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I expect GrafTech (NYSE:EAF ) to generate a 17% IRR over the next 5 years with a clear and decisive way to protect its cash flows. Investors who can stomach volatility will be rewarded.
EAF is located in Brooklyn Heights, Ohio, and is the only graphite electrode producer with vertically integrated needle coke production. Graphite electrode rods are used for EAF “electronic arc furnace” production of steel. Electric arc furnaces are cheaper to build than traditional blast furnaces, which make steel from iron ore and are fueled by coking coal. Graphite rods are a mission critical component of the EAF process but only contribute 1-5% of the overall cost.
The electrodes are part of the furnace lid and are assembled into columns. Electricity is then passed through the electrodes, forming an arc of intense heat that melts the scrap steel. These highly technical rods oftentimes take 5-6 months to make and require both graphite and needle coke as its main inputs.
After fully integrating Seadrift in 2010, EAF has become the second largest petroleum needle coke producer globally. This integration has led to EAF controlling 20%+ of the ex-China petroleum needle coke market, and undercutting competitors by $2,700/tonne on needle coke production. More recently, they've rid themselves of two underperforming facilities, bringing facility count down to four globally diverse locations. These four plants produce more electrode rods than the previous six. This result stems from technological efficiencies, increased safety standards, and successful debottlenecking initiatives. They currently produce 202,000MT of graphite electrodes per year with capacity to bring on more capacity after the warm idling of the St. Mary’s plant.
Electric arc furnaces, the market segment EAF operates in, are cheaper to build than traditional blast furnaces, which are fueled by a lower quality coking coal. Scrap steel is added to the furnace and turned into high quality steel that's used in a wide array of applications globally. Market share is split up among 8 key players. This includes Nippon Carbon 4%, SEC Carbon 4%, Energoprom 7%, HEG 10%, Tokai Carbon (OTCPK:TKCBY) 12%, GIL 12%, Showa Denko (OTCPK:SHWDF) 28%, and others comprising an additional 2%.
It’s estimated that EAF has grown from 30% to 50% of the market over the last 5 years. This doesn’t consider China's plan to increase its EAF production from 6% in 2016 to 20% by 2023. As reported by CRU, the growth for the EAF industry is expected to be 5% through 2019 and 3.5% per year moving forward. Assuming they can maintain their low-cost advantage, they should be able to outpace the overall EAF market growth by 2-3% per year.
The largest competitor for Seadrift in the needle coke production space is Phillips 66 (PSX). Phillips was a spin-off of ConocoPhillips’s (COP) downstream assets and midstream assets to create the independent energy company in 2012. While the needle coke industry has consolidated to a few large-scale players, China continues to reduce production. Between 2017 and 2018, China decreased its production by 100,000/tonnes, this supply side change has allowed both Seadrift and Phillips to debottleneck some of their facilities and add more capacity for ramped production. Between EAF and Phillips initiatives, there will be roughly 90kt of additional needle coke by YE 2019.
By reverse-integrating Seadrift, EAF's needle coke production facility, they’re able to do what competitors can’t - offer extended take-or-pay contracts on 65% of their production until 2022. Competitors can’t match their ability because of the reliance on outsourced needle coke producers. By outsourcing, the competition can't guarantee that capacity will keep up with production, and that spot prices won't change quarter to quarter. The advantage of locking-in customers adds immensely to the brand-ability of the underlying product and create a cash flow rich formula for the sales and marketing team to leverage.
Established in 1886, EAF has one of the lengthiest (130 years) histories of any electrode producer ex-China. This competitive advantage is best evidenced in the following claim by management:
We believe the lead time from initial permitting to full production of a greenfield graphite electrode manufacturing facility would be approximately three to five years and cost approximately $10,000 per MT. Similarly, brownfield development is complicated by significant capital costs and space and process constraints. Only one new greenfield graphite electrode facility outside of China has been built since the 1980s and only one significant brownfield expansion has occurred, reflecting the historical difficulty of adding further graphite electrode production capacity. As a result of this long- and uncertain-time horizon to build new plants, we believe only a few companies have the necessary technology and expertise to meet the rising demand for graphite electrodes.
Since only a top three global producer would be able to reproduce their capabilities, the barriers to entry are rather steep. The reproduction value of four leading production facilities is closer to $1 B per facility based on capacity, efficiency, and current spot prices. Conservatively, that amounts to $4 B in asset value for the manufacturing arm. By vertically integrating Seadrift’s low-cost production of needle coke, these assets are worth geometrically more than if it wasn't presently available.
When Seadrift was acquired in 2010 for $692m, needle coke spot prices were $1,500/MT. From then, the demand shift has increased spot prices to $3,500/MT for petroleum-based needle coke. If we assume asset values move in lockstep with pricing, then Seadrift as a standalone entity is worth closer to $1.6B. A global operator would have both the technical know-how and engineering efficiency to scale production. Therefore, no additional R&D spend is factored into this calculation. What’s left is an asset value of $5.6B vs. $5.8B of enterprise value.
