EAF - GrafTech

[johnny]

But they haven't actually explicitly defined what they think normalworld is going to look like right? So, if I'm trying to reverse engineer what number they're preparing for.

 

40-50% of FCF earmarked for debt in 2019. I don't know why they would front-load they pay-down given the LTAs, so if we assume similar through 2022 that would leave something in the range of $1B in debt? So that suggests they're preparing for something like $500M 2023 EBITDA?

[peterHK]

But they haven't actually explicitly defined what they think normalworld is going to look like right? So, if I'm trying to reverse engineer what number they're preparing for.

 

40-50% of FCF earmarked for debt in 2019. I don't know why they would front-load they pay-down given the LTAs, so if we assume similar through 2022 that would leave something in the range of $1B in debt? So that suggests they're preparing for something like $500M 2023 EBITDA?

 

Funnily enough, I have them doing $642, so it's not too too far off.

[valueinvestor]

Looks like Mohnish Pabrai is in EAF.

 

https://www.dataroma.com/m/holdings.php?m=PI

[Fitz]

Hey guys, this is my first post on the CB&F, I been lurking in the backgrounds reading all your great posts for a few years now and finally made an account, so really happy to be apart of this community.

 

Bad news is I didn't have the search option when I had no membership and thought there was no current EAF thread and I thought I would make one... so I basically typed up a few thoughts and just now read the previous 11 pages of posts and realized the ground has been well plowed. If its acceptable I would like to continue and post as if it was a new thread and please shoot holes in the thesis and thoughts.

 

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EAF GRAFTECH INTERNATIONAL LTD.

 

The investment in one sentence: Graphite rod manufacture that is world class and low cost provider of EAF rod’s selling for 4.4 times cash flow, that has 3-5 year take-or-pay contracts locked up with profits of today’s entire market cap, with a kicker of 30-40% more utilization to go.

 

I had never looked at this company until Monish Pabrai took a position in it recently. I read through the IPO prospectus and the 2018 AR and here are some thoughts, it looks like a very nice investment with a path to earning its entire market cap within the next 4 years.

 

Quick Bio on the company GrafTech manufactures Graphite Electrodes which are used as conduction rod’s in EAF furnaces that make steel out of scrap metal. Steel is made from a blast furnace or EAF furnace. EAF furnaces have a few advantages and have been taking market share from blast furnaces for the past 15 years (outside of China), they are much friendlier on the environment, use less energy and can use scrap metal to make steel. An EAF furnace requires much less capital, land and environmental hurdles than a blast furnace. As the use of EAF furnaces has risen, so has the demand for GrafTech’s graphite rods, they are very complex to make and take up to 6 months per rod, these rods are consumed and destroyed every 8-10 hours or arching in a EAF furnace, so steel manufacturers need a continuous and steady supply.

 

Steel is a very cyclical industry and blast furnaces out of China have been over producing steel and flooding the world with exports for some years, during this time EAF suffered losses and it was bad to own any steel mill or dependent business. What has changed? In 2016 China started idling production and closing mills, (a blast furnace is built and run constantly for 8-10 years until is is decommissioned) or not re-building supply as it comes offline. China’s growth slowed and the subsidies shrank, and forced consolidation as they were unable to use more and more of their domestically produced steel. At the same time the US and other European partners imposed duties to protect domestic steel production. This has lead to a resurgence in EAF steel production, and now it’s a great time to be in the business.

 

EAF was taken private from BAM in 2015 for 1.2 billion. EAF used to have 6 manufacturing plants running and produced 200,000 metric tons of graphite rod’s a year. With BAM’s management and streamlining they have divested an unrelated business, closed 2 plants, and browned out the only US plant for a total of 3 currently running. There were tremendous scale advantages to producing more Graphite Rods in fewer locations, they invested in debottlenecking at these facilities and in 2018 were able to crank out 202,000MT at 3 facilities. The Pennsylvania facility is browned out and could add another 30k to the total if fired back up. This cost cutting has saved 150mil a year according to BAM. EAF was listed as a controlled company IPO in 2018 with BAM loading 1.2 billion of debt back onto the company recovering there investment and retaining 79% of the stock.

