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Edited Transcript of EAF earnings conference call or presentation 31-Jul-19 2:00pm GMT

Q2 2019 GrafTech International Ltd Earnings Call

PARMA Aug 5, 2019 (Thomson StreetEvents) -- Edited Transcript of GrafTech International Ltd earnings conference call or presentation Wednesday, July 31, 2019 at 2:00:00pm GMT

TEXT version of Transcript

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Corporate Participants

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* David J. Rintoul

GrafTech International Ltd. - President, CEO & Director

* Meredith H. Bandy

GrafTech International Ltd. - VP of IR and Corporate Communications

* Quinn J. Coburn

GrafTech International Ltd. - VP, CFO & Treasurer

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Conference Call Participants

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* Alexander Nicholas Hacking

Citigroup Inc, Research Division - Director

* Arun Shankar Viswanathan

RBC Capital Markets, LLC, Research Division - Analyst

* David Francis Gagliano

BMO Capital Markets Equity Research - Co-Head of Metals & Mining Research and Metals & Mining Analyst

* Michael F. Gambardella

JP Morgan Chase & Co, Research Division - MD, Head of Global Metals & Mining Equity Research and Senior Analyst

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Presentation

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Operator [1]

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Good morning. My name is Shelley, and I will be your conference operator today. At this time, I'd like to welcome everyone to the GrafTech Second Quarter 2019 Financial Results Conference Call. (Operator Instructions) Thank you. Meredith Bandy, Vice President of Investor Relations, you may begin.

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Meredith H. Bandy, GrafTech International Ltd. - VP of IR and Corporate Communications [2]

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All right. Thank you, Shelley, and good morning, and welcome to GrafTech's Second Quarter Conference Call. On the call with me today is GrafTech's Chief Executive Officer, Dave Rintoul; and Chief Financial Officer, Quinn Coburn.

Turning to our first slide. As a reminder, some of the matters discussed on this call may include forward-looking statements regarding, among other things, results, performance and strategies. These statements are based on current expectations and are subject to risks and uncertainties. Factors that could cause actual results to differ materially from those indicated by forward-looking statements are shown here. We'll also discuss certain non-GAAP financial measures, for which you will find reconciliations in these slides. The slides are posted on our website at www.graftech.com in the Investors section. For your reference, a replay of the call will also be available on our website.

Now I'm pleased to turn the call over to Dave.

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David J. Rintoul, GrafTech International Ltd. - President, CEO & Director [3]

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Thank you, Meredith, and good morning, everyone. I'll begin the call with a discussion of our safety performance, second quarter highlights and an industry overview. Quinn Coburn will then cover financials and capital allocation. I will conclude our prepared remarks and then open the call to questions.

First, let me begin with safety. Safety is at the core of all we do and is absolutely essential to the success of an organization. Our year-to-date total recordable injury rate has improved to 1.07, a 29% improvement from the prior year. I'd like to take this opportunity to thank the team for all their hard work to achieve that improvement. At the same time, our focus must and will remain on reaching our ultimate goal of 0 injuries, that means every worker going home safely every day.

Turning to Slide 4. GrafTech delivered another solid set of results, including second quarter net income of $196 million or $0.68 per share and adjusted EBITDA from continuing operations of $284 million. Q2 net sales increased by 5% to the prior year, driven by higher volumes and price.

As expected, Q2 costs were higher than the prior year quarter due to higher third-party needle coke pricing. As many of you know from following our customers' steel production and therefore associated graphite electrode demand, there has been some slowing in several regions, most notably Europe. Spot graphite electrode pricing continues to drift somewhat lower, although it still remains at healthy levels.

As a reminder, the majority of GrafTech's volumes are sold on long-term contracts, which help reduce the volatility of our earnings and preserve margins. We are able to offer these stable long-term contracts, thanks to our vertical integration into petroleum needle coke, our primary raw material, which is currently in short supply.

Our wholly owned Seadrift facility produces about 2/3 of our petroleum needle coke needs. Our previously announced efficiency improvement project at Seadrift was completed on time and on budget and is currently ramping up production.

Turning now to Slide 5. The vast majority of our electrodes are sold to the growing EAF market. EAF steel production is advantaged in terms of cost structure, capital intensity and environmental efficiency. Global EAF make up almost 29% of steel production and that share is expected to grow over time. At the high end, EAF makes up nearly 70% of North American steel production. China produces roughly half the world's steel with just 12% of Chinese steel produced via electric arc furnace. The Chinese government has set a target to reach 20% EAF production by 2020.

