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The steel industry has been booming, with prices reaching highs late last year and recently coming back to Earth a bit before settling currently at a price that seems sustainable in the near term. During this time, utilization ratios of steel producing companies around the globe has remained high, which bodes well for GrafTech International (NYSE:EAF).
With companies moving away from blast furnaces and towards electric arc furnaces, GrafTech is in a prime position to take advantage of the possible headwinds that inflation may cause and increase their share of the graphite electrode industry.
GrafTech International Ltd. research, develops, manufactures, and sells graphite and carbon-based solutions worldwide. It offers graphite electrodes to produce electric arc furnace steel and other ferrous and non-ferrous metals; and petroleum needle coke, a crystalline form of carbon used in the production of graphite electrodes. The company sells its products primarily through direct sales force, independent sales representatives, and distributors. GrafTech International Ltd. was founded in 1886 and is headquartered in Brooklyn Heights, Ohio.
–Taken from Finviz.com
So before we go any further, I’m going to assume that some people reading this article have no clue what an electric arc furnace is, what a graphite electrode is, and what the importance of either of these are in the future of the steel industry.
If you do know all about these, skip ahead to the next section.
For a full breakdown of the difference between the two furnaces, here is a great blog post by Steel Supply LP that you can find here.
Here is a small snippet from the post for those that don’t want to go further:
The Electric arc furnace is smaller and more efficient. They do not require a constant coke supply; instead, they use electricity carried through graphite electrodes to create an arc. The metal used with an Electric arc furnace is usually scrap steel. Managing the temperature within the system is easier than a blast furnace, making it more efficient. Another benefit of using the EAF process is that all types of steel can be created.
The blast furnace symbolizes the metal industry as most know it. We see this in photos as a huge furnace system, and it involves multiple components.
Coke is utilized to melt the iron ore to create pig iron. Oxygen is then used to transform the pig iron into steel. However, this method produces high CO2 emissions because of the continual requirement of coke. – Steel Supply LP
The graphite electrodes inside the electric arc furnaces is what GrafTech produces, and these are not only essential to the steel production, they also are consumed by the process and need to be replaced. According to Reuters, it takes about 3kg of graphite electrodes to create one ton of steel. To dig deeper on the consumption rate of electrodes, you can find another resource here.
Now that we all have a little bit better grasp of what GrafTech produces and why it is important, let’s move on.
For those unfamiliar with moat, it is the ability for a company to maintain their competitive advantage and fend off competition. This is just like the protection of the medieval moats that were found around castles. I primarily like the description and categories of moat found here by Phil Town of Rule 1 Investing. I won’t go into each one here, so I encourage you to read about them if you are unfamiliar.
The major competitive advantage that GrafTech has, and will continue to have in my opinion, is Price. GrafTech currently is vertically integrated after purchasing Seadrift Coke in 2010. Seadrift is a standalone petroleum needle coke operation that allows GrafTech to harvest their raw materials in house without potential interruptions or price demands from outside companies. This will be a major factor in the future success of GrafTech.
But what else should we know?
Improving Balance Sheet. As previously noted, the current state of the steel industry has allowed many companies to have high utilization rates and therefore increase the usage of the graphite electrodes that are being consumed. Currently, GrafTech is projecting LTA revenue between $860-960 million dollars in full year 2022, as well as having non-LTA prices rising ~20% in Q1. While these prices will continue to be fluid, free cash flow of the company should remain high.
Now being profitable and using the money wisely are two very different things.
As you can see below, GrafTech has been continuing to use the free cash flow production to reduce the debt, buyback shares, and place themselves in a situation where they can be on the offensive.
Graftech Q1 2022 Earnings Slides
Graftech Q1 2022 Earnings Slides
An Integral Part of a Transitioning Industry. When purchasing a company that you believe is undervalued it is important to know if it is a cigar-butt company or a company with future prospects in an industry that will have continued growth. With GrafTech it is the latter.
Currently the steel industry is transitioning from blast furnaces to electric arc furnaces, and it may accelerate as we see the need for continued CO2 emission reduction. Not only this but electric arc furnaces can use significantly more scrap to produce new steel than blast furnaces.