 

2018 has been a banner year with pre-tax profits of 903 million, and 932 in the TTM.  This has largely been from an increase in commodity prices for the finished graphite electrodes, from a 2016 low of $2500 a metric ton to $10,000 a metric ton in 2018. During the lows of 2014-2016 aprox. 20% of graphite electrode production was permanently closed. Today EAF produces 25% of the Graphite Rod supply (ex-China) and is the second largest producer with there Pennsylvania factory idled currently, with it online it brings them at level with the top producer.

 

Prices have skyrocketed for several reasons, mainly EAF furnaces and the steel industry outside of China having a resurgence from decreased Chinese exports and more favorable domestic policies for the steel industry, shuttering of graphite rod supply, and a spike in the cost of the main input to graphite rods petroleum needle coke.

 

Rising petroleum needle coke prices in the graphite rod business is usually bad for the bottom line, but in EAF’s case not so much. The crown jewel of this business is its 100% ownership of SeaDrift the 2nd largest producer of petroleum needle coke outside of china. GrafTech is the only vertically integrated Graphite Rod manufacture and this leaves them much less exposed to the fluctuations of this commodity’s price. Sea drift can and does support 70% of EAF’s needle coke needs. This is where EAF has really made some savvy moves, the price of needle coke has risen tremendously due to its demand for use in electric car batteries and this trend looks likely to continue for the next 1-2 years as more production comes online.

 

EAF has shifted their business model from annual contracts to 3-5 year take or pay contracts, these new contracts sold like hot cakes as suppliers were eager to fix the future price of their rods and hedge against higher prices in the next few years. EAF has contracts for 674,000 MT, or approximately 60% to 65% of our cumulative expected production capacity from 2018 through 2022. Approximately 90% of the contracted volumes have terms extending to 2022. We have contracted to sell approximately 147,000, 144,000, 127,000 and 120,000 MT in 2019, 2020, 2021 and 2022, respectively. Contracts have a weighted average price of $9,700 per MT. This is 6.5 billion in revenue and if capacity gets used at the same rate as 2018 (99%), a 42% net margin (current margin) leaves 2.75 billion in net income from the take or pay contracts alone.

The current valuation of 3.3 billion has it trading at 4 times net income and 3.5 times pretax profits for TTM earnings. This is a very cheap valuation but not unheard of for a very cyclical industry currently experiencing peak profits. Where I disagree with the markets valuation in the value is the 3-5 year take or pay contracts locking in today's high profits for years to come.

Why wouldn’t all EAF’s competitors use a similar approach? They can’t, profitably at least. No one else has an in-house Needle coking plant. This allows EAF to lock in favorable and guaranteed supply of needle coke for the foreseeable future and make long term commitments on pricing. It appears to be a very powerful advantage. 

A few other areas of note: no new Graphite Rod manufacturing plant has been built in the last 10+ years, EAF management estimates it would take 3-5 years to get new supply online for a new build and require prices to exceed $10,000MT to be commercially viable. China’s 12th 5 year plan stated they wanted 20% of the steel production switched over to EAF furnace, although there 13th removed this fixed target and instead had language about new steel production needing to be environmentally friendly. This would result in a large increase in demand, and the supply side would be slower to keep up.

 

Risks:

1. Seadrift - If there is any stoppage (fire, malfunction, union strike, natural disaster etc..) of needle coking at Seadrift and the prices of needle coke remain elevated the 3-5 year contracts could become huge liabilities.

2. Debt load is now 2 billion leaving EAF with higher debt service and less ability to weather a downturn in prices as before IPO.

3. China: Makes multiples of the rest of the world's steel production and if the blast furnaces decide to power back on at full steam the world would again be flooded with steel.

4. Domestic Policy: Right now EAF and other non-chinese producers are enjoying some protection and duties this could change and effect the economics of EAF furnaces.

