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GrafTech International (EAF): An Asymmetric Opportunity

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Elevator Pitch

Graftech International (EAF) (Price:$11.50) represents a rare opportunity for investors seeking large upside with limited downside risk.

Graftech is in the niche industry of making ultra-high-performance graphite electrodes for electric arc furnaces (EAF) used to make steel.  Being one of few players in the global market, their advantage arises from being vertically integrated in that they manufacture one of the key raw materials to make these electrodes, namely, petroleum needle coke, a crude oil byproduct.

They actually own a facility that provides 2/3 of their needle coke needs, which costs them well below getting needle coke from a third party supplier.  No other graphite electrode manufacturer has their own needle coke facility.

Having this advantage, they’re able to secure long-term contracts with customers guaranteeing them supply at a set price.  They have long-term agreements with over 100 customers for 675,000 MT (metric tons) at a weighted average contract price of $9,800 / MT from 2018-2023.  (That’s $6.6 billion of sales from 2018-2023.)  This represents 70% of their sales.

So yes, literally 70% of their sales for the next 5 years or so are at a guaranteed quantity and set price.  This somewhat insulates them from fluctuations in the price of graphite electrodes.  No other manufacturer can offer customers these kind of set contracts because most don’t manufacture the key input, needle coke.  Graftech does.

The other 30% of Graftech’s electrode sales will depend on the market price of these electrodes.  So that’s an uncertainty.  Graftech can either make windfall profits if prices spike as in 2018 or they can make a lot less, but the 70% of sales at a set price of $9,800 / MT somewhat insulates them.

Over the past 12 months they have returned a whopping 70% of their free cash flow to shareholders, the rest being used to pay down their debt and retain cash.  They are guiding for the following in using their free cash flow:

  • Between 50%-60% returned to shareholders via buybacks or dividends
  • 25% used to pay down debt
  • 20% retained

Surprisingly, this highly-cash-flow generating stock is ultra cheap with great returns on capital, providing large upside with minimal downside because of the locked-in contracts.  Some metrics are presented below:

  • Price per share:  $11.50
  • Market cap:  $3.3 billion
  • Price/earnings trailing 12 months (TTM):  4
  • Price / free cash flow TTM = 4.5
  • Earnings before interest & taxes / enterprise value = 21%
  • Return on capital (ROC) TTM:  72%  (Capital defined as net working capital plus property, plant, & equipment)
  • Gross margin TTM:  ~ 60%
  • Operating margin TTM:  ~ 55%

Company Background

Graftech is an Ohio-based company with worldwide operations that’s been around in one form or another for over 100 years.  Graftech was acquired by Brookfield Asset Management in 2015 after going through financial struggles.  Brookfield saw several areas where Graftech could improve production and increase efficiency.

Brookfield sold off non-core assets, increased productivity and put the focus on Graftech’s core electrode business.  One of the advantages they saw was that Graftech owned Seadrift Coke, a producer of petroleum needle coke, an essential input into manufacturing graphite electrodes, representing about 44% of the total cost.

This vertical integration gives Graftech an advantage over other manufacturers and allows them to offer customers long-term forward contracts guaranteeing customers a specific quantity and price for graphite electrodes.  This gives EAF steel manufacturers peace of mind.

Brookfield took Graftech public with an IPO in 2018 and priced its IPO at $15 a share, well below their targeted range of $21-$24 per share.  Investors seemed to be concerned about the volatility of the business even though steel tariffs against China were expected to help Graftech.  So the share price has languished in the $10-$13 range for a while.

Steel is a generally shunned and unloved business by investors.

However, there are several catalysts that should prove to be positives for Graftech’s share price.  Namely:

  • Management’s call to return over 50% of free cash flow to investors as dividends or buybacks
  • More investors realizing that Graftech is the lowest cost producer in the world with their ability to in-source the raw material needed for electrodes:  needle coke.
  • The continued shift toward using electric arc furnaces instead of blast furnaces to produce steel due to environmental concerns and lower cost.  China has especially been pledging to make a huge shift toward cleaner EAF production.

https://www.mining-journal.com/politics/news/1310409/china-promotes-electric-arc-furnaces-steelmaking

Industry Background

There are two types of methods to produce steel.

  1. Blast Furnace
  2. Electric Arc Furnace

A blast furnace is used to make steel from liquid iron.  An electric arc furnace (EAF) is used to make steel from scrap metal.  There is a growing trend toward using the electric arc furnace method of making steel because it’s more environmentally friendly and requires lower investment.

Currently between 70%-75% of steel worldwide is produced using the blast furnace method.  However, the electric arc furnace market is expected to chip away at that and grow at a CAGR of 11% between 2019-2023.

Source:  https://www.businesswire.com/news/home/20181029005733/en/Global-Electric-Arc-Furnaces-Market-2019-2023Industry-Analysis

The EAF steel production method accounts for between 50%-70% in North and South America, 40% in Asia (ex-China), 40% in Europe, and only about 12% in China.  China is targeting 20% EAF production by 2020.

