EAF - GrafTech

[peterHK]

Very good write up on VIC (https://www.valueinvestorsclub.com/idea/GRAFTECH_INTERNATIONAL_LTD/5782887411) on this, so I won't rehash everything here. The comments are VERY worth reading.

Basically, only vertically integrated supplier of a key input into steelmaking: graphite electrodes. They are about 2% of the cost to make steel, but you can't run an electric arc furnace without them. The key input into graphite electrode is petroleum needle coke, a byproduct of refining that is in short supply globally.

The industry went bankrupt in 2016, lots of supply not just shuttered but demolished globally, then the steel industry took off. Graftech went BK, Brookfield bought them, restructured them, and took them public in an awful IPO that way underpriced the company.

They have ~25% FCF yield, with 60% of the business locked up under long term contracts at ~10k/ton vs. spot of ~15k/ton. There are lots of reasons why the spot market will be in short supply for years to come, one of which is that sourcing needle coke (which is also used in EV batteries) is very hard, so high needle coke prices guarantees high electrode pricing. Because needle coke is a byproduct, basically nobody is incentivized to build new supply and even if they were, it's very hard to do.

The company is 80% owned by BAM (BBU specifically), and has a low float, which is part of why its puking today. They said on their recent conference call that they wouldn't restart one of their facilities yet, but IMO they will at some point and even if they don't, the company is going to generate $1bn of FCF this year vs. a $4.6bn market cap. Because of the contracted business, it's fairly stable, I think deserves a higher multiple to peers, and they've said they're going to buy back shares with all their FCF.

Other thing worth noting is maintenance capex is very light: on $1bn of FCF, they'll need about $60mn of MCX.

[bjakes00]

Massive pullback today on the back of a Vertical Research report downgrade. Anyone have access to Vertical Research for more colour?

Here is another good write up that values the contracted cash flows at $19:
https://static1.squarespace.com/static/55cbe47de4b0a1e3b9b911fe/t/5b56268ef950b7be70cad9d7/1532372622855/GrafTech+%28EAF%29+Massif+Capital+22JUL2018.pdf

[Spekulatius]

These type of pricing aberrations for what is a commodity product are not sustainable. I believe the Chinese will bring on sufficient capacity to normalize the margins at much lower level. BAM really got the entry and exit (via IPO) of this business right. Gnerally speaking, you don’t want to buy what smart investors like BAM are selling or at least tread very carefully.

[peterHK]

They're all downgrading EAF because EAF said they'd wait to restart St.Mary's. I peg the value of that restart at ~$3/share.

[bjakes00]

Spekulatius, BAM still own 78%?
PeterHK, I understand the Vertical report from today was more a sectorwide downgrade that sparked the sell-off. Appreciate the St Mary point which led to some confusion on the investor call but the price made a come back post that.
In any case, there are 5 years of take or pay contracts in place here with integrated production - what am I missing? Are those contracts looser than I think or relatively enforceable?

[peterHK]

These type of pricing aberrations for what is a commodity product are not sustainable. I believe the Chinese will bring on sufficient capacity to normalize the margins at much lower level. BAM really got the entry and exit (via IPO) of this business right. Gnerally speaking, you don’t want to buy what smart investors like BAM are selling or at least tread very carefully.

Obviously they aren't sustainable. go read the VIC article, I think there are a lot of reasons that China can't add supply as quicky as people think and EAF at a 25% current FCF yield pays for the market cap in 4 years where we have a lot of visibility into their pricing, and then there's stub value left over after that.

BAM got the timing more right than those buying at the IPO, but I don't think those buying today are wrong to see 100% upside. I arrive at $21/share assuming that electrode prices drop to their historic spread of 3000 over needle coke prices, and needle coke prices stay where they are.

[valueinvestor]

Spekulatius, BAM still own 78%?
PeterHK, I understand the Vertical report from today was more a sectorwide downgrade that sparked the sell-off. Appreciate the St Mary point which led to some confusion on the investor call but the price made a come back post that.
In any case, there are 5 years of take or pay contracts in place here with integrated production - what am I missing? Are those contracts looser than I think or relatively enforceable?

With my perspective the whole thesis is how systemic is this business? If Graftech disappeared today would the steel industry care? If they are the only vertically-integrated producer of high-quality electrodes, as well as a low-cost operator - their customers wants Graftech to survive. With questions to the contract, it becomes unenforceable when the customer does not have any ability to pay. Since the electrodes are 3-5% of the total cost of steel production, for them not to pay for electrodes that are crucial to steel production, it would mean a shut down of a lot of steel factories. I typically do not invest in commodity businesses, but seeing how uniquely positioned they are, I pulled the trigger. The only reason why I would sell is if the thesis above how systemic and important they are in the industry is wrong. As most companies deal with graftech, not being they are the cheapest in price, but the largest in value, as they can rely on the electrode to last when going through the steel production process. Please note, I’m basing this on annual reports and haven’t look through the source material. So please feel free to poke holes in my thesis. As this is a relatively large position.

