Description

Introduction:

Ucar International is the world’s largest manufacturer of graphite electrodes, carbon electrodes, cathodes and flexible graphite. Trading at a 40% discount to its intrinsic value, Ucar’s current price represents an overreaction to the steel industry’s misfortune and its hefty financial leverage. Ucar is organized around two key segments: Graphite Power Systems (GPS) and Advanced Energy Technology (AET). The Graphite Power Systems segment produces graphite and carbon electrodes, as well as cathodic systems, serving primarily the steel, aluminum and ferroalloy industries. The Advanced Energy Technology segment produces flexible graphite, and graphite specialties, serving the semiconductor, energy, and electronics industries.

Operating Segments:

Of the GPS segment products, Ucar is best known for its graphite electrodes, which are used in smelting operations and constitute 68% of sales. Graphite electrodes are used almost exclusively within the electric arc furnace of steel mini-mills, but can also be used for refining steel in ladle furnaces and other smelting processes. To truly understand a graphite electrode, an understanding of an electric arc furnace is required. Essentially, an electric arc furnace is a large pot that recycles scrap steel. Old cars, bikes, refrigerators, and other scrap steel items are dumped into the pot and lowered into the furnace. The electrodes are part of the furnace’s roof structure. Electrodes are typically between 3 inches and 30 inches in diameter, and usually are assembled in columns of three. The electrodes receive massive amounts of energy through water-cooled cables heating them to approximately 5,000 degrees Fahrenheit. Once the furnace lid is in place, the electrodes are lowered until the tips of the electrodes almost touch the scrap steel. At this point, the electricity “arcs” (jumps) from the electrode tip to the nearest piece of scrap. This intense heat proceeds to melt all the scrap. The furnace is then tipped on its side into giant buckets called ladles. During this process the electrodes are consumed at the rate of one every 9 hours. Employing a lowest cost producer strategy, Ucar has been producing graphite electrodes since 1886 and dominates the market with 26% market share. Ucar’s carbon electrodes have a similar function to the graphite electrodes, but are utilized in submerged arc furnaces. The main difference between submerged arc furnaces and electric arc furnaces is that submerged arc furnaces are loaded with raw materials such as quartz, wood, charcoal and ores, and have a chemical component to their melting process. Submerged arc furnaces are used in the production of molten metals such as silicon, phosphorous and ferroalloys. Another key product in the GPS segment is Ucar’s Cathodic systems. In 1997 acquired a majority share in Carbone Savoie, a division of Pechiney, which supplies a third of the world’s requirements for graphite and carbon cathode blocks. These graphite and carbon cathode blocks are primarily used as lining for furnaces that smelt aluminum. GPS’s products as a whole comprise approximately 80% of sales.

The AET segment houses Graftech, a wholly owned subsidiary that sells Ucar’s flexible graphite products. Flexible graphite is made from natural graphite and is used in gaskets and for other sealing purposes. Recently Graftech has been developing flexible graphite products that can be used for applications in fuel cells, thermal energy management, and fire protection industries. The product line of flexible graphite products includes: Grafcell(for fuel cells), Grafoil(developed in 1970’s as a replacement for asbestos insulation used in internal combustion engines), Grafguard (fire retardant), Grafshield (heat shield), and eGraf (solutions for thermal buildup in electronic devices). Supplying key parts required by fuel cell power generation poses a growth opportunity for Graftech, albeit it is not immediate, but nevertheless it exists as an opportunity that could come to fruition over the next few years depending upon the commercialization of fuel cells. Graftech has entered into long-term supply agreements with Ballard Power Systems (BLDP). Graftech is the exclusive developer and supplier for a vital material required by proton exchange membrane (PEM) fuel cells such as Ballard’s Mark 900 fuel cell stack. UCAR has been actively working with BLDP for over 9 years. The Graphite Specialties business creates hundreds of graphite products for applications in industries requiring a material that can withstand high temperature and hostile environments including aerospace, semiconductor, power storage, and several other industries. As a whole, the AET segment constitutes approximately 20% of sales.

Investment Thesis:

There are three factors that will support the alignment of Ucar’s market value with its intrinsic value: 1) fruition of the cost cutting initiatives; 2) recognition of the shareholder value added by the Graftech subsidiary; and 3) deleveraging of the balance sheet. Over the past few years, Ucar’s management has focused on a broad cost cutting plan, and has been exceeding their announced targets. Clearly, the cost cutting initiative is an excellent response to the economic conditions impacting Ucar’s customers, however, the longer-term benefits of the project must also be acknowledged. Since the savings from this initiative are permanent on-going cost savings, they have the ability to substantially improve Ucar’s margins in the future. For example, Ucar’s recent facility relocations will lower cost per ton of graphite electrode by $100/t going forward. Continued success of the cost cutting plan combined with a higher capacity utilization from the steel industry could enhance Ucar’s earnings power to approximately $1.50 a share (conservatively).