On to Slide 6. According to the World Steel Association, near-term production growth is expected to be positive, but is moderating in some key regions. Year-to-date steel production growth in North America, the Middle East and Africa has been offset by softening in Europe and South America. In The United States, steelmakers have announced electric arc furnace capacity additions, representing a potential 15% to 20% increase in U.S. graphite electrode demand by 2022.

Needle coke is expected to remain in high demand for both graphite electrodes and electrical vehicle battery anodes. The International Energy Administration (sic) [International Energy Agency] expects the number of electric vehicles on the road to grow from about 3 million in 2017 to more than 50 million by 2025, assuming current and announced policies.

As the use of needle coke in EV batteries continues to grow, we're very pleased to have our own high-quality secure supply from our Seadrift petroleum needle coke facility. This competitive position differentiates us from our competitors and gives us a secure, low-cost, high-quality supply of petroleum needle coke.

Moving on to Slide 7. As a reminder, GrafTech has over 70% of our 2019 production capacity sold under long-term take-or-pay contracts. These contracts provide profitability and visibility of earnings. I'll now turn it over to Quinn on Slide 8 for more details on our financial results.

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Quinn J. Coburn, GrafTech International Ltd. - VP, CFO & Treasurer [4]

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Thanks, Dave. As Dave mentioned, we're pleased to report another strong quarter of financial performance. Second quarter net sales of $480 million were up from Q2 2018 on higher sales volume and higher pricing.

During the quarter, we sold 45,000 metric tons of graphite electrodes, up 7% from prior year period due to the benefits of our debottlenecking. Capacity utilization is expected to average approximately 90% for the full year.

GrafTech's second quarter average realized price was slightly over $10,000 per metric ton, slightly above the prior quarter. We're moving towards more general pricing disclosure for competitive reasons, but we'll continue to provide indications of price in future quarters.

Approximately 79% of our second quarter net sales were to customers with long-term agreements.

Turning to Slide 9 for financial results. Second quarter 2019 net income totaled $196 million or $0.68 per diluted share. Q2 2019 adjusted EBITDA from continuing operations was $284 million. Compared to the prior year quarter, EBITDA results driven by higher sales were offset by higher raw materials cost, specifically related to third-party needle coke costs. These higher third-party needle coke costs continue to impact cost of sales. Only 1/3 of our costs are impacted by third-party needle coke costs, and we continue to benefit from vertical integration with our Seadrift facility.

We estimate that increased third-party needle coke costs will increase our Q3 2019 cost of sales by approximately $6 million compared to Q2 2019.

Second quarter 2019 free cash flow decreased to $188 million due to timing of working capital changes. Q2 shipments were weighted towards the latter part of the quarter, resulting in higher accounts receivable for the quarter.

Turning to Slide 10. There were no meaningful adjustments to EBITDA in the quarter. I'll quickly walk you through the EBITDA reconciliation. We began with $196 million of net income, add back $15 million of depreciation and amortization, add back $32 million of net interest expense and $38 million of GAAP income taxes. Finally, add back other adjustments of just $3 million, the largest of which was less than $1 million related to pension and OPEB plan expenses, for a total adjusted EBITDA from continuing operations of $284 million.

Now turning to Slide 11. GrafTech has a strong track record of shareholder returns. In the past 12 months, GrafTech has generated nearly $0.75 billion of free cash flow, of which about 70% has been returned to shareholders. Our trailing 12-month capital allocation includes $181 million in debt repayment, $99 million in regular quarterly dividends, $225 million of share repurchases and a $203 million special dividend.

Now turning to Page 12. Our continued solid results enable us to balance capital reinvestment, debt repayment and returns to shareholders. 2019 capital expenditures are expected to be between $60 million and $70 million, in line with our previous outlook and similar to last year. Our focus is on operational improvements to maintain the productivity, quality and cost position of our asset base. We repaid $125 million of debt in Q1 of 2019, and we expect to prepay additional debt in the second half of 2019, working towards a long-term capital structure consistent with the nature of our business.

As discussed last quarter, our target is to return approximately 50% to 60% of 2019 free cash flow to shareholders.

Yesterday, we announced our regular quarterly dividend. This morning, we also announced that our Board has authorized the repurchase of up to $100 million of common stock on the open market. At today's share price -- or at recent share price, that equates to approximately 15% of public float. Share repurchases are highly accretive to all shareholders and a tax-efficient distribution.