5. Slow down in economy reduces steel consumption

6. Minority share holder and possibility of having conflicting interest with majority owner / BAM

[landstander]

Mohnish sharing his thoughts on EAF -

[valueinvestor]

 

Risks:

6. Minority share holder and possibility of having conflicting interest with majority owner / BAM

 

I sold out after the pop - because with Teekay, Brookfield Office Properties, and GGP (to a certain extent), they were very opportunistic. The possibility is closer to a certainty, where BAM has conflicting interest. Hence, I look at this more of a trade, then an investment.

 

Unless someone gives me a tangible reason why this does not matter? Most times with acquiror like BAM, the intrinsic value does not equal the acquisition value of the company. Especially, when they can pay intrinsic and use platform value to obtain a fair return.

[Broeb22]

 

 

The investment in one sentence: Graphite rod manufacture that is world class and low cost provider of EAF rod’s selling for 4.4 times cash flow, that has 3-5 year take-or-pay contracts locked up with profits of today’s entire market cap, with a kicker of 30-40% more utilization to go.

 

Are these take-or-pay agreements the same kind that MLPs restructured when their O&G customers went bankrupt en masse?

[Philbert77]

 

I sold out after the pop - because with Teekay, Brookfield Office Properties, and GGP (to a certain extent), they were very opportunistic. The possibility is closer to a certainty, where BAM has conflicting interest. Hence, I look at this more of a trade, then an investment.

 

Unless someone gives me a tangible reason why this does not matter? Most times with acquiror like BAM, the intrinsic value does not equal the acquisition value of the company. Especially, when they can pay intrinsic and use platform value to obtain a fair return.

 

I just sold EAF today. After the whole TOO debacle i do not trust BAM affiliated companies to treat their minority shareholders fairly. I also hold MIC and am considering how to get rid of that one as well... though the special dividend just announced is pretty sweet!

[johnny]

I still don't understand why the Seadrift employees, who I think have an expiring contract (or negotiation period) THIS YEAR, are not opening up with a suggestion that 30% of the equity in the company be immediately deposited into their pension fund.

[elliott]

• A key argument of the bull thesis is that there is not enough petroleum needle coke. Now, a lot of capacity was shut down some years ago (partly the reason of the recent under supply). That capacity may take some time to rebuild cannot be denied, but the fact that much more capacity existed in the past, however, must mean that enough input existed, and possibly is still available today to expand capacity again. I am talking about decant oil. If decant oil is not a constraint, does that mean that it is only a matter of time before petroleum needle cake supply increases?
  
• Another key point of the bull thesis is that the Chinese lack the know how for building UHP graphite electrodes. However, management indicated some months ago that 2-3 players there had managed to build some UHP graphite electrodes, even if not yet production ready. Nevertheless, should we see this as an indication that the chinese will eventually get there? If so, it would only be a matter of time before graphite electrode supply increases.
  

 

If petcoke and graphite electrode supply increases, then Graftech may become a poor business to own - just as it was before. Whats more, for a stockholder it is not about capacity actually increasing - so long as the market can confidently see that happening in the future, why would anyone invest in the company?

My point is that this may literally be a cigar butt.

 

We may look at the contracts and think that there is margin of safety there. But, even if the company makes so much money in contracts in the next 3Y-5Y, how much will actually trickle down into common stockholders pockets? Management targets a 50%-60% return of FCF to shareholders, ie dividends and buybacks, but buybacks may prove worthless if shares tank in the future. Therefore, will dividends received before the market can see the business turning ugly cover much of the investment?

 

Appreciate any comments.

[Spekulatius]

• Another key point of the bull thesis is that the Chinese lack the know how for building UHP graphite electrodes. However, management indicated some months ago that 2-3 players there had managed to build some UHP graphite electrodes, even if not yet production ready. Nevertheless, should we see this as an indication that the chinese will eventually get there? If so, it would only be a matter of time before graphite electrode supply increases.
  

 

 

I am no expert in this field, but based on my general knowledge of material science and the Chinese abilities to reverse engineer, I don’t think it will be too hard for Chinese companies to create their own UHP needle coke supply. The general process is known, equipment to do this can be purchased, so it’s matter to learn some tricks of the trade that are proprietary. It will happen, it’s just a matter of time.