Another reason producers haven’t increased capacity to arbitrage away the supply and demand gap is due to the recent history of both greenfield and brownfield startups. To put it lightly, the last two starts, SGL’s greenfield project in Malaysia and SDK’s brownfield in the US have been underwhelming. These two projects have yet to fully ramp up after 10 years. The industry is aware of the technical difficulties, and only few well-versed players could add to the market. On top of that, the current demand environment for needle coke is creating higher input costs, which graphite electrode manufacturers can’t pass on to customers.
Aside from both time and capital intensity of developing additional plants, the technological know-how is immense. A typical, high quality electrode takes nearly 6 months to produce by sophisticated methods. EAF has employed hundreds of well-educated engineers over the last 130 years and has leveraged its experiences through its world-class operating efficiency and the business acumen gathered from the astute operators at Brookfield.
Market share in the graphite electrode market has changed hands at 3% annually from 2013 to 2017. Due to their 21% share of the global market, it’s fair to assume that there are roughly 7 years of earnings visibility. Since their management is hinting to take-or-pay contract visibility until 2022, the actual competitive advantage period extends an additional 2 years to 2024. There should be a high degree of confidence in the sustainability of their market share due to multiple competitive advantages working in their favor, along with large secular tailwinds.
While both spot needle coke prices and graphite electrode rods are selling for more than two times their historical average, this trend doesn’t seem to be slowing down anytime soon. The depressed prices for both needle coke and graphite rods prior to 2017 came mostly from the over-supply out of China. This supply was fueled by expansive economic growth, influx of low-quality rod and coke production, and Chinese subsidies given to steel producers. This “perfect storm” of supply side increases has subsided and is slated to persist due to a few reasons:
1) China’s unsustainable growth led to subsidy cuts to graphite rod producers and coal-based needle coke suppliers as scrap steel use has declined from historical highs.
2) China’s environmental initiatives are meant to stymie any further expansion of environmentally harmful processes such as coal-based petroleum needle coke use and traditional blast furnaces which leave a larger carbon footprint than UHP EAFs.
3) Both greenfield and brownfield production at this point in the cycle would be a poor risk/reward project for most operators. Since the costs are between $300 and $500m and would take roughly 10 years to complete, only the top three companies worldwide would have the capability to take on such tasks.
4) According to Bloomberg, EVs comprise less than 5% of auto sales currently and are forecasted to make up roughly 35% of new vehicle sales by 2040, or a 10% CAGR. This long runway should keep petroleum-based needle coke demand for lithium ion batteries resilient.
My estimate of EAF earnings power is derived from a few assumptions, including $9,800/tonne electrode spot prices on 202,000MT of production, 62% EBIT margins on $2B of sales by FY20, maintenance CAPEX of $40m, interest expense declining to $120m, 16% tax rate, and $60m in D&A. These assumptions, I believe, are conservative as most cash flows are contracted at historically high spot prices. My expectation is for both needle coke and graphite rod demand to stay robust until at least 2022. The non-contracted revenues are a free option on increasing demand, which I expect to occur. There’s a large margin of safety in these numbers. Even in the case where $950m of cash flows doesn’t materialize, the downside is capped by guaranteed revenue from large, well-diversified customers.
Return on capital (conservative during upcycle) - 20%
Retained earnings growth = 2x COC
*Yields assume an EV of $5.8B
Earnings Power Risk: Commodity down-cycle, tariffs affect global manufacturing and steel usage. Needle coke demand falls as EV projects are delayed, and many UHP EAF furnaces are idled. I assign a 20% chance of EAF losing 40% of their current earnings power. This means they would be trading at half of their free cash flow coverage on current take-or-pay contracts of $15 per share.
Their $1.7B worth of corporate debt was recently re-rated from a BB+ to a BB-. The reason is mostly due to the significant contract revenues that will generate cash flows over the contracted period (2022). Because the credit market is typically better at underwriting risk than the equity market, it seems interesting that there’s a large discrepancy between the two discount rates. One way to include the probability of default is to apply a BB- rating (EAF credit rating) 5-year default probability of 12.5% to our expected return of 25%. The resulting return is 22% after considering the default risk. More conservatively, if we discount the risk adjusted return of 17% by 12.5%, we are left with an expected return of 15%. According to Standard & Poor’s:
U.S.–based graphite electrode manufacturer GrafTech International Ltd. signed new long-term agreements (LTAs) at favorable prices in the first quarter of 2019. These new contracts, for 40,000 metrics tons (MT) of graphite electrode, combined with existing contracts, should help lock in about $700 million in EBITDA per year through 2021. The company also prepaid $100 million in debt in the first quarter of 2019 and has $112.5 million in annual term loan amortization payments. In our view, GrafTech's improved profitability prospects reflect a stronger competitive position while the company also pursues more prudent financial policies. We have raised our issuer credit rating and secured term loan rating to 'BB-'from 'B+'.
