well spent as the company’s Adj. EBITDA skyrocketed from $95.8 million on revenue of $550.8 million in 2017 to $1.2 billion on revenue of $1.9 billion in 2018 – followed by Adj. EBITDA of $1.05 billion on revenue of $1.8 billion in 2019.

GrafTech used the favorable pricing environment during late 2017 and 2018 to lock in three-to-five year take-or-pay agreements (LTAs) with its finite customer base for 60% to 65% of its expected capacity from 2018 through 2022, adding multiple-expanding visibility to its top and bottom lines.

The company, now a generator of considerable free cash flow, began repurchasing shares from both the public ($10.9 million) and Brookfield ($250 million at $13.125 per) in 2019. It had previously purchased $233.8 million of stock from Brookfield at $20 per share in 2018 concurrent to pricing a 23 million share secondary offering at the same price.

GrafTech also paid a quarterly dividend of $0.085 in 2019 after paying a special $0.70 dividend at the end of 2018.

Pandemic Impact 2020

Then the pandemic struck, accelerating the pricing declines witnessed in 2019. Thanks in large measure to the LTAs, the company still managed to generate net income of $1.62 a share, Adj. EBITDA of $659 million, and cash flow from operating activities of $564 million in FY20 despite a 32% downdraft in revenue to $1.2 billion. Further illustrating the importance of the LTAs, they constituted 84% of the company’s FY20 top line with average pricing of $9,600 per MT in 4Q20 versus only $4,900 per MT on non-LTA business.

GrafTech used its free cash flow in 2020 to reduce its debt load by $400 million and refinanced $500 million of debt due 2025 out to 2028. It did repurchase $30.1 million of shares earlier in the year but later indicated that its free cash would be allocated to debt repayment. Further driving home this point, the company’s quarterly dividend was cut to $0.01.

Owing to these dynamics, after peaking above $24 a share in August 2018, GrafTech’s stock plummeted to under $6 during the pandemic-induced selloff of March 2020.

1Q21 Results

Despite the company’s decent operational performance, the graphite electrode market continues to be challenging as the pandemic hangover continues. On May 5, 2021, GrafTech reported 1Q21 net income of $0.37 a share, Adj. EBITDA of $155 million, and cash flow from operations of $122 million on revenue of $304.4 million, representing declines of 4%, 18%, 13%, and 12% over the prior-year period, respectively. Sales volumes did rise 9% to 37,000 MT, comprised of 26,000 MT of LTAs at an average price of ~$9,500 and 11,000 MT of non-LTAs at an average price of $4,200 per MT. Capacity utilization did improve from 65% in 1Q20 to 71% in 1Q21. For perspective, this metric was 99% in 2018 and 88% in 2019.

Source: May Company Presentation

Obviously, lower pricing was the culprit for the declining revenue, but management put a positive spin on events, stating that the rebound in the economy was portending higher non-LTA pricing in the 2H21, with global steel capacity utilization ex-China up to 73% from 56% at its nadir in 2Q20. Due to its position in the steel producer supply chain, electrode pricing generally follows upticks in steel prices and production.

Source: May Company Presentation

Balance Sheet & Analyst Commentary:

GrafTech did pay down an additional $150 million in debt in the quarter and lowered the interest rate on its term loan by 100 basis points on the back of ratings upgrades from Moody’s and S&P. The company has $342 million of liquidity, consisting of $96 million in cash and $246 million available under a revolving credit facility. Total debt stands at ~$1.3 billion with $794 million due 2025 and the balance due in 2028. Leverage is currently 2.0x.

Source: May Company Presentation

The company enjoys limited but solid sponsorship from the Street, with one buy and two outperform ratings and a median twelve-month price target of $17 per share.

As private equity shops are wont to do, once they have put their imprimatur on a business, they position it for sale. In this instance, Brookfield chose the IPO route for its exit and has unloaded ~225 million shares since – including 20 million shares in late May 2021, leaving its ownership interest at ~77.8 million shares, or 29.1%. It should be noted that a change in control provision (under 30% ownership) was triggered with this most recent disposition, resulting in the vesting of incentives for senior management dating back to 2015, creating a $65-$75 million liability for the company that will be settled in cash.

Source: May Company Presentation

Verdict:

Returning to Brookfield, any momentum in GrafTech’s stock price is likely to be met with additional selling. As a side note, its transformation of the company will likely net its investors a five-bagger when all is said and done. Besides this menacing overhang, the only burning question facing a would-be GrafTech investor is whether the graphite electrode business will turn upwards to a point where it can negotiate favorable new take-or-pay contracts with its customer base before most of them expire in 2022. GrafTech can expect ~$960 million from these contracts in 2022 but will be much more vulnerable to the whims of the market in 2023-2024 when it only has ~$200 million per annum in executed contracts. With non-LTA pricing currently trading at a 56% discount to the company’s LTAs, the execution risk is very real. Furthermore, China will play a meaningful role in price determination and its UHF graphite electrode market is largely unknown.

However, the market appears at an inflection point with GrafTech’s balance sheet and operational footprint in excellent shape. This story is still unfolding but using a look back metric, it appears to have limited downside trading at around six times TTM free cash flow of $511 million, a metric that shouldn’t diminish too much in 2021 or 2022. Once Brookfield exits GrafTech, shares of EAF have significant upside if the graphite electrode market breaks the company’s way. The bet here is that with all the in-built tailwinds and the steel industry’s emergence from the pandemic, it will.

Inflation is a way to take people’s wealth from them without having to openly raise taxes. Inflation is the most universal tax of all. " - Thomas Sowell

Bret Jensen is the Founder of and authors articles for the Biotech Forum, Busted IPO Forum, and Insiders Forum

Analyst’s Disclosure: I/we have a beneficial long position in the shares of EAF either through stock ownership, options, or other derivatives. 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.