GrafTech International: An-In depth Look At This Mohnish Pabrai holding

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Mohnish Pabrai likes GrafTech International Ltd (NYSE:EAF), and he’s not the only one. Various firms have been writing about the company off and on over the last few years, so it’s one stock many investors are considering. There are plenty of good things in the company’s financials right now, but there are also some concerns, just as there are with any investment.

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Q4 2019 hedge fund letters, conferences and more

We looked at Pabrai's thesis for GrafTech and compared it with the views of analysts and others who have written or spoken about it over the last year or two.

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Graftech is trading at around $6.20 at the time of this writing versus a 52 week high of $14.84 in late 2019.

Please note this post is not investment advice, consult with a licensed expert for advice.

What does GrafTech International do?

GrafTech is certainly no Apple or Tesla, so most investors may not be familiar with it. The company is an industrial play that manufactures graphite electrodes for electronic arc furnaces, or EAF (hence, its ticker symbol EAF). These graphite electrodes aren't as sexy as electric cars, but they are a vital part of the steelmaking process. Specifically, the electrodes are used to make EAF steel, which is about half of the total steel that's produced outside China. The company's business also touches the electric vehicle market, so it should benefit from growing adoption of EVs.

GrafTech held its initial public offering less than two years ago, and its shares have been volatile since then. Some of the factors that have been impacting its price include uncertainty, graphite electrode pricing, customer contracts, free cash flow, and dealings with Brookfield Business Partners.

Take-or-pay contracts

In the third quarter, Mohnish Pabrai added more than 1.4 million shares of GrafTech International to his portfolio, which increased his stake by about 35%. As of the end of September, his fund owned 5.5 million shares of the company.

One thing Pabrai especially likes about GrafTech is the virtual guarantee on two-thirds of the company's earnings. GrafTech has contracted about two-thirds of its capacity through take-or-pay contracts through 2022. That effectively guarantees the company's income for the next three years on graphite materials, although as we mention below, that income isn't fully guaranteed.

Because of those contracts, the electrode producer managed strong results in 2019.The company generated over $800 million in cash from operations and returned $360 million to shareholders through share buybacks and dividends. It also paid off $350 million in debt. GrafTech had a $3 billion market capitalization at the time Pabrai weighed in on it, and with $800 million in cash flow and earnings guarantees from the contracts, the multiple looks attractive to some value investors like Pabrai.

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Latest earnings numbers

Analysts have been watching GrafTech International for quite some time and offered insight into the company's latest earnings report, which was released in February. For the fourth quarter, the company reported earnings of 61 cents per share, coming out ahead of the consensus of 55 cents per share. Adjusted EBITDA amounted to $235 million, coming in above the consensus of $230 million but a bit below JPMorgan's estimate of $256 million. Revenue amounted to $414.6 million, compared to the consensus of $402 million.

JPMorgan wasn't expecting any spot sales during the fourth quarter, although there were spot sales. Spot sales came in below the average contract price, and costs were higher than expected. JPMorgan analyst Michael Gambardella believes the higher prices came from third-party needle coke purchases for spot volumes. GrafTech's tax rate was 4%, compared to his estimate of 18%.

Credit Suisse analyst Curt Woodworth remained bullish on GrafTech following the fourth-quarter earnings report. He reiterated his Outperform rating but cut his target price from $18 to $17 per share. He expects the graphite electrode market to recover in the second half of the year. Curt estimates spot prices of $7,050 per ton for graphite electrodes this year and needle coke prices of $4,000 per ton, which he sees as conservative.

He highlighted the company's low-cost Seadrift platform as one way to drive strong free cash flow generation in the next three years. He estimates that the company will generate $1.9 billion in free cash flow through 2020, compared to its market cap of $3 billion at the time he wrote in February.

Price targets for GrafTech stock cut

At the time of the earnings report, BMO Capital Markets analyst David Gagliano maintained his Market Perform rating and cut his price target for GrafTech International stock to $12. He noted that the company continues to generate significant cash flow. Although he saw several headwinds in the near term, he believes the company is well-positioned to benefit from favorable trends in the graphite electrode market.