[peterHK]

Spekulatius, BAM still own 78%?
PeterHK, I understand the Vertical report from today was more a sectorwide downgrade that sparked the sell-off. Appreciate the St Mary point which led to some confusion on the investor call but the price made a come back post that.
In any case, there are 5 years of take or pay contracts in place here with integrated production - what am I missing? Are those contracts looser than I think or relatively enforceable?

With my perspective the whole thesis is how systemic is this business? If Graftech disappeared today would the steel industry care? If they are the only vertically-integrated producer of high-quality electrodes, as well as a low-cost operator - their customers wants Graftech to survive. With questions to the contract, it becomes unenforceable when the customer does not have any ability to pay. Since the electrodes are 3-5% of the total cost of steel production, for them not to pay for electrodes that are crucial to steel production, it would mean a shut down of a lot of steel factories. I typically do not invest in commodity businesses, but seeing how uniquely positioned they are, I pulled the trigger. The only reason why I would sell is if the thesis above how systemic and important they are in the industry is wrong. As most companies deal with graftech, not being they are the cheapest in price, but the largest in value, as they can rely on the electrode to last when going through the steel production process. Please note, I’m basing this on annual reports and haven’t look through the source material. So please feel free to poke holes in my thesis. As this is a relatively large position.

It's still a cyclical business, just likely less cyclical than peers because of the contracts. In typical BAM fashion, they're trading pricing for stability, which I think is the right move. Not my largest position, but I added in the 13's today because the price move was just stupid. Small float makes this fun. 

I'd also point out that even at prices half of what they are today, this is a business that can earn 30%+ ROIC's, which shows that actually it's a fairly high quality business. Another point is they have a structurally lower tax rate than peers, so comping them on an EV/EBITDA basis I think misses some things (stability being the other).

I view this as, oddly, a defensive company. If we get the market cap back to us in cash, then the stub value is free upside. I have a fairly high degree of confidence that, assuming $10k, then $8k, the $6k electrode pricing in 2019/2020/2021 vs. $15k today, that they're going to earn the cash I expect they will.

[valueinvestor]

Spekulatius, BAM still own 78%?
PeterHK, I understand the Vertical report from today was more a sectorwide downgrade that sparked the sell-off. Appreciate the St Mary point which led to some confusion on the investor call but the price made a come back post that.
In any case, there are 5 years of take or pay contracts in place here with integrated production - what am I missing? Are those contracts looser than I think or relatively enforceable?

With my perspective the whole thesis is how systemic is this business? If Graftech disappeared today would the steel industry care? If they are the only vertically-integrated producer of high-quality electrodes, as well as a low-cost operator - their customers wants Graftech to survive. With questions to the contract, it becomes unenforceable when the customer does not have any ability to pay. Since the electrodes are 3-5% of the total cost of steel production, for them not to pay for electrodes that are crucial to steel production, it would mean a shut down of a lot of steel factories. I typically do not invest in commodity businesses, but seeing how uniquely positioned they are, I pulled the trigger. The only reason why I would sell is if the thesis above how systemic and important they are in the industry is wrong. As most companies deal with graftech, not being they are the cheapest in price, but the largest in value, as they can rely on the electrode to last when going through the steel production process. Please note, I’m basing this on annual reports and haven’t look through the source material. So please feel free to poke holes in my thesis. As this is a relatively large position.

It's still a cyclical business, just likely less cyclical than peers because of the contracts. In typical BAM fashion, they're trading pricing for stability, which I think is the right move. Not my largest position, but I added in the 13's today because the price move was just stupid. Small float makes this fun. 

I'd also point out that even at prices half of what they are today, this is a business that can earn 30%+ ROIC's, which shows that actually it's a fairly high quality business. Another point is they have a structurally lower tax rate than peers, so comping them on an EV/EBITDA basis I think misses some things (stability being the other).

I view this as, oddly, a defensive company. If we get the market cap back to us in cash, then the stub value is free upside. I have a fairly high degree of confidence that, assuming $10k, then $8k, the $6k electrode pricing in 2019/2020/2021 vs. $15k today, that they're going to earn the cash I expect they will.

That's kind of my point. It is a defensive company where you can be comfortable that prices have to be cut more than 50% or more for Graftech to not earn a net income. This is the first time I invested in a commodity-type business, but I do not have to be an expert in commodities to know this can be a lucrative investment with very little downside.

[valueinvestor]

Not sure why Graftech went down by 8%, possibly because of https://www.recyclingtoday.com/article/sdi-steelmaking-recycling-eaf-southwestern-usa/.

Not sure why this matters, as the mill is only to start construction by 2020 or 2021.

The fact that they are building out new EAF furnaces, where "over 85% of senior management compensation at risk / Over 60% of production employee compensation at risk," where 100% of annual bonus is linked to ROE and long-term incentive plans tied to ROE, Operating Margins, Revenue Growth and Operating Cash Flow per Revenue metrics shows they believe the long term viability of Electric Arc Furnace. However, I typically refrain using that argument, because there have been numerous occasions where shareholders' interest were aligned with the managements, but still turned out to be a bad investment.

I have not bought more, as it is a large position, but tempted.