According to World Steel Association:
Today, it is estimated that the global steel industry used about 2 billion tonnes of iron ore, 1 billion tonnes of metallurgical coal and 575 million tonnes of steel scrap to produce about 1.7 billion tonnes of crude steel.
Recycled steel (also called scrap steel) is one of the industry’s most important raw materials. It comes from demolished structures and end of life vehicles and machinery as well as from the yield losses in the steelmaking process.
Every steel plant is also a recycling plant, and all steel production uses scrap, up to 100% in the electric arc furnace (EAF) and up to 30% in the blast furnace (BF) route.
All scrap that is collected is recycled, and the overall recycling rate today is estimated to be about 85%. This high level of recycling means that there is limited room for improvement.
Scrap plays a key role in reducing industry emissions and resource consumption. Every tonne of scrap used for steel production avoids the emission of 1.5 tonnes of carbon dioxide, and the consumption of 1.4 tonnes of iron ore, 740 kg of coal and 120 kg of limestone.
–World Steel Association
World Steel Association
According to the World Steel Association, electric arc furnaces only account for 30% of global steel production. This is opens the door for GrafTech to be potentially be a future supplier to a significant portion of new companies that will be transitioning.
Vertical Integration. It’s important to note the major strength that GrafTech has in comparison to its competitors, and that is of its own vertical integration. As noted before, in 2010 GrafTech purchased SeaDrift Coke, a standalone petroleum needle coke operator. For those unaware, petroleum needle coke is the main cost in the production of graphite electrodes. By having this production in house, GrafTech allows itself to have some built in insulation to the rest of the coke market. An interesting article found here can give you a little bit of a look into how the coke prices are effecting the industry right now. Add to all this the need for the same coke for EV batteries, and the pricing for coke could skyrocket. This would bode very well for GrafTech’s already well positioned pricing strategy.
Brookfield Asset Management. So before I go on and crush Brookfield, let me say first that they are simply doing their job. They bought GrafTech in a bad position, turned it around, went public, and now are selling shares to capture their profit. That being said, for an investor like me, it’s a real pain. By selling massive amounts of shares over the last few years, the price has continued to been kept artificially low. Also Brookfield gave out massive bonuses upon their ownership reaching a level below 30%. Currently Brookfield owns around 25% of the company and I imagine will continue to drop that percentage in the near future.
Steel Prices are Above Historic Rates. Why would steel prices climbing towards all time highs be an issue with a company that should profit from this? Well the problem isn’t the price now, but instead where the price may be going from here.
With a company like GrafTech that only thrives as the utilization rate of steel production is high, a drop in price leads to a drop in production, which in turn leads to a drop in the need for their product. Whether it happens now, or later in 2022 (currently HRC sits at ~$1200) most analysts are predicting that the steel prices will fall back towards historical norms. This could lead to a lack of sales for Graftech in comparison to what we have seen over the past year.
Inflationary Concerns/Recession. Just like any other company out there, GrafTech has to be concerned rising inflationary costs. They already have stated in their latest earnings call that the cost per metric ton of electrodes has increased by ~9% over the previous quarter and will most likely continue to rise. With the housing market looking to cool off as mortgage rates climb from record lows and builders begin to slow the production of new residences, steel prices will surely follow. If we see a pure recession, that includes a correction in much of the production that is driving those prices, then GrafTech may have a major pullback in their realized price per ton.
Now I have my own method of valuing companies, much like those that write these articles. Valuations, no matter how you do them, always take a certain amount of speculation, whether it is organic growth, acquisitions, future debt refinancing, changes to the landscape of the industry, effects of inflation, etc.
When performing estimates of a company’s value like GrafTech, I like to look at them in through two different lenses. These lenses include:
Let’s begin with the Cash flow per share valuation. This equation I like to use because it not only looks at the FCF production but also how the market typically values companies in the particular industry. I also use this as my Margin of Safety valuation, due to my fair price you will see at the end.