[Fitz]

• A key argument of the bull thesis is that there is not enough petroleum needle coke. Now, a lot of capacity was shut down some years ago (partly the reason of the recent under supply). That capacity may take some time to rebuild cannot be denied, but the fact that much more capacity existed in the past, however, must mean that enough input existed, and possibly is still available today to expand capacity again. I am talking about decant oil. If decant oil is not a constraint, does that mean that it is only a matter of time before petroleum needle cake supply increases?
  
• Another key point of the bull thesis is that the Chinese lack the know how for building UHP graphite electrodes. However, management indicated some months ago that 2-3 players there had managed to build some UHP graphite electrodes, even if not yet production ready. Nevertheless, should we see this as an indication that the chinese will eventually get there? If so, it would only be a matter of time before graphite electrode supply increases.
  

 

If petcoke and graphite electrode supply increases, then Graftech may become a poor business to own - just as it was before. Whats more, for a stockholder it is not about capacity actually increasing - so long as the market can confidently see that happening in the future, why would anyone invest in the company?

My point is that this may literally be a cigar butt.

 

We may look at the contracts and think that there is margin of safety there. But, even if the company makes so much money in contracts in the next 3Y-5Y, how much will actually trickle down into common stockholders pockets? Management targets a 50%-60% return of FCF to shareholders, ie dividends and buybacks, but buybacks may prove worthless if shares tank in the future. Therefore, will dividends received before the market can see the business turning ugly cover much of the investment?

 

Appreciate any comments.

 

 

- I'm not aware of needle coke supply shutting down, UHP Graphite rod production was taken off line. The squeeze on needle coke supply has been the increase in demand in the lithium ion batteries used in EV's.

 

- The main thesis for this trade wouldn't ride on needle coke supply at 70% is made in house and already locked up in 3-5 year contracts. The spot price of needle coke gives you the margin on 30% of revenus and if it persists at elevated levels this will allow for future contracts to be signed at much higher prices. These rosy assumptions aren't built into the buy today but would just be nice kickers!

 

- As for China entering the UHP or Needle Coke production market, I'm sure they are working very hard right now to produce needle coke or an alternate domestically and would be supersede if they were unsuccessful, but would also be surprised if it came online in a couple years. They are the largest manufacture of Lithium batteries and with all the uncertainty in the global trade market it would be crazy if they weren't working on an in house alternative.

 

- Capital allocation, I see a majority of the capital returned to be in dividends, at least I hope this is the case. Not because I wouldn't like to see a lot of buy backs today but there just isn't enough float to make this happen. The two people who own most of the stock are BBU and Pabrai both are pretty smart investors and I doubt will be selling back at low prices. This will leave them paying down debt at a higher clip than originally projected or more special and large dividends, and buying back whatever small amounts they can in the public market. If prices rise I hope there is enough independence in management / board to not blindly take in BBU's stock, but after seeing TOO debacle its something to look out for.

 

Look forward to hearing your thoughts.

 

-Fitz

 

[elliott]

Fitz, you are right about the petroleum needle coke capacity. The capacity decrease I was talking about was of graphite electrodes - I mixed the two. Still, it remains to be seen for how long petroleum needle coke capacity will remain as it is, and not increase over demand as it usually happens with commodities. Decant oil is certainly not a constraint.

 

As for your comment that persisting elevated prices might give the opportunity for Graftech to sign contracts at higher prices, I have some doubts. For one, coke prices seems to be dropping off their recent highs, and I think no one is really surprised. Further, I am not sure about the timing so maybe I am wrong here, but Graftech has managed to sign contracts at an average price short of USD 10,000 / MT when petroleum needle coke spot prices ranged between 15-30,000 per MT. What prices will they get if coke price drops to, say, 10,000 / MT?

EDIT: Actually, most of the capacity that management "sells" in the form of contracts, 3Y-5Y out, is already contracted, so any new contract should only have a very minimal impact anyways. It will be interesting to see what the situation is like 3 years from now, though, when some of these contracts expire and must be renewed.

