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My bullish view on GrafTech (EAF) does not depend on quarterly earnings releases nor on the price of iron at any given time. Commodity inflation could be beneficial in the short term but doesn’t really change the intrinsic value of any company. Timing the market is a foolish game. I prefer placing my bets on companies that are protected on the downside but have a significant upside potential. Such a probabilistic approach has been very rewarding for me and is probably the essence of value investing.

When I published my first article on GrafTech in Jan-21, despite the risks of various nature, there was a good probability that the Company will continue to pay down its debt, will recover and the stock price will follow suit. When I decided to publish my second report in Apr-21, I felt that the GrafTech thesis is getting stronger. Now, for any reason, the share price is close to my bear case price scenario, hence the reduction of risk and price has created a very interesting case.

Automated Orders: GrafTech produces ultra-high performance (UHP) graphite electrodes that are consumed in electric arc furnaces for steel production. UHP electrodes are consumed in just 8 hours and capture only 1-5% of the total steel production cost. Top quality electrodes prevent the accelerated consumption and produce high quality steel grades. Hence top-tier steel manufacturers will probably prioritise quality, consistency of supply and relationship over price. This means that the company holds a special position in the steel manufacturing chain. Orders of insignificant cost (raw materials) that add value to the final product tend to be automated, recurring and protected from the competition. That’s a very special characteristic.

Vertical Integration: GrafTech is the only large graphite electrode manufacturer that is vertical integrated into petroleum needle coke. The company gets 70% of needle coke (graphite electrode main raw material) from Seadrift fully-owned subsidiary and the remaining 30% from the market. Making GrafTech the lowest cost producer in all markets excluding China which remains a black box. This means that the Company has the ability to generate profits when the rest of the industry is bleeding. It’s very hard to beat that!

Market Disruption: Green agendas are everywhere. Institutional investors have ESG mandates and companies pushing hard to improve their ESG profile. Steel industry is one of the most carbon-intensive industries. Making steel production greener is inevitable. Global steel demand is expected to increase from 1,870 Mt in 2019 to 2,500 Mt in 2050. This means that steel manufacturers need to reduce CO2/Ton of steel by 90% until then. That’s a see change!

Steel manufacturers are investing heavily in DRI-EAF technology that is already matured and able to reduce CO2 emissions significantly, as per the graph below.

After holding at approximately 25% of global steelmaking production for about a decade through 2012, the migration to EAF steelmaking accelerated during the past seven years. EAF steelmaking production hit a new high in 2017 with a 7.5% YoY increase, followed by an additional 12.3% increase in 2018. This means that EAFs accounted for almost 404Mt, or 29%, of the 1800Mt of steel produced globally.

EAF-based steel production continues to grow both in the US and worldwide. The past 5 years have seen increases in the supply and use of Pig Iron, Direct Reduced Iron (DRI), and Hot Briquetted Iron (HBI) in the EAF.

EAF-based steelmaking production in the US accounted for 70% of the total steel production in 2019. Identifying appropriate feedstock (scrap) has been an issue for the last 10 years. EAF-based steelmaking production in the EU accounts only for 42% of total steel production. If EU decides to increase EAF-based production, sourcing feedstock could be an issue.

DRI should not be considered as a scrap substitute but rather as a source of clean iron units that can be used to supplement and enhance the scrap charge. DRI hasn’t been in shortage globally with production being steady at 76Mt until 2016. Since then, DRI production increased to 100Mt (2018). Smart producers are taking steps to secure supply given the expected increase in the adoption of the DRI-EAF method.

All in all, EAF steelmaking is building momentum. One can argue that is too early to see a big jump in electrodes demand but the tailwind is there.

However, all comes down to the supply/demand dynamics of graphite electrodes that drive spot prices. Over the last 20 years, electrode prices averaged between $4.0k and $4.6k. Nothing can really tell us that the future will be significantly different than the past. The only high-probability hypothesis is that steelmaking will get greener and EAF will play a more significant role (increasing demand). Additional production capacity could come online but it takes years to perfect UHP electrodes something that GrafTech does for the last 130 years. I am not saying that we are fully protected from the competition but additional capacity should not be expected from one day to another.

The table below tries to put some numbers behind my estimation of intrinsic value. GrafTech, including St. Mary's facility can produce up to 230 Mt per year. An average utilisation of 83% over the next 5 years is not unrealistic. The number that stands out though is GrafTech's fat operating margin, which I don't see why to be significantly different than history.

Source: Company's accounts and Author's estimations

BEAR CASE: 160 Mt Average Sales @ $4.0k per Mt spot price (Price average excludes the contracted revenues)

BASE CASE: 190 Mt Average Sales @ $4.8k per Mt spot prices (exc. LTA)

BULL CASE: 200 Mt Average Sales @ $5.5k per Mt spot prices

I don’t have strong feelings about these numbers. I’m very open to discuss the assumptions with you in order to better estimate the intrinsic value of the company. However, I don’t really see how we lose money here. The company generated $414m in profits during the most challenging year for business in the last 100 years. A company that doesn’t generate losses during crisis shouldn’t be traded at a premium?

Buying GrafTech at $10.5 per share is like accepting the bear (worst) case scenario. Isn’t that the definition of “heads I win tails I don’t lose much”?

Companies that take part in this radical shift towards a more sustainable future will grow and will get rewarded with higher multiples. Debt reduction, Brookfield exit, steel industry resurgence have decreased investment risk significantly. The only remaining risk is around China’s production capacity. I am willing to take that risk though.

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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.