He said visibility in the market and prices is very low, which is why the company's market commentary and pricing details are more important than other commentary in metals and mining. GrafTech management said on the earnings call that they expect graphite electrode inventories to remain high through the first half of the year. As destocking occurs, the market should improve in the second half of the year. He believes volumes will be flat to down for the first quarter and expects lower spot prices.

GrafTech management reduced the company's 2020 contracted position from 142,000 MT to 130,000 MT, cutting "customer financial difficulties and variabilities associated with LTA provisions." They also said they were working to place the extra volume in the spot market, although Gagliano believes the spot prices will be lower than the contracted prices.

Gagliano noted that about 65% of the company's contracted volumes for 2020 to 2022 are sold at prices between $9,600 and $9,700 per ton, amounting to between $1.5 billion and $1.8 billion in free cash flow during that timeframe.

Although several analysts reduced their price targets for GrafTech International stock after the fourth-quarter earnings report, the stock has now fallen well below those reduced price targets.

What bears have to say about GrafTech International

RBC Capital Markets analyst Arun Viswanathan is perhaps the most bearish on GrafTech of all the analysts we reviewed. He downgraded the stock from Outperform to Sector Perform and lowered his price target from $15 to $11 per share following the last earnings report. However, it's important to note that GrafTech stock now remains well below his reduced target price amid the ongoing plunge in the stock market.

Viswanathan said the company's sales came in at $415 million, missing his estimate of $432 million for the fourth quarter. Sales volumes were 41,000 tons, which was lower than the 45,000 tons he had been estimating.

He downgraded GrafTech International stock due to customer destocking in the next six to nine months due to elevated inventory levels. Arun also downgraded it because of heightened potential for renegotiation of the company's contracts, resulting in lower volumes and earnings misses in the near term. He also expects a cyclical downturn in steel production and industrial production rates, resulting in lower sales volumes this year.

Further, he expects higher fixed costs due to reduced operating rates to the 65% to 70% level and lower spot pricing. Thus, he cut his 2020 earnings per share estimate to $2.02 and his EBITDA estimate to $850 million. He also expects less capital to be returned to shareholders in 2020 than what was returned last year.

Improvements in second half of 2020

At the BMO Global Metals and Mining Conference in February, GrafTech management said there were already signs that customer destocking of electrodes was declining. They expect the market to improve in the second half of the year. However, they said at the time that it was too early to know the impact from the coronavirus on operations.

In the long term, they believe the outlook for EAF steelmaking is strong, and the company remains in a good position to take advantage of the growing market. Seadrift enables GrafTech to enjoy a sustainable advantage through vertical integration as the petroleum needle coke market is expected to keep tightening due to demand from electric vehicles.

Here's what Pabrai likes about GrafTech International

Mohnish Pabrai discussed his GrafTech International investment during the annual meeting for his funds. A transcript of the 2019 annual meeting reveals that some investors asked him about the company. He said GrafTech had a market cap of about $3 billion and contracted revenues and profits over the next five years of $3 billion.

Further, he noted that the contracts cover two-thirds of the company's production, which means one-third is still being sold on the spot market, providing some variance in earnings. He added that while GrafTech's future after the end of the five-year contracts is unclear, the market is pricing the company as if the only thing they will get is the five years of revenue and cash flows and nothing else.

"I have no idea what the value of GrafTech is because who knows what happens there. Then you get to the governance issue with Brookfield, pimple on a camel's butt. Completely irrelevant. Can you see a pimple on a camel's butt? You can't even see it."

Issues with Brookfield Business Partners

Massif Capital also had a position in GrafTech as of early 2019, and the firm's first-quarter letter to investors explained the issues involving Brookfield Business Partners. That's an important part of the company's history because the firm took the company private five year ago and then brought it public again about two years ago.

The firm wrote early last year that GrafTech had a difficult first quarter because of "what can only be considered poor planning by the largest shareholder, Brookfield Business Partners. Brookfield owned 75% of GrafTech at the time of Massif's letter. The firm had said it was interested in reducing its position and increasing GrafTech's liquidity.

Brookfield sold shares at the IPO price of $15 and then at $21 in a secondary offering in late 2018. Massif management described the secondary offering as "poorly executed," noting that it resulted in a significant decline in the stock. Last year, Brookfield tried to hold another secondary offering at $14.23 per share, but it ended up reversing that decision after the stock fell to $11.61 in confusion over the offering.