S&P Global Rating
Growth in China resumes previous levels leading to government subsidies towards electrode rod manufacturing, increasing competition. A leading competitor such as Showa Denko reverse-integrates needle coke production. Global economic growth slows, diminishing steel production, which leads to less favorable demand side economics. Brookfield continues to opportunistically sell their stake in EAF at marginal prices, depressing shareholder value. Margins are squeezed on the 35% of non-contracted revenues due to higher needle coke input costs and lower demand for graphite electrode rods.
Since the expansion and contraction of both earnings growth and gross margins are correlated in commodity-heavy businesses, there's an increased risk of compounding losses. This means that as global demand for steel decreases (growth), less is used. In turn, this leads to an oversupply of steel in the market which then compresses (margins). While I believe this effect is unlikely given the current demand for needle coke and graphite electrode rods, there’s a possibility that the 35% of non-contracted revenues are susceptible to this pricing pressure. The late-cycle risk is reduced significantly by both long-term take-or-pay contracts on 65% of revenues until 2022 and gross margins of 60% at current spot prices.
Since their IPO, and separation from Brookfield they devised a comprehensive capital return policy. This is evidenced by a press release on July 31st, 2019, by David Rintoul (President and CEO) and the board to repurchase $100m worth of stock through open market purchases. This equates to roughly 15% of their equity float. Previously, they issued a special dividend of $0.70 per share, or $204m to holders of record on December 7th, 2018. The last layer of capital return is from their quarterly dividend which yields 2.6% and is in the amount of $100m annually. Tallying the total cash return we are left with $404m of capital returns per year, or a 10.5% yield on their market cap. I expect additional capital returns including a raise in share repurchases and special dividends paid through cash flows.
Management alignment was strengthened under the wing of Brookfield. BAM created a system that forced the new CEO (David Rintoul) to receive 10x his annual salary in long-term incentives, including options and stock awards. This policy shift allows for greater retention and adds emphasis on long-term value creation. Board members, Messrs Acton and Dumas, chose to defer all their cash fees into deferred share units (“DSUs”), which signals their confidence in the underlying economics and future of EAF. Also, independent directors will be required within five years of joining the Board to acquire shares or share equivalents in the company having an aggregate value equal to at least three times the then annual retainer (currently $375,000).
In 2019, Mr. Rintoul received an equity award comprised of 75,000 restricted stock units that will vest ratably over 5 years on each anniversary of the date of grant. Based on my assessment of when these shares start to vest, management had no incentive of talking up their book before April 19, 2019. After this date, the CEO’s shares begin to vest in increments over the next 5 years. This alignment is evidenced in the large ($100m) buyback initiative implemented on July 31, 2019. It’s reasonable to expect management to implement additional repurchases and dividend increases moving forward as it would gain attention of investors searching for yield in their portfolios. While management's incentives are tied to adjusted EBITDA, there’s reason to believe that this proxy for cash flow will benefit shareholders.
Since our acquisition by Brookfield, and until our IPO, we have not relied upon equity awards for incentivizing long-term performance. Instead, at the time of the acquisition, we adopted a long-term cash incentive program – the GrafTech International Ltd. Long-Term Incentive Plan (the “LTIP”) – designed to retain senior management of the company, to incentivize them to make decisions with a long-term view and to motivate and influence behavior on their part that is consistent with maximizing value for the stockholders of the company in a prudent manner.
Mr. Rintoul was awarded stock options at the time of the IPO determined by dividing $6,250,000 (representing 10x of his annual base salary) by the IPO share price. As these stock options become exercise-able over five years following grant, they incentivize steady, long-term value creation with a focus on increasing stock price and align Mr. Rintoul’s compensation with the interests of the company’s stockholders.
After Brookfield gained possession of EAF in 2015, they made large strides in the right direction, operationally. The addition of long-term contracted revenue, long-term management incentives, and instructive capital return policies via Brookfield has added incremental value to shareholders. On August 13, 2018, Brookfield sold $225m worth of EAF stock back to the company for $19.25 per share. Since then, Brookfield continues to be a majority shareholder, maintaining roughly 79% of their shares outstanding. Since March of 2019, Brookfield has sold an additional 61m shares at prices between $11 and $13 per share.
Brookfield’s initial $1.25B investment in EAF returned approximately 5x by 2018’s IPO or an approximate 70% compounded rate of return. In baseball, we would call this a homerun! However, the ongoing concern is that Brookfield will opportunistically sell shares below the IPO price. If this happens, it can create a drag on shareholder returns even if performance expectations are met. While this concern is valid, I believe it's uncertainty rather than actual risk. However, Brookfield’s private equity arm typically has an investment horizon of 3-5 years. Following this logic, we would assume that Brookfield will be completely divested of their shares before 2021.
I expect EAF to generate roughly $4.8B of cash flows over the next 5 years with a clear and decisive way to protect those cash flows. While we can’t control the sale price for this business, we can control the purchase price. Based on the vast array of potential outcomes, I believe it’s much too difficult to precisely value EAF. However, simply put, we’re able to generate a 17% return on our purchase price and repurchase the entire market cap within 4 years. What can we expect? If they can compound at 17%, we will end up with 2.2X our initial investment in 5 years and still own the business at virtually no cost.
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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.