A multiple of one

Why I bought GrafTech shares

Published on:
December 7, 2019
Reading Time: 13 Minutes
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The first part of this essay is a description of GrafTech (EAF on Nyse), a manufacturer of graphite electrode and petroleum coke. I kept this part objective, stating facts and not my opinions.  But the second part is subjective. Here I give reasons why I bought GrafTech's common stock.

GrafTech's business

You can tell that GrafTech's company is manufacturing something (more on that 'something' below) by glancing at the property, plant, and equipment account (PP&E).

PP&E of $689 million represents about a third of the balance sheet. It is $67 million in the value of buildings, $46 million in land and $532 million in machinery. It short, pp&e shows that GrafTech makes stuff.  

Specifically the company makes graphite electrodes which is a small-but-integral part of the steel manufacturing process. Graphtech's customers are steel companies. In Graphtech's words:

"Graphite electrodes are an industrial consumable product used primarily in EAF steel production, one of the two primary methods of steel production and the steelmaking technology used by all "mini-mills."  

Here is how Brookfield that boughtGrafTech in 2015, describes electrodes graphite:

"Electrodes graphite are 10 to 12 inches in diameter and can be up to nine feet long. They can take up to six months to manufacture, in a multistage process that requires significant technical skill and raw material known as petroleum needle coke. Graphtech is the only graphite electrode produce able to produce its needle coke, a significant competitive advantage."

Graphtech's five plants are in Mexico,Pennsylvania [1], Texas, Brazil, France, and Spain. The company;s headquarters are in Brooklyn Heights, Ohio. It also leases five locations, mainly for sales.  

While GrafTech does not itemize the depreciation expense in the income statement, it is worthwhile data to go over. The total depreciation expense was $131 million in the past three years.

During this 3-year period, the total capital expenditures were precisely $131 million, too. So if you belong to the group of investors that follow the magic formula investing [2], you would be pleased to see in GrafTech a business that requires hardly any capital improvements.

GrafTech Key Operating Metrics 2018-2017
GrafTech Key Operating Metrics 2018-2017. Source: Public filings.

The table above shows that GraphTech had a dramatic revenue increase in 2018, largely the result of the electrode graphite prices increases. (Also, bottom line benefitted from some operational efficiencies.)

The weighted realized price for electrode graphite was $9,937 in 2018 compared to $2,945 in 2017. The company produced 185 million tons of it in 2018 compared to 172 million in 2017. Now let's look at 2019.

The price of electrode graphite is up threefold. The price was $9,937 in 2018 compared to $2,945 in 2017.

Over the past three quarters of 2019, GraphTech showed high operating margins. The average realized price for electrode graphite was $9,976; the average operating margin was 56%, with an average net income margin of 41%.

I estimate the company will report in 2019 an annual revenue of $1,800 million in revenue and earnings of $767 million, roughly $2.5 to $3.0 per share.

"Change is the law of life," former U.S. President John F. Kennedy once said. "And those look only to the past or present are certain to miss the future." In the case of Graphtech, we have to look at future earnings.

GrafTech cumulative profits until 2022
GrafTech cumulative profits until 2022. Source: Public filings.

On page 45 of GrafTech's annual report which you can download here, GraphTech shows future contracts  of 674,000 million ton of electodes graphite at about $10,000 per MT. These contracts represent about 65% of the planned capacity. Graphtech writes:

"We have executed three- to five- year take-or-pay contract, representing approximately 674,000 MT, or approximately 60% to 65% of our cumulative expected production capacity from 2018 through 2022. Approximately 90% of the ocntracted volumes have terms exending to 2022.

Electric arc furnace versus basic oxyen furance

There are two ways to make steel, the electric arc furance (EAF) method and basic oxygen furnace (BOF) method.

This is how EAF looks like: 

This is how BOF looks like this: 

GraphTech writes: "In the EAF method, steel scrap is melted and recycled to produce liquid steel, while in the BOF method, virgin iron ore is smelted with metallurgical coke, a carbon product derived from metallurgical coal."

GrafTech's competitive advantage

Graftech is a low-cost producer. In my view, it cost the company about one-fourth to produce the produce compared to its peers. To be a low cost producer is always good, it is even better in a tight marketplace, where the top five electrode graphite companies [3] of the world hold over 80% of total production.

GrafTech is a low-cost produce because the company is  the only vertically integrated electrode manufacturer. Which means they control the price of needle coke, the main ingredient behind electrode graphite.  GraphTech writes on page 10 of the 2018 annual report: 

"Seadrift provides a substantial portion of our petroleum needle coke supply needs internally and at a competitive cost and allows us to maximize capacity utilization more efficiently than
competitors, who may be more constrained by petroleum needle coke supply."