I'll now turn it back to Dave on Slide 13.

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David J. Rintoul, GrafTech International Ltd. - President, CEO & Director [5]

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Thanks, Quinn. In summary, GrafTech is a leading provider of highly engineered graphite electrode services solution and products to the growing EAF steel market. We delivered another solid quarter result of Q2 2019, and we continue to execute our strategy to deliver long-term sustainable value. Ongoing operational improvements and vertical integration give GrafTech economies of scale and a competitive cost structure. This, in turn, enables us to offer secure long-term contracts to our customers and strong earnings visibility.

That concludes our prepared remarks. We'll now open the call up for questions.

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Questions and Answers

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Operator [1]

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(Operator Instructions) Your first question comes from the line of David Gagliano from BMO Capital Markets.

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David Francis Gagliano, BMO Capital Markets Equity Research - Co-Head of Metals & Mining Research and Metals & Mining Analyst [2]

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Just to drill down on a couple of topics real quickly here. First of all, I think you said 79% of sales in the second quarter were to contract customers. So I think that implies about 9,500 tons of spot sales. If we do the math on the implied spot price, we're coming up with about $10,800 a ton in the second quarter, but we're making some assumptions to get to that number. So my question is, is that a reasonable estimate for your average spot price for the second quarter?

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David J. Rintoul, GrafTech International Ltd. - President, CEO & Director [3]

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Yes. Your mathematics are within a reasonable margin of error.

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David Francis Gagliano, BMO Capital Markets Equity Research - Co-Head of Metals & Mining Research and Metals & Mining Analyst [4]

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Okay. And then my other question. This is the second consecutive quarter where production came in ahead of sales. So I have a two-part question. Number one, can you just talk us through why that's happening? And number two, should we expect that to reverse in the upcoming quarters?

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Quinn J. Coburn, GrafTech International Ltd. - VP, CFO & Treasurer [5]

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Yes. So David, one of the things we noted in our comments is that we expect our full year capacity utilization to be approximately 90%. And so I think even in the second half, obviously, we haven't given guidance on sales, but you can kind of see what our expected production is in the second half using that number.

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David Francis Gagliano, BMO Capital Markets Equity Research - Co-Head of Metals & Mining Research and Metals & Mining Analyst [6]

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Okay. But my question was -- okay, I appreciate that, that's helpful, actually. But the question really was about the difference between production and sales in the second quarter and in the first quarter. Why is that happening? And then the second question is, you gave us a good sense just now on the utilization rates, obviously, on the production side. Should we expect inventories to come down in the second half of the year?

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Quinn J. Coburn, GrafTech International Ltd. - VP, CFO & Treasurer [7]

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Sure. So first half of the year, clearly, we produced about 5,000 tons more than we need. Demand was slightly less than we anticipated in the first half of the year. Obviously, our objective here would be to align our sales and -- our production in the second half with our sales, that would be clearly the objective. We would not be intending to overproduce on an ongoing basis.

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David J. Rintoul, GrafTech International Ltd. - President, CEO & Director [8]

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I think there'll be some product mix issues that come into play in the second half that will also assist with some of that rebalancing, but Quinn's comments are correct relative to efforts to make sure that our inventory numbers don't climb.

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Operator [9]

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Your next question comes from the line of Alex Hacking from Citi Research.

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Alexander Nicholas Hacking, Citigroup Inc, Research Division - Director [10]

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So I guess the first question was just around the utilization guidance, you mentioned 90%. I think previously you had talked about mid-90s for the year, if I remember correct. So would we be fair in assuming that you're sort of balancing out sales with where you see demand and pulling back production a little bit, similar to what we've seen some of the electrode producers in Japan do?

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David J. Rintoul, GrafTech International Ltd. - President, CEO & Director [11]

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Yes. I think -- Alex, I think that's a fair representation.

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Alexander Nicholas Hacking, Citigroup Inc, Research Division - Director [12]

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Okay. And then just -- I guess just looking at the market, one of the things that the Japanese producers talked about was that there was too much inventory out there right now, especially in Asia. Is that something that you're also seeing in -- potentially seeing in U.S. and Europe, is a little bit too much inventory through the supply chain?