[elliott]

Another thing I also think about is...

How much FCF will Graftech generate when the chinese start producing and selling UHP graphite electrodes? Half of what it does today? Less? Not to mention that in such a reality, FCF would probably swing from the positive to the negative, unpredictably as is the case with other commodities.

 

The reason I ask myself that question is becasue Graftech is currently doing ca USD 700M in FCF. Lets say it keeps generating that amount through 2023, so that by the end of 2023 Graftech has made USB 3.5B in FCF. Its current EV is still higher than that though, ca USD 5.5B, and I am not sure that in 2024, if the chinese are actually producing UHP graphite electrodes and the necessary coke, the company will be worth USD 2B or more.

So, is Graftech really that cheap?

[Saluki]

if the chinese are actually producing UHP graphite electrodes and the necessary coke,

 

The second part is a very big if.  You can only get needle coke when you start by scraping the crud out of a petroleum refinery coker and work it from sponge coke to the good stuff.  But only certain refineries use the crude that you need to start with.  My understanding is that you can't make it from a refinery that processes that venezuelan junk. Since it's a by product, to make more, you would need more refineries that work with light crude. To do that, you would need to find more oil.

EAF and PSX own 70% of the needle coke production capacity in the world. So if you want to make more graphite rods, you can buy the coke from EAF, but if you want more needle coke, where will you get the stuff to make it with?  If you want a house made out redwood trees, you can't just tell people to plant them in georgia because the ones from oregon are getting too expensive.

[elliott]

Couldnt the chinese (or anyone else) buy the decant oil from the US?

 

According to Graftech, there is abundant decant oil.

While Seadrift has purchased a substantial majority of its raw material inventory from a limited number of suppliers in recent years, we believe that there is a large supply of suitable decant oil in the United States available from a variety of sources.

 

Also, note that I am not considering if the chinese will be competitive 2 years from now, but in say 5 years. The economy there is planned, or at least semi planned. Even if the economics dont look good, they will spend as much money as is necessary in order to be able to manufacture their own needle coke - at least if they believe its a strategic concern or something of the sort.

Even Graftech management acknowledged that the chinese will make it at some point - I am pretty sure they said this in one of the last two conference calls, in the Q&A sessions. Dont ask me if they said it will happen in 3 years or 20, I think they didnt mention, but somehow was clear they were not thinking in 20 years. Anyway, I think this was also discussed in the Value investors club writeup. You may check there for more info, Saluki.

[Stuart D]

Apr2020 calls, strike price $17.50, last selling for $0.05 seems cheap.

[johnny]

Given the action of the past year, what worldly events could you imagine causing this to get to $18 within six months? Even if they contracted every last remaining ton of capacity through 2022 at the previous highs, you couldn't quite get there

[Fitz]

If EAF is going to be above 17.50 in April the common seems like quite the deal!

 

Elliot, one thing I have thought about with the timing and amount of Needle coke production coming on line is this. No one has any coming right now (that I have been able to find, if anyone has more accurate information please share!), so the near term looks to be more of the same; supply is fixed and demand conintues to rise. But as more Needle Coke comes online EAF will be able to benefit in there ability to bring back St. Mary's PA with 28,000 more MT of production annually. With prices sky high right now the only logical reason the PA facility hasn't been restarted is they are unable to obtain the additional Needle Coke for production.

[Stuart D]

Given the action of the past year, what worldly events could you imagine causing this to get to $18 within six months? Even if they contracted every last remaining ton of capacity through 2022 at the previous highs, you couldn't quite get there

 

I see the call option as $0.05/share to protect against the chance of BAM doing something shareholder friendly before April. On second thoughts, perhaps $0.05 is not cheap enough!

 

The dynamite is there (800m float & 800m fcf), it’s just whether or not they want to light a match.

 

 

[elliott]

Given the action of the past year, what worldly events could you imagine causing this to get to $18 within six months? Even if they contracted every last remaining ton of capacity through 2022 at the previous highs, you couldn't quite get there

 

I see the call option as $0.05/share to protect against the chance of BAM doing something shareholder friendly before April. On second thoughts, perhaps $0.05 is not cheap enough!

