GrafTech (EAF) is one of the leading manufacturers of Ultra High Power (UHP) graphite electrode with unique business model compared to the rest of the peers i.e. vertical integration of key raw material manufacturing, which is needleCoke (70% of grafTech’s needs are met by its subsidiary Sandrift ). Sandrift is the 2nd largest manufacturer of needleCoke at 18% of industry capacity after PSX which has ~55% of industry capacity.
Why Buy GrafTech (EAF)
There are multiple factors that have aligned in favor of GrafTech in the medium term (3-5 years), which may result in superior returns to the shareholders based on current valuation.
- BAM took GrafTech private in 2015 and has restructured the company to be more productive and enhanced the business model (e.g. a. reduced # of manufacturing units from 6 to 3 with increased capacity, b. Achieved cost savings of $100M annually c. worked out take-or-pay contract for 70% of capacity at ~$10,000 per MT, which is significantly higher than the cost of production, which is close to $4000 per MT
- Electric Arc Furnace, which uses Graphite Electrodes is in a secular growth across the globe compared to blast furnace due to its operational efficiency and lower carbon footprint i.e. less pollution and environmentally friendly (Recently China ordered significant # of blast furnaces to be shutdown to control pollution)
- Demand for NeedleCoke is growing rapidly due to EV/lithium ion batteries apart from migration to Electric Arc furnace, which benefits EAF as they produce 70% of their needleCoke requirement themselves at $2500 or less, while their competitors are forced top pay higher prices.
- Producing NeedleCoke or High-quality UHP GraphiteElectrodes are complex and takes a minimum of 5-7 years and huge upfront capital to bring new capacity online, hence the current high prices of GraphiteElectrode of ~$10K to $30K per MT is likely to persist in the medium term (1-3 years) – The industry also went thru consolidation and rationalization in the recent past and hence the supply is barely keeping up with demand
- Brooksfield is a prudent asset management firm and has a 73% stake in the company with 3 board seats, hence GrafTech has their backing.
- GrafTech has secured 70% of their production capacity with take-or-pay contracts up to 2022, which ensures $2.2 billion in net of debt free cash flow (current market Cap is $3.4B). The company has announced their intention to return capital to shareholders via buy-backs and dividends
- Graphite Electrodes are 1-3% of the total cost incurred by steel manufacturers while operating Electric Arc furnace, however any breakages in Electrodes will cause shutdown of the furnace (up to 4-8 hours to restart operations), which can cost steel manufacturers ~$1.5M per furnace, Hence they are less sensitive to the price of electrodes rather they look for high quality and predictable supply.
- GrafElectrores are consumable, i.e. UHP graphite electrodes are consumed at a rate of 1.7 kilograms per MT of steel produced. Hence the demand for graphite electrodes are consistent with steel production with electric arc furnace
- You get a 2.78% yield in dividends with a payout ratio of 12% while you wait.
- Significant decreases in spot prices of Graphite Electrode. This is a cyclical business and the prices of Graphite Electrodes per metric ton (MT) was as low as ~$2500 in 2016 (it depends on multiple factors and needleCoke prices is one of the key factors)
- Decline in NeedleCoke demand/prices due to substitutes for graphite like Silica in lithium ion batteries (expected to be commercialized by 2023), this will take away the high gross margin GrafTech enjoys as they control 70% of their needleCoke supply at lower costs than their competitors
- Decline in EAF Steel production due to the recession or other factors, which might force GrafTech to renegotiate their take-or-pay contracts as their customers are in financial stress ( they had to do this with one of the customers recently) , hence we can’t be complacent about the take-or-pay contracts.
- New capacity might come online in the future, especially from China, which can lower the price for all players ( as of now Chinese companies don’t have the capability to produce UHP graphite electrodes required in electric arc furnaces, they only produce HP electrodes required for blast furnace, this might change in the future, however it might take 5+ years to bring them online, also Chinese are not known for quality even in the HP electride market.)
- Brooksfield owns 73% of the outstanding shares and they might sell them in open market in future . So far they have reduced their stake via buy-back, but there is a risk of them hurting minority shareholders to benefit themselves.
- GrafTech is a new IPO and hence there is limited historical track record to project future earning potential. (e.g. the sales volume data prior to 2017 is significantly less / different than starting 2018 )
Will update my valuation of grafTech soon. If you are interested in more details or have questions please message me on my twitter handle @harirama.