Source:  Graftech.com

Overall, worldwide calls for cleaner & more environmentally friendly methods are shifting steel production toward the electric arc furnace method.

Graphite electrodes are used in electric arc furnaces.  They provide the high conductivity and capability to withstand extreme levels of heat in order to melt scrap metal.  Manufacturers of these graphite electrodes should therefore perform well as the shift toward electric arc furnaces happens over the next several years.

Graftech is uniquely positioned to take advantage of this growing trend, not least because they manufacture the key raw material for electrodes, needle coke.  They are the low-cost leader in manufacturing graphite electrodes.

Valuation

At a price of $11.50, Graftech trades at just 4 times TTM earnings and 4.5 times TTM free cash flow with an EBIT / EV yield of 21%.  Return on capital is excellent at 72% for TTM.  Gross margins are in the 60% range and operating margins in the 55% range.

Debt is high at $1.99 billion but their interest coverage ratio is around 8, meaning their operating income is more than covering their quarterly interest expense.  They’re also targeting 25% of their free cash flow to pay down their debt.  As we know, they have locked in contracts until the end of 2023 representing 70% of their sales, so debt reduction will be consistent and one of their priorities.

With 675,000 MT contracted at $9,800 / MT from 2018-2023 representing 70% of sales, that’s $6,615 m in sales over 6 years.  So about 300,000 MT representing the other 30% is not under contract.  Let’s say this remaining 30% is sold at $7,000 / MT, well below today’s price.  That’s $2,100 m.

So total sales over 6 years would be $6,615 m + $2,100 m = $8,715 m in sales over 6 years, or around $1,452 m / year in revenue.

Over the last several periods, they’ve converted a median of 38% of their revenue into free cash flow.  Let’s assume it continues this way for our back-of-envelope analysis.  Note that I define free cash flow here as operating cash flow less capital expenditures.

After 3 years (2020-2022), total free cash flow is estimated at $1,452 m sales * 3 years * 38% = $1,655 m.

The company says their free cash flow will be utilized as follows:  50%-60% returned to shareholders, 25% to pay down debt, 20% retained as cash.

So after 3 years, 55% of $1,655 m, or about $910 m is returned to shareholders in the form of buybacks and dividends.  (Management indicates they see buybacks as a better, more tax-efficient way of distributing excess cash.)

$910 m returned / $3,300 m market cap = 27.6% of the current market cap is returned to shareholders after 3 years.  Not bad.

Let’s try to put an estimate on what the shares are worth.

By the end of 3 years (end of  2022), assuming zero growth, and assuming an average operating margin of 50%, annual revenue of around $1,452 m * 50% = $726 m in yearly operating income on average.  (Well below the $1,068 m in operating income for the last 12 months, so we’re being conservative.)

For the 3 year total cash flow of $1,655 m estimated above, 25%, or $414 m goes to pay down debt, so total long term debt will be around $1,991 m (current) – $414 m = $1,577 m.

Total cash retained is 20% of their $1,655 free cash flow or $331 m, so their cash balance might be $205 m (current) + $331 m = $536 m.

Assuming an EV / EBIT multiple of 10, and yearly EBIT of $726 m with no growth, we get an enterprise value of $7,260 m.  Subtracting out debt of $1,577 m and adding cash of $536 m gives us an equity value of $6,219 m.

( I found average EV / EBIT multiples of various industries from the following NYU link:

http://pages.stern.nyu.edu/~adamodar/New_Home_Page/datafile/vebitda.html

The steel industry has an average EV / EBIT multiple of 7, but I’m giving Graftech a 10 multiple because it’s not technically a steel producer, it has long-term contracts with a large customer base at set prices, and it’s able to in-source a key raw material, needle coke, at prices lower than competitors, giving Graftech an edge and allowing it to be the lowest cost producer.  For this I believe it deserves a higher multiple. )

Let’s say they reduce their share count by 20% over the next 3 years. (Not unreasonable considering they just authorized a $100 m share repurchase program to buy back 15% of the stock.)  Shares at end of 3 years = 290 m * (1-0.20) = 232 m.

This gives us a per share value of $6,219 / 232 = $26.80, or 133% upside from today’s price.

That’s a CAGR of ($26.80/$11.50)^(1/3) -1 =

32.5% per year over 3 years.

Risks

  • The shift from blast furnaces to electric arc furnaces takes longer than expected
  • Graphite electrode prices decrease sharply
  • Global steel demand falls due to economic slowdown
  • Large debt could become a burden if free cash flow isn’t sufficient due to above factors

Disclosure

RTN Investments holds a position in Graftech International (EAF) stock.  This article is not meant to be investment advice.  Do your own research before investing.


Robert Nowak is the founder of RTN Investments, LLC.  RTN is a registered investment advisory managing separate accounts for clients and is modeled after Warren Buffett’s original partnerships.  RTN’s goals are the preservation of client’s capital and to outperform the S&P 500 on a rolling 5 year basis by investing in undervalued stocks of high quality companies.