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EAF - GrafTech


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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.

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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.

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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?

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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.

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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.

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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.

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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.

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  • 4 weeks later...

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.

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The dividend is some of it. Also remember that this trades with China and steelmaking (very high correlation to Iron Ore and Met Coal, even though those aren't used in EAF steelmaking...), and it has a very low float so it's easily pushed around.

 

I think it's a bargain here, but it's a large enough position for me so I'm not going to add more just for risk control reasons.

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It's so cheap it makes you completely doubt your thesis...on the Massif capital numbers, next 5 year contracted FCF is 62% of current EV? Nevermind any kind of terminal value or the other third of the business (going to 25% once management puts new take-or-pay contracts in place) that is still very healthy but based on spot prices.

 

Makes you wonder how Brookfield is going to sell down - my best guess is that they have a $20 floor price on any future selldowns they do.

 

 

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Who knows what's Brookfield's game plan is on this one, but they are motivated to see this trade well.

 

I've bought some more for the possible bump back, because the only real risk is that their customers cannot pay and there's a liquidity issue with the company because they do have a decent chunk of debt.

 

 

 

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I have the trading down to the float. I think the market is just missing the cash flow story and management sort of shot itself in the foot the last conference call.

 

As for BAM's strategy, look at the buyback vs. dividend decision. Secondaries above $20, dividends to release cash without BAM selling their stake below $20. I think that outlines what they think intrinsic value is fairly clearly.

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The secondary at $20 is very telling of what they think the value is.  Granted, if you own a very large chunk of a company, you manage position size and start selling earlier than if you owned a 2% position or just a smaller % of the entire company. 

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So this is selling below the IPO price now?

 

In the VIC write up, comments section, somebody mentioned that those take-or-pay contract cannot always be forced and has room to negotiate. Is this true?  (Somehow I can only view part of the comments in VIC, not all).  I think this is  critical because the contracted revenue is basically where the margin of safety is.

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So this is selling below the IPO price now?

 

In the VIC write up, comments section, somebody mentioned that those take-or-pay contract cannot always be forced and has room to negotiate. Is this true?  (Somehow I can only view part of the comments in VIC, not all).  I think this is  critical because the contracted revenue is basically where the margin of safety is.

 

Based on what I have seen with drilling rigs, contracts ended up sometimes not getting enforced and renegotiation was occurring. I am guessing it depends on the balance of power between the customer and the supplier, the financial health of the customer (if he can’t pay, he won’t) and how the contracts are written. For example with Chinese customers, I always would be worried about them just bailing out, if they are unfavorable. Then they have to be sued  in a chinese court - good luck!

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So this is selling below the IPO price now?

 

In the VIC write up, comments section, somebody mentioned that those take-or-pay contract cannot always be forced and has room to negotiate. Is this true?  (Somehow I can only view part of the comments in VIC, not all).  I think this is  critical because the contracted revenue is basically where the margin of safety is.

 

Based on what I have seen with drilling rigs, contracts ended up sometimes not getting enforced and renegotiation was occurring. I am guessing it depends on the balance of power between the customer and the supplier, the financial health of the customer (if he can’t pay, he won’t) and how the contracts are written. For example with Chinese customers, I always would be worried about them just bailing out, if they are unfavorable. Then they have to be sued  in a chinese court - good luck!

 

Well if the thesis was based on contracted cash-flow without any consideration to quality of the business, then it may not be prudent to invest in such an idea. What I see with Graftech is that it is a business that it is a high-quality and defensive business. The spot price is already 50% above the contract price, and typically, prices go down by 50% during a recession.

 

In order for Graftech to not make a net income, conservatively, spot price has to be at ~$4500.00. While the contracted price is ~10 000.00 (where they make ~40%+ net profit margin), and current spot prices are around ~$15K. So if a 50% decline does come, then it does not affect Graftech. This does not factor any future growth.

 

Lastly, Graftech does not supply to China.

 

However, Spekulatius is right in a way that contract for the most part is enforceable, when there's an ability to fulfil one's obligation, but once the ability is gone, then... it's a different story.

 

My fear is the debt, where cash-flow required for the liabilities may not be sufficient during a down-turn. Hence, the position-sizing.

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1) Less than 5% of EAF steelmaking costs are electrodes. It is highly unlikely that the costs of these things will force a customer out of business.

 

2) Keeping plants open is often more profitable than closing them.

 

3) EAF has said that there are no reopeners on contracts, so there is no renegotiation available until the contracts roll over.

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1) Less than 5% of EAF steelmaking costs are electrodes. It is highly unlikely that the costs of these things will force a customer out of business.

 

2) Keeping plants open is often more profitable than closing them.

 

3) EAF has said that there are no reopeners on contracts, so there is no renegotiation available until the contracts roll over.

 

Any chance you looked at how their Accounts Receivable works? I'm not really concerned about steelmakers ability to stay open, but rather their ability to pay on time during a downturn, which can have a domino effect, especially when it comes time to pay bills, and payroll. 

 

 

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1) Less than 5% of EAF steelmaking costs are electrodes. It is highly unlikely that the costs of these things will force a customer out of business.

 

2) Keeping plants open is often more profitable than closing them.

 

3) EAF has said that there are no reopeners on contracts, so there is no renegotiation available until the contracts roll over.

 

Any chance you looked at how their Accounts Receivable works? I'm not really concerned about steelmakers ability to stay open, but rather their ability to pay on time during a downturn, which can have a domino effect, especially when it comes time to pay bills, and payroll.

 

Seems AR is net 30 to 120, but what's interesting is that their AR only increased by 76%, when revenues went up 280%.

 

On a completely different note, not sure why the stock got killed because of the Vertical Group Report last month. Even if 91,000 MT in additional capacity comes in, which increases supply by 14%, I fail to see how it will reduce the value of Graftech by almost half.

 

 

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Bear market. People sell everything out of fear. Fundamentals no longer part of the equation.

 

Listening to many managers on TV, they all try to hide somewhere and almost all expect a bad economy in 2019. It now pays to be negative as they all have had a bad 2018 and their clients are not or will not be happy.

 

I don't own this stock but, I will be doing some research on it as it looks interesting.

 

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