Mohnish Pabrai isn't overly worried about what's been happening with Brookfield.

"Brookfield may have a view on GrafTech International which is different from me, but so far with GrafTech, they have improved the hell out of the business," he said during his annual meeting in 2019. "They made it a vastly better business. The five-year contracts, they're the only ones who do that. Everything Brookfield has done so far with GrafTech, hats off to them. I have seen no behavior from Brookfield which gives me any cause for concern. But even if there is cause for concern, it's OK. We'll take our $60 million and go somewhere else. No problem."

Challenges for GrafTech International

One risk associated with GrafTech is related to the take-or-pay contracts. They are beneficial for the company because they should guarantee its income, although that is turning out not to be concrete. Under the terms of the contracts, customers must purchase a set number of the electrodes whether they need them or not. As a result, such contracts can push unstable companies into bankruptcy if they're unable to pay their contracts.

On the 2019 earnings call, company management said some of their customers have filed for bankruptcy, while other customers are having financial difficulties. Due to these two issues, GrafTech International expects its contracted sales volumes to be impacted. Thus, management adjusted their 2020 shipment estimates.

The issue of customer bankruptcies isn't new for the company, but the market started pricing in a great deal of uncertainty due to management's announcement. Bulls argue that the company's stock is trading at such a low multiple that it will still look attractive even if earnings drop off significantly.

Bullish for years

Since the latest market decline, GrafTech's market capitalization is down to $1.7 billion. However, hedge funds have been bullish on the company for years. At the Morgan Stanley Investment Leadership Conference in June 2018, Sandro Capital presented a long thesis for GrafTech, which had a market cap of $5.5 billion at that time.

The fund saw further upside from the share price at that time. In fact, Sandro expected the company's stock price to rise another 50% from that point due to high demand and low production. At the time, production was running 25% below demand. Sandro management also said the market had consolidated as many players exited, leaving more opportunities for those that stayed in.

The fund also said the market has been helped by anti-pollution activities in China, resulting in a reduction of blast furnaces and increase in electric furnaces. As a result of increased demand, graphite electrode prices were increasing.

The lollapalooza effect in GrafTech

Starvine Capital also wrote about GrafTech International in its first-quarter letter in 2018. The firm referred to something Charlie Munger said about the lollapalooza effect, which is when two or more forces operate in the same direction. The result is a non-linear outcome, and Starvine management saw this effect at work in GrafTech.

Brookfield took the company private in 2015 when its earnings were pressured for four years due to oversupply in the steel industry. GrafTech was losing money until at some point in 2017. Brookfield then filed for an IPO for the company, taking it public once again to monetize some of its holding. The firm refinanced about $1.1 billion in incremental debt in 2018 with Brookfield, which then distributed 130% of the initial $855 million equity investment.

At the midpoint of the IPO range, the stock was worth about $6.8 billion. Between the $1.1 billion in refinancing and a $750 million promissory note to Brookfield, it amounted to $8.6 billion in value, representing a more than ten-fold increase in less than three years.

At the time Starvine Capital was writing in 2018, the price of graphite electrodes soared. It climbed from an industry low of about $2,500 per MT, compared to the long-term average of about $4,500 per MT in 2016 to record highs between $15,000 and $30,000 per MT in the first quarter of 2018.

The firm also highlighted GrafTech's cash flow in 2018. Starvine management estimated the company's free cash flow at about $650 million at that time.

One other benefit for GrafTech International

Starvine also said the company should benefit from increased demand for electric vehicles. Although EVs do not use graphite electrodes, increased demand for them is driving more demand for petroleum needle coke, which is needed for production of both lithium-ion battery and graphite electrode production.

The International Energy Agency estimated at the time that global EV stock will grow to between 40 million and 70 million vehicles by 2025, which drove needle coke prices higher, thus raising graphite electrode prices.

GrafTech International enjoys a cost advantage due to the increased demand for needle coke because it produces 75% of its needle coke requirements. Additionally, the company benefited from a 20% closure or repurposing of graphite electrode since 2014.

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