Description

GrafTech is a reasonable quality cyclical business in a secularly growing industry that has burned every (long) equity investor who has touched it since its return to public markets in 2018.  We believe it is a viable, cash-producing business saddled with too much debt from its former PE owners that is now having a little trouble with the cycle.  We believe the opportunity to make multiple times an investment, along with the company’s demonstrated ability to limit cash outflows during previous downturns, makes it an attractive risk reward from here.  This is a high level pitch that makes the case that patient investors will be handsomely rewarded when the cycle turns.

GrafTech International LTD is an industrial company that makes graphite electrodes (GEs) for the steel industry.  These are used in the Electric Arc Furnace (EAF - hence the ticker) method of steelmaking which basically melts recycled scrap metal down by sending huge amounts of electricity through it to heat it to high levels.  Incidentally, the EAF method is the relatively environmentally friendly way to produce steel (compared to the traditional BOF Basic Oxygen Furnace method) and has increased in popularity to become the dominant method in the United States.  It is also becoming more popular in China and elsewhere as environmental concerns have increased.

The GE business has historically been a very cyclical business.  However, GrafTech is supposedly a low cost producer and their results since the 90s show only a few short periods of negative net income and negative cash flow.  In 2010 they acquired a producer of a key input (petroleum needle coke) which made them partially vertically integrated.  

In 2015, GrafTech (which used to trade under the symbol GTI) was in the midst of one of these periodic downturns when it was purchased by Brookfield for approximately $1.25 billion enterprise value.  Brookefield sold some non-core divisions (approximately 10% of EBITDA), and rationalized production from 6 to 3 facilities.  In classic cyclical industry fashion, these and other capacity reductions lead to a crushing shortage of GE production capacity when demand started to increase again in about 2018.  During this shortage, GEs increased precipitously in price as customers became desperate to procure them at any price.

Brookfield took advantage of this historically tight market to sign historically long term contracts of up to 4 years to produce GEs for customers at elevated prices (though still well below even higher spot GE prices at this time).  It was in this environment, and with so much of their revenue profitably contracted into the future, that Brookfield took the company they purchased 3 years earlier for $1.25 billion and IPO’d it at $18 a share for an $8.25 billion enterprise valuation.  (What a trade!)  There are two well-written, well-researched VICs from this time that express the thinking of why this valuation was warranted.  In large part it had to do with the ideas that industry dynamics had changed due to the long term contracts mentioned and that the difficulty of increasing production of the key needle coke input would limit supply expansion and generally benefit GrafTech.

Since the 2018 IPO, a number of things have happened.  The company has been extremely profitable, paid down $1.3 billion dollars of debt, repurchased $630 million dollars’ worth of company stock, and paid $200 million dollars worth of dividends.  Brookfield has sold down their share of stock owned from 90% at the IPO to 10% today.  And operating results and the share price have steadily declined, the latter from above $18 to $1.35 at last close.  This is due to the expiration of above mentioned contracts, inevitability of worsening industry conditions, a series of missteps (especially recently), constant pressure from the Brookfield overhang, and the general realization that this is not such a fantastic business after all.  Today, the enterprise value is $1.1 billion, back below where Brookfield originally purchased it in 2015.  This enterprise value is also below the 1995-2014 average of $1.7 billion, which includes the period before 2010 when they acquired their source of needle coke input (Seadrift). The 2010-2014 average EV was $2.1 billion.

We believe this is a decent cyclical business that has again become cheap enough to warrant a good chance of positive outcome if purchased today.  EAF turned out not to be a good purchase when it was expanding production, generating gobs of cash, and available at a cheap multiple.  We believe GrafTech, like many cyclicals, may be a better purchase today when it is cutting production, losing money, and available at an infinite multiple.

Though the stock chart looks like that of a company in secular decline, our graphite industry contacts don’t believe there is any secular issue that pressures the company.  To start making money again, as they have done during the vast majority of their history, they simply need a better operating environment (along with avoiding any unforced errors).

When will that environment come?  That is the key question.  We are not experts on the GE or needle coke cycles, and indeed if the turn was readily observable, this company would not be available at the price it is today.  We would simply observe that, judging from the company’s operating history of peaks and troughs (1997, 2002, 2008, 2016), the average elapsed time from peak to trough has been 6.5 years.  It is now 6 years since the 2018 peak.  

Judging from the share price alone, there is at least some going concern risk, and the downside here is 100%.  The company has $177 million in cash and $289 million of liquidity.  Their $950 million in debt comes due in Dec 2028.   At present, short interest is only 4%.  While free cash flow has deteriorated over recent quarters, we would note that it is not, at present, consistently negative.  Cash flow history is shown during the prior two downturns for reference.

CFO and Capex over the Last 8 Quarters

CFO and Capex 2014 - 2017

Total Net Cash Flow over this period: +20

CFO and Capex 2000 - 2003

Total Net Cash Flow over this period: -156

How much upside can be expected if the company makes it through to the other side of this cycle?  We think the profitability of recent years was a bit of an anomaly and wouldn’t look to the recent past for guidance.  The simplest method would be to again observe that the 1995-2014 average EV was $1.7B and the 2010-2014 post-Seadrift-purchase period average EV was $2.1B.  

Assuming mid-cycle EBITDA is difficult if you also view recent years as an anomaly.  One approach would be to take their approximately $1 billion in invested capital and assume a 10% ROIC, 20% assumed tax rate, and 60 million average D&A for a hypothetical $185MM EBITDA.  This squares well with the observed pre-Brookfield pre-Supercycle average annual EBITDA of $184 MM (and much less than the supercycle years of over $1+ billion).  The historical multiple of around 10 gets you to $1.85 B fair value over the cycle which is likely very conservative.  Obviously making less conservative assumptions yields higher upside potential estimates, though one can imagine upside beyond that shown below. After all, just a few years ago this company had EPS greater than the current share price.

Others have argued for higher estimates based on a number of factors, such as the EAF process being seen as a secular grower, or increased demand for needle coke (remember EAF is a producer) for the graphite electrodes used in electric vehicles.  We are somewhat skeptical, though recently the company has been talking about diverting some of their needle coke production to the EV industry.

Prior management clearly made mistakes in getting to this point, most obviously in repurchasing so many shares versus prioritizing paying down the debt.  Also notable was the closure of their Monterrey, Mexico facility in September 2022 by the government due to environmental concerns.  Although the facility was closed for only a few months, that delay caused them to miss negotiations for ‘23 and subsequent sales.  Subsequent to that in November 2023 the CEO resigned and the company is now being lead by the CFO while the board searches for a replacement.  Last year they announced the re-opening of a plant that today is re-closing indefinitely.  Clearly there is some potential for improved management.  The appointment of a new CEO could be a positive catalyst.

As an interesting aside, there is an individual who is on the verge of announcing a proxy campaign for board membership after the current board refused to engage with him regarding the selection of a new CEO.  Mr. Nilesh Undavia, who has acquired a 5.7% stake in the company in the mid $1 to $2 range, appears to be an energy investor with experience at Wellington.  It will be interesting to see what he comes out with.  Certainly, his LinkedIn “about” section is interesting.

You can read his statement here: https://www.sec.gov/Archives/edgar/data/931148/000121465924003433/p222240sc13d.htm

Catalyst

Green shoots for the cycle.

New CEO.

Activist campaign.