GrafTech's peers

GrafTech has direct and indirect competitors. The direct competition is the four companies mentioned above. With these  companies, GrafTech competes in production capacity, the price of the product, and the cost to produce the product.

The indirect competition to GraphTech business is the BOF steelmaking. While the difference between the steel manufacturing method is probably only exciting to students of mechanical engineering, for this essay suffice to note that if BOF manufacturing decreases, then EAF manufacturing increases. And if EAF manufacturing increases, GraphTech benefits.

If BOF manufacturing decreases, then EAF manufacturing increases. And if EAF manufacturing increases, GraphTech benefits.

That, at least, has been the historical case. According to the steel statistical yearbook, produced by the World Steel Association, Between 1984 and 2011, EAF steelmaking was growing at 3.5% per year. But this trend was reversed between 2011 and 2015 because of an increase in blast furnace (BOF) steel production. China was the culprit.

Write to me if you would like a detailed description of the dynamics in the steel industry.

The steel industry's gloomy outlook

Value Line ranks the steel industry in 91 of 97 possible ranks. ( Why I read Value Line reports.) According to Value Line, you can't find any worse businesses to invest in over the next few years.

An illustration: here is how much you would have lost if you bought five years ago any of the following steel companies:

AK Steel Holdings loss was 69%; Posco loss was 42%; Timmenksteel loss 83%; and U.S. Steel loss was 53%. (If you want to spot a liar, ask someone at a party if they made money on steel stocks over the past few years.) 

Because of the reported declines in both revenue and earnings by practically all publicly traded steel companies, the outlook for the steel industry is now gloomy. Paraphrasing Howard Marks [4], there is too much steel chasing too few manufacturers.

There is too much steel chasing too few manufacturers.

"The main question is the long-term outlook for the company," writes Sven Carlin. "As the main product is steel, electrode prices will depend on steel prices and demand for it, especially for EAF steelmaking." 

Earnings will determine GraphTech's future value. We can divide GrafTech's profits on (1) growth in the electrode industry, (2) the price of graphite electrode, (3) the production capacity, (4) the competitiveness, and (5) the cost to produce the product.

Why I bought GrafTech

At a market capitalization of about $3,500 million, GraphTech is trading a multiple of one. As I wrote in the first section of this essay, I estimate GraphTech will report to shareholders of $1,800 in revenue and of $767 million in earnings for 2019.

And since GraphTech sold 674,000 million tons at $9,937 per MT, we can estimate total revenue of $6,700 million and earnings of $2,814 million by 2022.  Adding $767 million and $2,814 million, we find $3,851 million in profits by 2022.

A p/e of one for a company whose 2018 operating margin was 49% and net profit margin was 45%  seemed nonsensical to me.

Write to me if you would like a detailed analysis of GraphTech's valuation analysis.

Careful readers of GraphTech's annual report will see that between 2008 and 2017, the price for electrodes graphite was $4,500, and during the worse year (2016), the price was $2,500 per MT. Mr.

At about $10,000 per million ton, Graphtech's margins are high. But the operating margins are reasonable at $5,000 per MT, too.

At about $10,000 per million ton, GraphTech's margins are high. But the  margins are reasonable at $5,000, too.

There are also reasons to believe of growth. The first reason is that China will export less steel. In 2019, for example, it exported between 4 to 6 million tons of steel per month. But in 2015, in comparison, China exported about twice as much, between 6 to 10 million tons of steel per month.  

There are two other factors, which I cannot estimate their effect numerically. The first factor is the price of needle coke may jump in the near term as a result of the growth in electric vehicles (EV) sales [5].

And the growth in the EV industry is clear. Five years ago lithium-ion batteries production was 1,00 million tons. And last time I cheked it was 60 times as much, about 60,000 million ton.  

The growth in the EV industry is clear. For example, make lithium-ion batteries was 1,00 million tons. In 2017, it was 60 times as much, 60,000 million ton.  

In short, GraphTech's current valuation and future growth possibilities were enough for me to buy the stock.

Postscript

A reminder for new readers: my goal in writing is to share thoughts. None that was said above should be construed as investment advice.

Also, this essay is incomplete; there are many important topics I left out. Among them: Graphtech's management and compensation structure, why Brookfield purchased GraphTech, a detailed analysis of the risks ahead, a peer-company review, and a valuation analysis.

If you find any of the above topics of interest, write to me. I reply to emails within a day.

FOOTNOTES: [1] The facility in St. Mary's is warm-idles according to GrafTech. [2] Magic formula investing an investment technique outlined by Joel Greenblatt which puts emphasis on companies with high return on capital. [3]  These five companies are Showa Denko K.K., GrafTech, Graphite India Limited, Tokai Carbon Co., Ltd., and HEG Ltd. [4] For more information, read his 2018 memo titled The Seven Worst Words in the World. [5]  The EV industry uses needle coke for the production of lithium-ion batteries.