Looking at the historical values of the Price to Cash Flow of GrafTech since 2018 it has an average of just over 5. This is pretty low (likely a result of Brookfield), and according to gurufocus.com the median for the industry is just over 20. While 20 is a bit aggressive for my taste, I feel comfortable placing my future estimate at 15. I will use a growth rate of 7% (10% minus 3% discount) as I believe in current cash flow use that management is showing.
Here is my calculation:
While this is an overly simplistic way of looking at a company’s valuation, it is one that I have consistently used, and one that has treated me well. As you can see, the fair price (not the price I would purchase GrafTech at) sits just above $12 per share. That places GrafTech at a significant discount right now.
This isn’t the full picture though.
My second equation is based off of the payback rate of free cash flow, which in my equation is simply operating cash flow minus maintenance capital expenditures combined with growth and discount rates (aka Buffett owner’s earnings). I also reduced the total long term debt from the final payback number as well.
Here is what that looks like on paper.
One thing that you may have noticed that I do different than The Oracle is that I use an 8-year instead of a 10-year calculation. Why is this? Well, I stole this one from Phil Town as well, where he speaks about the payback time that private equity investors expect. He literally wrote a book about this, so instead of me wading through it, I suggest you take a look at his explanation. This, again, leaves me more conservative than most.
Finally, there is one last step, which is how to combine the two calculations. There are a couple of ways to do this. First, I could take a 50/50 split and average the two prices. Second, I could assume that the next 5-10 years of stock price depends more on pure FCF growth and label it 60/40 in favor of the FCF calculation. Finally, my third choice is to perform the opposite and go 60/40 in favor of a Price/FCF valuation which also can account for their value based on industry medians.
Here are the calculations:
For GrafTech I will just split the difference because although I expect a reduction in shares, a move back towards the industry median, and possibly even a bump in the dividend payment in the future, the major growth factor to the stock price will most likely come through their ability to grow revenue through acquisitions or operational improvements.
So where do I value the company at? Currently I value the company at just over $14 per share. At time of writing, that is around 60% higher than the current share price.
Whenever I am buying, I am looking in a five to ten-year horizon and want to be able to safely see annualized returns of around 15%. Note that I said safely, which will mean that I need to be conservative.
Currently GrafTech doesn’t have a dividend that is really going to help my returns so I will need to project a rate of return somewhere between 17-20% to safely reach my goal.
At a 20% annualized rate of return, GrafTech’s price per share would need to end up being ~$21.50 in five years. This actually is lower than the projected rate of return based on my FCF per share valuation. Combine this with an owner’s earnings number that stands at half price, even with all debt repaid, and I feel safer nudging closer to my calculated buy price.
While both of these calculations point me towards adding until I hit $11 per share, Brookfield’s sales still loom, and the steel industry retreating back to norms also have be a bit hesitant to use that price. Because of this, I will lower my 80% calculation to 70% of fair value and continue to add at intervals until we reach it or something fundamental changes.
Buy Price = Add any time EAF is under $9.89
On the long-term weekly chart, EAF currently sits right in the middle between support and resistance. It appears that it may be at a turning point though, with MACD about to cross and stochastics showing positive signs. Currently as it stands, holding may be the most prudent thing to do until it reaches a turning point.
The daily chart shows much of the same, with EAF sitting just above support. The MACD has crossed and settled a bit and stochastics point to a potential stalling out in the works. Again, holding may be the best strategy at this point.
There has been relatively little going on of late for the EAF insiders. With zero moves over the last 5 months there is very little to learn here.
GrafTech International is currently in the midst of a transitioning industry that is also is selling at prices above historic norms. Management has done a tremendous job with the balance sheet, positioning themselves to be able to take advantage of any weakness that may occur in the industry and opportunities that could come along because of them.
With a vertically integrated production line, a market that will increasingly need their product, and the ability to insulate themselves from potential petroleum needle coke supply issues, I am labeling GrafTech a long term buy and will continue to pick up shares as long as they stay at the low P/FCF ratios.
Thanks for reading. Until next time, Happy Investing!
This article was written by
Disclosure: I/we have a beneficial long position in the shares of EAF either through stock ownership, options, or other derivatives. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.