**Idea Source: Massif Capital**
GrafTech International (EAF) is a leading manufacturer of high-quality graphite electrode products that are essential components to the production of Electric Arc Furnace steel. The company sports a vertically integrated, highly differentiated business model with supply-side advantages giving it pricing power over competitors. Reduced supply of electrodes coupled with increased demand and long-term contracted revenues present large tailwinds to double one’s investment. We believe current share prices signal extreme misunderstanding from Wall Street on the future of GrafTech’s business. Existing contracted revenues provide a path to over $3B in FCF over the next five years (almost 70% of the current market cap), all of which the investor can own for under 5x EBITDA. If that’s not good enough, management has a history of returning high percentages of those cash-flows back to its shareholders in the form of dividends, buybacks and special dividends.
Industry Background and Overview
Electric Arc Furnace steel production is the fastest growing sector within the overall steel industry, growing around 8 – 10% in 2017 compared with Blast Furnace production at around 3.5%. EAF has grown at higher rates mainly due to greater resilience, a more variable cost structure, lower capital intensity and less taxing on the environment. In order to run Electric Arc Furnaces, producers rely on graphite electrodes as an essential part of production. That the electrodes generate enough heat to melt the scrap metals (and other materials) while being able to sustain composition without breaking down makes GE the only product on the market capable of fulfilling EAF requirements. In order to make these graphite electrodes, you need petroleum needle coke to serve as your largest raw input. Without getting too deep into the weeds on this, it’s important to know that petroleum needle coke is a final-stage carbon and highly essential for the production of electrodes using the EAF technique.
Petroleum Needle Coke & Vertical Integration
The petroleum needle coke industry is extremely concentrated with Phillips 66 and Seadrift Coke, LP accounting for more than 50% of the overall market. Demand for needle coke is growing rapidly due to two structural changes: Supply shortages & increased product demand. Since 2014, the needle coke industry has consolidated and retired plants resulting in a 20% reduction in overall supply. This makes intuitive sense given that in 2016, graphite electrode prices per metric ton were just $2,600 – causing most firms to retire (in some cases permanently) plants that were running at losses. GrafTech is now well positioned, capturing both the supply side — with the petroleum needle — and the demand side — finished electrode products.
GrafTech acquired Seadrift Coke in 2010, significantly reducing their dependence on third-party needle coke providers. Seadrift Coke provides GrafTech with over 60% of its required needle coke material to produce their electrodes. This vertical integration provides GrafTech with incredible cost savings compared to its competitors as well as a more secure source of materials when supply runs tight (like current conditions). In doing this, GrafTech enjoys a 26% margin advantage against its competitors that use third-party suppliers to source their needle coke. To put that into numbers; GrafTech spends roughly $2,500 per metric ton on producing electrodes while their competitors spend over $5,000 to produce the same electrodes.
The supply/demand discombobulation resulted in skyrocketing prices for graphite electrodes. Between 2006 – 2016, graphite electrode (GE) price per ton floated around $4,500. With the renewed vigor from the demand side, GE prices per MT ranged from $15,000 – $30,000 in 2018. These record prices won’t stay around forever, and the GrafTech management teams knows that. In order to capture as much of this price hike as they can, the company changed their sales strategy, focusing on long-term take-or-pay contracts.
The Power of Contracted Revenues
Before 2018, GrafTech ran on 100% short-term contracts (less than a year), mostly six months in duration. Given the price hikes and demand for their product, switching to long-term take-or-pay commitments provided the company with high visibility into revenues over the next five years. GrafTech has over 100 existing long-term agreements — 87% of those of the five-year type – for a total contracted supply of around 636,000 metric tons, locking in an average price per MT of $9,700. That’s a contracted revenue backlog of over $6.2B over the next five years.
Couple these revenues with the cost advantages the company enjoys through its wholly-owned subsidiary and you end up with 65% gross margins on that $6.2B in revenues. After netting out capital expenditures (which are around 8% of total revenues) we’re left with $3.1B in free cash flow over the next five years. Even if you subtract out debt, the company is still projected to crank out over $2B in unlevered FCF. If we use today’s market cap value of $4.1B (as of 02/15) that means 75% of the company’s market cap will be generated in FCF over the next five years. These figures are only for the take-or-pay contracts, we still haven’t talked about the spot price sales business that churns out cash, which we’ll touch on soon.