 

The dynamite is there (800m float & 800m fcf), it’s just whether or not they want to light a match.

 

Maybe you already counted with this, but...

 

"Going forward, we are expanding our capacity by 20,000 TPA. This will catapult HEG into a new orbit."

 

Stated about a year ago, when capacity was 80TPA. Worse yet expressed using the rhetoric typical of managers who clearly dont understand the capital cycle, and instead are skillful at carving their own tombs. To be clear, that ongoing expansion will take some time to come online, but is already in process.

 

Also from a year ago is this comment by HEG:

"Currently, the graphite electrode capacity is delicately balanced – additional capacity will take anywhere between 2-3 years to become operational."

 

[Fitz]

Elliott you’re correct that HEG is in the process of adding 20k of annual production of UHP Graphite rods. I’m sure I’m just not reading your posts correctly but I think Needle coke supply and UHP rod supply has been used interchangeably.

 

More EAF rod production coming online would be a good thing if your concerned about the price of needle coke declining as stated earlier. If I have mis read your posts My apologies and look forward to being educated :)

[Stuart D]

Given the action of the past year, what worldly events could you imagine causing this to get to $18 within six months? Even if they contracted every last remaining ton of capacity through 2022 at the previous highs, you couldn't quite get there

 

I see the call option as $0.05/share to protect against the chance of BAM doing something shareholder friendly before April. On second thoughts, perhaps $0.05 is not cheap enough!

 

The dynamite is there (800m float & 800m fcf), it’s just whether or not they want to light a match.

 

Maybe you already counted with this, but...

 

"Going forward, we are expanding our capacity by 20,000 TPA. This will catapult HEG into a new orbit."

 

Stated about a year ago, when capacity was 80TPA. Worse yet expressed using the rhetoric typical of managers who clearly dont understand the capital cycle, and instead are skillful at carving their own tombs. To be clear, that ongoing expansion will take some time to come online, but is already in process.

 

Also from a year ago is this comment by HEG:

"Currently, the graphite electrode capacity is delicately balanced – additional capacity will take anywhere between 2-3 years to become operational."

 

Yeah, that's a good point on the overcapacity. I'm looking at it from a slightly different angle. I'll expand a bit on my thesis.

 

I’m trying to think about options like rolling a dice. Where each roll represents the time left on the option before expiry (in this case a bit less than 6 months), and the result that shows up on the dice is the share price outcome. Then I’ll pick a price above the strike, e.g. $20/share, and ask:

 

“how many times would I need to roll the dice before this number showed up?”

 

In this case, I think if we were able to roll the dice 10-20 times we would almost certainly have 1 x scenario where the EAF share price surged beyond $20. Maybe it would be caused by buybacks, perhaps BAM performs a pump & dump, institutional investors take large positions, a takeover bid from a Japanese company or some other tail-end probability event that no one could predict. The point is, that while unlikely in any single roll, I think it becomes almost a certainty when we hit 10-20 rolls.

 

At $0.05 it is priced as though we need 50 rolls ($20.00 - $17.50)/$0.05 = 50. Does this line of thinking make sense?

[Fitz]

Pabrai Interview with Graham and Doddsville, he speaks about his EAF investment in more detail. Interview starts on page 22.

 

https://www8.gsb.columbia.edu/valueinvesting/sites/valueinvesting/files/files/Graham%26Doddsville_Issue37.pdf

[johnny]

His comparison to IPSCO really feels like a stretch. There you were buying a no-debt company for 2x earnings and 2 years of contract. Okay, so you get a free company operating in the spot market two years from now--seems like a straightforward thesis that doesn't require strong convictions about the steel industry.

 

Here, you have $2B of debt and a bit more than that in net income coming from the LTAs. So we're mostly transforming the capital structure, not working our basis in the company anywhere near $0. It's still a company you're paying ~$3B for, in a market where there's a lot of weird stuff going on and a graveyard full of corpses. 1/3 of a portfolio in EAF sounds insane to me; I'm not sure I understand where he is coming from at all.