In a previous discussion on GrafTech International Ltd. (NYSE:EAF), I highlighted how valuable it was for the company to have long-term agreement contracts in place, which provide a predictable revenue stream. In addition, the vertical integration into one of the few pure needle coke producers (the fully-owned subsidiary Seadrift) represents a solid competitive advantage.
While the LTAs were clearly put in jeopardy by the Covid-19 pandemic, especially as a consequence of the lockdowns implemented all over the world, the moat provided by Seadrift is still there, and I believe that it will prove even more valuable in periods of recession.
Moreover, the company is quite cheap in absolute terms and also compared to its competitors.
The company has a Greenblatt earnings yield of 24.04, which is quite high compared to the other companies operating in the same industry.
First-quarter results and second-quarter projections
GrafTech closed the first quarter with net income of $122 million, or 45 cents per share, while operating cash flow was $139 million, down from $157 million for first-quarter 2019.
Liquidity as of March 31 was $400 million, consisting of $152 million in cash (and equivalents) and $247 million in available revolving credit facility.
The sales volume was 34,000 metric tons , consisting of 29,000 tons related to LTAs and 5,000 tons of spot sales.
Based on the press release and related conference call transcripts, I was able to "fill in the blanks" to arrive at the final revenue breakdown for the quarter.
Here?s a snapshot of my spreadsheet calculations:
Apart from the above-mentioned volumes, I used the LTA 2020 average graphite electrodes price per kMT and the (disclosed in conference call) spot price for the quarter. Byproducts revenues are obtain by difference. As we can see, both volume and price for UHP electrodes outside of LTAs are lower than the previous quarter; the percentage of UHP electrodes sold on LTAs grew to 86% of total revenues.
Looking ahead to the next quarter, let?s try to make some realistic revenue projections. During the last conference call, management estimated that even if the theoretical LTA contracted volumes for 2020 are set to 130,000 metric tons, given the circumstances, the new volume will be in the 100,000 to 115,000 tons range. Let?s assume it will be 100, subtract the already delivered volume from the first quarter and divide by the remaining quarters. Let?s also assume that the electrode spot price will go down to $5,000 per metric ton (volume remaining the same).
Here are the second-quarter revenue breakdown projections:
In this scenario, sales will go down to $243 million, so 24%.
Covid-19 impact on the business
Apart from lower realized prices for graphite electrodes (which impacts less than 30% of the production), the effect of this pandemic on GrafTech is all about LTA issues.
The company declared that over 20 LTA customers have submitted force majeure notices, which means they are now forced by reasons outside of their control to suspend production, and try to consequently seek relief from their suppliers on deliveries and payment obligations.
For these customers, provided that they are not at risk of going bankrupt, it means that the LTA contracts will be extended for the duration of the lockdown. Of course, there is also a number of customers that are in serious financial trouble, so for some of them, GrafTech will probably not be able to recover the potential revenues (or the contractual break-up fees). We?ll know more about them in the next quarterly report.
Now that the graphite electrode spot price is below the fixed LTA price, there are also a number of customers trying to renegotiate the LTAs on more favorable terms. GrafTech?s management declared that, in the case they accept the renegotiation (and this can vary case by case), this will be done in a way to preserve the total value of the contract. This probably means shifting some volume to the end of the contract timeline (so beyond 2022). I will be disappointed if they change the price tag of the LTAs as this would create a dangerous precedent.
In my previous discussion, I must admit I overlooked the risk of being a minority shareholder in GrafTech and that the major shareholder, Brookfield Asset Management (BAM), already proved its intent to extract as much capital as possible from its investment (the investment has already been largely repaid for the company).
The real risk here is that Brookfield could want to take the company private again, but at a very depressed price while both the steel cycle and the pandemic have a direct impact on the company. This was less evident a few months ago as Brookfield was trying to sell its shares at a price of around $13 each. As of March 31, Brookfield Asset Management still holds approximately 74% of GrafTech's shares (199 million out of 269 million), so it is pretty much in control of the company.
Brookfield also knows very well the potential of this company as, after acquiring the company, it put in place changes that lead, for example, to Ebitda to increase from a few tens of millions of dollars to more than $1 billion in 2019 (of course, a steep increase in graphite electrode prices was also a big contributor).
Hopefully, it will hold on and let the company pay down its debt instead of distributing big dividends (as they did in the past) as soon as free cash flow starts to go up.
Liquidity and debt reduction
The company ended the first quarter of 2020 with liquidity of $400 million (cash and equivalents of $152 million and $247 of available liquidity under their revolving credit facility).
Let's have a look at the debt. The company has no maturities due until the end of 2021, and only around $300 million to be repaid until the end of 2024. The first big payment is set to around $1.5 billion in 2025.
So there?s plenty of time for both the pandemic and the lower part of the steel industry cycle to make their course and fade away. Moreover, the company also recently declared that the majority of the free cash flow will be used for debt reduction.
During the current quarter, GrafTech has repurchased $30 million worth of shares and paid $23 million in dividends. As share repurchases were put on hold and the dividend was reduced to a penny due to the pandemic hitting the U.S., this is probably (and hopefully) to be the case for at least several quarters.
Is the moat still valuable?
Definitely. This is actually the main reason why I invested in GrafTech in the first place.
I think that GrafTech?s moat (that is, the vertical integration with its owned needle coke producer) is going to prove to actually be more valuable in bad times than in good.
As the spread between the graphite electrode spot price and the cost of of needle coke decreases (it is estimated to be around $3,000 per metric ton in the first quarter, excluding operating expenses), most of GrafTech's competitors' margins will suffer because of lower margins (in the best case), or will be forced to suspend production to avoid going in the red.
This means that GrafTech could easily come out of this crisis stronger than before, and potentially with a higher market share.
While GrafTech was hit hard by the pandemic (which simply accelerated the already approaching steel market cyclical downside), the company is still profitable, has no imminent maturities and sufficient liquidity to weather the storm.
The risks are more related to how Brookfield, the majority shareholder, is going to handle the situation than to operating potential issues (for this reason, I am simply holding my position and not averaging down).
The next few quarters will be important to understand when and how the steel market is going to recover, and if the company;s management will keep their promises (especially on deleveraging).
Disclosure: The author owns shares of GrafTech International.
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