What Will Management Do with The Cash?
It certainly is a great thing that GrafTech can generate large amounts of cash, but if management is lousy at allocating, what good are those cash flows? Luckily management has shown a track record of being extremely shareholder friendly since its IPO back in April. Before its last earnings report, the company generated Post IPO FCF of $595M. Of that $595M, $203M went into special dividends, $225M went to share buybacks, $69M went to standard quarterly dividends and $56M went to debt repayment. In other words, management has returned 84% of its FCF to its shareholders.
Looking forward, management laid out a similar plan for 2019 capital allocation in their last earnings call. Share buybacks and regular dividends are on tap for 2019, but management will allocate more capital to paying down debt – adding $100M in repayment on top of their $28M minimum requirement. I like the idea of splitting the allocation between buybacks and debt repayment. In fact, I wouldn’t mind seeing them chip away at the dividend to pay back debt and increase buybacks – both of which would be more accretive to shareholders compared to a dividend.
Valuation
With a business like GrafTech, it makes better sense to value its two sales components as a sum-of-the-parts valuation. Let’s start with contracted revenues segment. The company is expected to generate roughly $3B in FCF. If we assume 65% gross margins – in line with the cost and price at which their revenues are contracted – we arrive at around $970M in 2022 EBIT. Taking out taxes, capital expenditures, D&A and changes in working capital we achieve 2022 FCF of $753M. Assuming a terminal growth rate of 1% we get an Enterprise Value of $7.6B and an 8x EV/EBITDA multiple. Adding in net debt of roughly $1.4B and dividing by shares (290M) we get an intrinsic value range around $21 – $22. We can cross-reference this with a multiple valuation, at 10x and arrive at $24/share for the contracted revenues – giving us a near 40% margin of safety.
Moving on, GrafTech generated roughly 30% of revenues from spot volume sales. To be on the conservative side, we’ll assume spot prices mean revert to the lower end of their range (roughly $7K/metric ton). Keeping spot volumes close to 25% of revenues gets us 2022 EBIT of $226M. After backing out taxes we’re left with FCF of $178. Keep in mind GrafTech doesn’t incur any cap-ex costs for their spot volume sales. After taxes, all incremental increases in revenues drop straight through to FCF. Assuming the same growth rate of 1% and a 10% discount rate, we get an EV of $1.5B – giving us fair value range around $5/share.
So, not only are you getting the core contracted revenue business for a substantial discount, but you’re thrown in a $5/share spot volume business for free. In fact, you can get all of this for less than 5x forward earnings and 5x EBITDA.
Risks
I couldn’t get away writing about a steel producer without mentioning China. The steel industry has experienced cyclical headwinds, notably in 2008 – 2009 when EAF steel production cut 17%, as well as between 2011 – 2015 when production declined another 10%. These production declines were mostly the result of Chinese BOF steel over-production. However, the China risk seems mitigated for two reasons. First, China doesn’t manufacture Electric Arc Furnace steel – they work mostly with BOF steel. Secondly, China has no direct source for petroleum needle coke – so even if they wanted to start producing EAF steel, they would have to first find a way to obtain the raw material in a tightening supply market.
Other risks would be a sharp decline in the price of graphite electrodes (like the prices around 2016 at $2,600/metric ton). A decline in the use of Electric Arc Furnace steel production would cascade into reduced demand for the electrodes, causing downward pressure on margins and profits. Another risk would be continued selling pressure from Brookfield (who acquired GrafTech in 2015), which controls a healthy portion of shares outstanding.
The Market Plunger 
What did you use as the WACC for EAF’s valuation?
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I use 10% for all DCF valuations. Although in some instances that might lead to a conservative fair value, I’d rather a position be super cheap on a conservative basis than cheap on an outstretched WACC basis.
Hope that helps!
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Thank you and awesome analysis. A few questions: 1- Mohnish Pabrai has a big position in EAF. Any comments on that ? 2- A very dumb and basic question: can you explain in more detail the ‘we achieve 2022 FCF of $753M. Assuming a terminal growth rate of 1% we get an Enterprise Value of $7.6B and an 8x EV/EBITDA multiple’ part ? how do you arrive from 753M expected future revenue in year 2022 and a terminal growth rate of 1% to 7.6B ? I am very new to this 🙂
3-Mohnish says: ‘so if you’re investing in 2015 in a $200 million market cap, and by 2018 or 2019 its earnings are $200 million, generally good things are going to happen to you’ Do we have a similar situation here ? The EAF market cap is 3.4B and It is earnings are approximately 900M per year.