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David J. Rintoul, GrafTech International Ltd. - President, CEO & Director [13]

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So I think as -- to my earlier comments, there are pockets of the steel manufacturing economy that have performed well so far this year. There are other pockets in different geographic locations that had a bit more difficulty. And so I think it's fair to say in some of those areas that have struggled, there is a bit of inventory. And I think that's thanks to, if you think back to last year in 2018, and there was somewhat of a gross undersupply into the market and things were so tight that people bought whatever they could. And so if 1 ton of electrodes during '18 was good, if they could get their hands on 2, that was even better. So there was some inventory build, I think, throughout the system. And in some of the areas where the economy has gone sideways a bit, that build is a little larger. So I think as the manufacturing sector globally continues to move along, we'll see some of that inventory work through. But as I said, yes, there are in some areas inventory builds.

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Operator [14]

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Your next question comes from the line of Michael Gambardella from JPMorgan.

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Michael F. Gambardella, JP Morgan Chase & Co, Research Division - MD, Head of Global Metals & Mining Equity Research and Senior Analyst [15]

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Congratulations on the quarter.

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David J. Rintoul, GrafTech International Ltd. - President, CEO & Director [16]

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Thank you.

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Michael F. Gambardella, JP Morgan Chase & Co, Research Division - MD, Head of Global Metals & Mining Equity Research and Senior Analyst [17]

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Your second quarter EBITDA margin is around 59%, equivalent with first quarter as well. If you look at where the stock is trading based on just the first half annualized, you're looking at something -- somewhere around 4.5, 5x PE. And you have a very defensible position in terms of your cash flow, in terms of the integration with Seadrift and also your contract business. How do -- with all that, obviously, the stock is very cheap, in my opinion, but how do you balance the capital allocation given the relatively small float in the stock? Obviously, the share repurchase comes out, the shares are very cheap. But have you balanced that with the size of the float?

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Quinn J. Coburn, GrafTech International Ltd. - VP, CFO & Treasurer [18]

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Yes. It's a great question, Mike. Previously, we would not repurchase shares on the open market in order to maintain a healthy public float and good liquidity in the stock, but recent prices, given our cash flow yield, as you know, we do think that the share repurchase is a very attractive use of our free cash flow, and we're willing to trade off some liquidity for the benefits of the share repurchase and the accretion from the share repurchase.

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Michael F. Gambardella, JP Morgan Chase & Co, Research Division - MD, Head of Global Metals & Mining Equity Research and Senior Analyst [19]

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Okay. Is there a possibility of going private again?

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David J. Rintoul, GrafTech International Ltd. - President, CEO & Director [20]

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Goodness gracious, not that we're aware of. That's all we can say to that question.

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Operator [21]

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And your next question comes from the line of Arun Viswanathan from RBC Capital Markets.

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Arun Shankar Viswanathan, RBC Capital Markets, LLC, Research Division - Analyst [22]

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My first question, I guess, is along the same lines. Maybe you can just give us your thoughts on the level of capital return and your optimal level there? By our math, it looks like you'd be generating a fair amount of free cash flow this year, probably north of $800 million. So how would you allocate that? And is there any desire to potentially do a special dividend or even greater buybacks?

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Quinn J. Coburn, GrafTech International Ltd. - VP, CFO & Treasurer [23]

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Sure, Arun. So as we've indicated this quarter in the script, kind of the key metric is that we look to return 50% to 60% of the cash to shareholders. And the remainder will be used for debt repayment. With regards to debt repayment, we had $125 million in the first half. We expect to have additional prepayments in the second half. But with regards to the 50% to 60%, we feel good about the share repurchase plan that has been authorized. We have indicated in previous calls that given recent share prices, we favor share repurchase over special dividend, but look, ultimately that is the Board decision, and ultimately, that will get decided in the future. But I guess the key points are 50% to 60% cash return to shareholders, and in general, given where the stock price is, we favor share repurchases.

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Arun Shankar Viswanathan, RBC Capital Markets, LLC, Research Division - Analyst [24]

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And is there any thoughts on timing you could share with us, on how this will be completed?

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Quinn J. Coburn, GrafTech International Ltd. - VP, CFO & Treasurer [25]

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No. Really not probably appropriate for me to go into details on specifics on that in terms of timing. There's no mandatory deadline for use or anything like that. But otherwise, probably not appropriate to go into details on that.

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Arun Shankar Viswanathan, RBC Capital Markets, LLC, Research Division - Analyst [26]

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Okay. But just given the 50% to 60% target, we should assume, I guess, that it would be kind of something that you'd want to do annually in this range?