While, I do not anticipate that Ucar shareholders will realize a benefit from Grafttech in the near term, it is important to note that when Ballard took a 2.5% stake in June 2001 the Graftech subsidiary was valued at $200m. I believe that Ucar’s current public market valuation of $450m creates an inconsistency that value investors can capitalize upon, given that Ucar’s GPS segment historically contributes approximately 80% of sales, while the AET segment contributes 20% of sales but is currently not adding to profitability. Ucar’s Management has repeatedly expressed an interest in exploring financial alternatives to try and unlock the value that the Graftech subsidiary provides to shareholders via a spin-off. The spin-off is certain as an S-1 was already filed for Graftech, but given the market conditions Ucar’s management elected to postpone the IPO. The Graftech subsidiary alone is worth at least $2.00 per share, which is equivalent to an 11 times EBITDA multiple, or a 3 times Sales multiple. This 3x sales multiple is clearly justified considering that Ballard Power (BLDP), Fuel Cell (FCEL), and Plug Power (PLUG) trade at respective price to 2002 sales multiples of 40x, 35x, and 8.5x.

Ucar’s management team has placed debt reduction on high priority, and plans to reduce debt to $550m by 2002.
Management’s commitment to deleveraging the balance sheet is demonstrated by the reduction in net debt from $702m at the end of 1999 to $636m at the end of the third quarter of 2001. Investors should continue to benefit from the debt reduction, which has been able to persist despite the decline in sales.

Earnings estimates have been drastically decreased for Ucar due to the difficult economic environment, and the tribulations affecting the steel industry. If the economy improves estimates could be substantially revised upwards. Furthermore, I conservatively estimate Ucar’s intrinsic value to be approximately $13.00 per share. My estimate of Ucar’s intrinsic value was derived based on the following assumptions:

1) Economic rebound, and steel industry demand/capacity utilization
improve in 2002, with the bulk of the improvement occurring in
2003.
2) Cost cutting initiative achieves 50% of its goals
3) Excluding accretion from the spin-off of Graftech
4) Excludes potential gains from litigation against parents
5) Includes reasonable estimates for potential future charges
relating to anti-trust litigation against Ucar

At current price levels of roughly $8.50 per share, the stock market has overreacted to Ucar’s debt levels and the steel industry’s misfortune creating a 40% disparity. Based on my estimate of $59m in free cash flow for 2001, and 56m shares outstanding, Ucar has about $1.00 in free cash flow per share. At a price to free cash flow of 7.5x on my estimates for this year, Ucar’s current valuation creates an attractive investment opportunity. Additional valuation and liquidity measures can be found at the end of this report.

Risks:

There are four primary risks that threaten the aforementioned investment thesis: 1) macroeconomic conditions; 2) hefty leverage, 3) outstanding litigation and 4) deployment of capital to higher growth businesses. The persistence of the global recession through 2003, could pose a liquidity problem for Ucar. Furthermore, if steel customers abroad begin to experience the same kind of mortality rate that United States steel firms have recently, could adversely impact Ucar as the majority of its sales are to firms abroad. Fortunately, Ucar does not have much exposure to many of the steel companies that have gone into bankruptcy in the United States.

Clearly, with a debt to equity ratio of 1.43, and debt to EBITDA of 4.6x, Ucar is a highly levered company that is heavily dependent on the health of the steel mini-mill industry. Certainly, until steel demand and capacity utilization rebound, Ucar will not experience a ramp in demand for their GPS products. Therefore, insolvency should be further examined as a risk factor as the slump in demand continues. However, Ucar’s recent debt reorganization and establishment of large credit lines should provide some cushion over the next few quarters.

Essentially, Ucar’s has two current outstanding legal issues: 1) litigation against its former parents: Union Carbide and Mitsubishi; and 2)the antitrust cases against Ucar. In the $1.5B litigation against its former parents Ucar argues that in connection with its 1995 equity recapitalization its former parents breached their fiduciary duties. Ucar has already taken a $350m charge as a reserve for estimated potential liabilities in relation to its antitrust activities. In April 1998, Ucar pled guilty to a one-count charge of violating US antitrust law in connection with the sale of its graphite electrodes, and was sentenced to pay a fine of $110m. Fortunately, through December 31, 2000 $244m of fines, settlements and interest was paid out leaving $106m to pay out based on the prerecorded $340m charge. The April 1998 guilty plea could have detrimental implications during the course of further future prosecutions concerning its price fixing of the graphite electrodes.

While the company has promised to pay down debt and has been acting on this promise, the company has also expressed an interest to deploy free cash in its higher growth AET segment. If the AET segment is, if fuel cells are not embraced as quickly as they have anticipated growth may not be as robust as management expects.

Warren Buffet once reflected upon his ownership of Gillette, “I can always sleep each night knowing there are 3 Billion males in the world who will need to shave when they wakeup.” Similarly, the Ucar shareholder is gratified that after a 9-hour slumber he can awake knowing that there are approximately 2000 electric arc furnaces in the world that will need to consume an additional graphite electrode.


MKT CAP $472
CASH $20
DEBT $636
--------------------------------
EV $1,088



Valuation Metrics:
($mm) 2001 ------------ 2002
EPS $0.47 $0.55
EBITDA $138.7m $141.7m
CFLO $32.5 $36.9
FCF $60 $76

EV/Sales 1.7 1.6
P/FCF 7.49x 5.9x
P/E 17.0x 14.4x
EV/EBITDA 7.84 7.68
P/B N/A N/A

Interest Coverage 1.6x 1.7x
Debt to EBITDA 4.6x 4.5x

D/E 1.43

Catalyst

Catalysts:
- Deleveraging of balance sheet.
- Spinoff of Graftech
- Rebound in Steel demand / prices / capacity utilization
- Fuel Cell commercialization
- New contracts for the AET segment