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Hey Can. It was definitely nice to see Mohnish take such a large stake in EAF. He’s one of the best value investors out there, so it’s always a plus to have him invested alongside us.
The DCF model uses personal assumptions on future growth prospects. The terminal growth rate is usually 3% (or a proxy for US GDP growth). Using 1% makes the valuation more conservative.
So if the idea is still a bargain in a more conservative scenario, it makes us more bullish on the idea.
The 2022 FCF figure is based on assumptions as well as the contracted revenues of the company and assumed margins on EBITDA and FCF.
Feel free to email me if you have any further questions. I love chatting about ideas.
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Love the prospects of this the future of EAF- was wondering if you can shed light on an issue that has not been brought up in a while- but possibly has worked itself out. Employee Relations. Any update on this issue. In their Annual Report in February 2019 this was reported on page 18.
Employee relations
As of December 31, 2018 , we had 1,387 employees (excluding contractors). A total of 451 employees were in Europe (including Russia), 710 were in
Mexico and Brazil, 3 were in South Africa, 216 were in the United States and 7 were in the Asia Pacific region. As of December 31, 2018 , 945 of our employees
were hourly employees.
As of December 31, 2018 , approximately 846 employees, or 61%, of our worldwide employees, are covered by collective bargaining or similar
agreements. As of December 31, 2018 , approximately 691 employees, or 50%, of our worldwide employees, were covered by agreements that expire, or are
subject to renegotiation, at various times through December 31, 2019. We believe that, in general, our relationships with our unions are satisfactory and that we
will be able to renew or extend our collective bargaining or similar agreements on reasonable terms as they expire. We cannot assure, however, that renewed or
extended agreements will be reached without a work stoppage or strike or will be reached on terms satisfactory to us. As of December 31, 2018 , none of the
employees in our Seadrift plant or St. Marys facility were covered by collective bargaining or similar agreements.
We have not had any material work stoppages or strikes during the past decade.
Any updates on this issue.
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Hey VALUADD —
Thanks for dropping the comment. Unfortunately my answer will disappoint. I’ve got nothing to add to what’s already been stated in their 10-Q. I don’t pay too close attention to the employee relations stuff. But that could be a glaring mistake in my investment process.
Would love your thoughts on that.
Thanks,
Brandon
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Hello, BAM sold 11.18 shares yesterday. One of the risks you mentioned in the thesis. If they take all the cash on the side whats left for the minority shareholders? Whats your thoughts on this?
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I’m hoping this is indiscriminate selling on Brookfield’s part. Looks like management is buying some of that block in $250K increments. Hopefully they keep doing that.
I wouldn’t be against them cutting or reducing their dividend to have more cash to buyback stock.
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Thank You for sharing your analysis. I am going through the process of understanding this company and it’s management. Understanding that Brookfield owns about 79% of graftech, I found the below notes in the 2018 annual report pretty concerning.
Why did graftech take a debt of $1.5B to pay brookfield $1.1B and an another $750M in dividends?
I am new to investing so i might have misunderstood this, if you could throw some light on this that would be awesome. Are there chances the management always looks out for Brookfield instead of all the shareholders?
“On February 12, 2018, we entered into the 2018 Credit Agreement, which provides for the 2018 Revolving Facility and the 2018 Term Loan Facility. On
February 12, 2018, our wholly owned subsidiary, GrafTech Finance, borrowed $1,500 million under the 2018 Term Loan Facility. The funds received were used to
pay off our outstanding debt, including borrowings under our Old Credit Agreement and the Senior Notes and accrued interest relating to those borrowings and the
Senior Notes, declare and pay a dividend of $1,112.0 million to our sole pre-IPO stockholder, pay fees and expenses incurred in connection therewith and for other
general corporate purposes.” (from 2018 annual report)
“On April 19, 2018, we declared a dividend in the form of the Brookfield Promissory Note to the sole pre-IPO stockholder. The $750 million Brookfield
Promissory Note was conditioned upon….” ( from the 2018 annual report)
Thank You,
Akshay
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