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Quinn J. Coburn, GrafTech International Ltd. - VP, CFO & Treasurer [27]

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Well, let's see about the future, but in terms of 2019, the 50% to 60% target is what we've committed to for 2019.

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Arun Shankar Viswanathan, RBC Capital Markets, LLC, Research Division - Analyst [28]

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Okay. And then just a couple of fundamental questions, if I may. So first off, could you provide an update, I guess, on needle coke, both from a pricing standpoint as well as supply-demand. It appears there's still quite a bit of tightness there, you guys were seeing increases in third-party costs, but how should we think about needle coke pricing trends?

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David J. Rintoul, GrafTech International Ltd. - President, CEO & Director [29]

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So I think we've spoke earlier in the year around our position on not -- not rather making our needle coke numbers public because we recognize that was not in the best interest of GrafTech to do so. However, having said that, the demand for needle coke appears to continue to be fairly solid. I can speak to where we're at in our negotiations for the second half where we have secured adequate volumes for our second half needs.

We're still in the midst of finishing up negotiations to complete the second half pricing side of the equation, if you will. So those aren't done, and as such, I can't signal or comment on them. So we believe that the EV battery market is still alive and well and growing strong, which will assist in keeping the demand for graphite needle coke, excuse me, and strong demand on that side. I think that the production numbers that we gave as well as some of our competitors are not monumental changes and as such, would except (sic) [expect] the needle coke market to be stable.

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Arun Shankar Viswanathan, RBC Capital Markets, LLC, Research Division - Analyst [30]

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And just given that, I mean, do you expect more capacity announcements? Or would that be necessary in the near future to -- if we continue to see growth as it has been.

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David J. Rintoul, GrafTech International Ltd. - President, CEO & Director [31]

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Are you referring to needle coke or graphite electrodes?

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Arun Shankar Viswanathan, RBC Capital Markets, LLC, Research Division - Analyst [32]

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Yes. Well, both, but I guess needle coke first.

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David J. Rintoul, GrafTech International Ltd. - President, CEO & Director [33]

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Well, look, I don't think ex China we're aware of any needle coke -- new needle coke facilities being constructed or even commented on. Inside China, as we have spoken in the past, information is a bit opaque, but believe that they are most likely working on some plans. Although, again, recognize that we've commented many times on the growth of the electric arc furnace industry in China, and it's grown pretty significantly just in the last 24 months, and recent announcements would suggest that they're continuing to be on this kind of 20% pace, if you will, which when you're making as much steel as they do, 20% is a pretty darn big number. So they are going to need those expansions to continue to stay abreast of their own consumption.

So -- but ex China, no. I think on the electrode side, the market was significantly undersupplied through '18 as the statistics would show and caused some of the very large price increases that were brought through. And we brought on some capacity with our debottlenecking, some of our competitors have done similar. So I think most of those that we're aware of, again, ex China, have come to fruition by and large. And the market's well served at this point and we'd expect that to remain the case. And as people work through the inventories that they had built because of the '18 tightness, that the stability will prevail.

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Arun Shankar Viswanathan, RBC Capital Markets, LLC, Research Division - Analyst [34]

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And then just last question. Could you describe the contracting environment? Are you still seeing strong acceptance of your longer-term contracts? And have you been extending those out and rolling those forward as well?

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David J. Rintoul, GrafTech International Ltd. - President, CEO & Director [35]

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So normally, we think of these long-term contracts in terms of new ones and extensions or whatever the case may be, as something that happens calendar year by calendar year. And as such, a lot of that work we would be looking at in the context of this fall and what it might mean for years beyond that.

In the current market environment, we'll see when we get to September, October where the land lays on that. We have some ideas that make sense for people. I think I've mentioned this in the past that the way we think the big service that the LTAs bring to the market is that they provide security to our customers, and there's no reason that we shouldn't continue to provide that service to the marketplace. We're the only ones that can, and we think that provides, for both us and our customers, a way to have a value in what we can bring to the table.

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Operator [36]

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This concludes our question-and-answer session. I would now hand the call back over to Mr. Rintoul for closing remarks.

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David J. Rintoul, GrafTech International Ltd. - President, CEO & Director [37]

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Thank you very much. And in conclusion, GrafTech is well positioned to leverage our unique competitive position. We will continue to maximize the value of our vertical integration and low-cost production base to provide industry-leading services, solutions and products to our customers. Again, thank you for your interest in GrafTech, and we look forward to speaking with you next quarter.

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Operator [38]

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This concludes today's conference call. You may now disconnect.