Introduction
I recently became interested in GrafTech International Ltd. (EAF, Financial) after reading a June 2019 Mohnish Pabrai (Trades, Portfolio) interview, where he anticipated that he was going to commit a big chunk of his assets to a company he would not disclose because they were still in the process of buying it, but, he added, anyone who was interested could simply check the 13F, which they were going to disclose in August. As I was reading the article in September, I immediately rushed to the Securities and Exchange Commission's website and discovered the name (Dalal Street, his investment vehicle, had a whopping 27% of its funds invested in GrafTech at the end of the third quarter).
To be honest, it was not the first time I had heard of GrafTech. Indeed, a dear friend of mine picked it from Joel Greenblatt (Trades, Portfolio)'s magic formula website (as of writing, GrafTech is still on the list).
GrafTech is involved in the production of UHP (ultra-high-performance) graphite electrodes, used to efficiently produce steel in electric arc furnaces with a low environmental impact. The electrodes are able to sustain an extremely high voltage, which is a key part of the steel production process. The main raw material needed to produce the electrodes is called needle coke (which in turn is produced starting from byproducts of oil refining).
GrafTech's predictable revenue stream
Here is Pabrai's investment thesis: the company has three- to five-year take-or-pay contracts in place with a diversified set of customers, which covers a big part of his average cost (around $12). So whatever is going to happen when the contracts expire represents a low-risk scenario as you're going to get the whole company for almost nothing.
Here is the above-mentioned contract revenue breakdown (from the latest 10-Q):
As you can see, most of them expire by the end of 2022 and allow for more than $1 billion of revenue per year (and around $700 million to $750 million in free cash flow).
This implies an high degree of predictability (even if a customer refuses to buy the planned fixed volume of graphite electrodes, the penalties would practically force them to pay almost 100% of the price anyway).
A solid moat
Another very important aspect of GrafTech is the fact it isthe only vertically-integrated graphite electrodes producer. Indeed, one of its subsidiaries, Seadrift, produces 70% to 80% of the total amount of needle coke needed by the company in production, at a cost that is way lower than the current average cost of the industry. This basically means the company has an unparalleled control on raw material prices: indeed, needle coke costs constitute the bulk of input costs for a graphite electrodes producer. For the remaining 20% to 30%, GrafTech is forced to buy the needle coke on the spot market.
For a company operating in the steel sector, the structural uncertainty of raw material and final products prices, combined with the fact that the industry is typically cyclical, is one of the most difficult headwinds for investors trying to figure out its future prospects, but here we have a company which was able to (almost) fix one of the two variables, making future assumptions easier and, more importantly, leading to a big competitive advantage over its competitors, which are fully subject to the swings of needle coke spot market.
Moreover, needle coke supply is going to be under pressure in the coming years as it is also a key ingredient in lithium ion batteries, which are currently in very high demand from electric vehicle producers.
But what happens when the price of needle coke increases? Either the electrode producers pass the cost on to their customers or, if electrodes prices don´t change, profit margins for GrafTech competitors will shrink and, at some point, they will be forced to reduce or suspend production. This, in turn, will decrease the supply of graphite electrodes. At that point, the only way a customer is going to gain access to them is paying a higher price. So I expect that GrafTech will be able to gain some more take-or-pay contracts at good prices with customers who want to protect themselves from the inevitable (of course, GrafTech only sells on fixed price-volume the production part that is linked to its available low-cost needle coke resources).
GrafTech has also built, over the years, an expertise in high-quality needle coke production. Currently there are only three other companies in the world that can produce it with the same characteristics (the biggest of which is Phillips66 (PSX, Financial)), and it can take several years before any company can build such a high-tech facility, so this can also be considered an advantage, even if not a permanent one.
Uncertainty and risk
The question is: why is the market willing to assign such a depressed price to GrafTech? Because, as it often happens in these cyclical industries, it's confusing uncertainty with risk.
Here are the main reasons:
- The 30% of production which is not covered by the take-or-pay contracts is exposed to UHP graphite electrodes spot market prices.
- Even if it's quite probable, we don't know if the company will be able to secure the same type of contracts (and at the same prices) when they will expire in 2022.
- The recent rally in graphite electrodes prices flooded the market with an oversupply, so the market will be in destocking mode (according to the CEO David Rintoul, at least for the first two quarters of 2020).
It is evident that the outcome of this story cannot be accurately predicted by one single scenario; there are simply too many variables to consider. But what can be said is that there are not so many ways GrafTech can fail because of its structural advantages, moat, highly skilled employees and market oligopoly status.
Conclusion
Even if it is difficult to assign a precise value to GrafTech (which lies in the $20 to $30 per share range) because of the high uncertainty related to the steel sector, the scenarios which can materialize in the next two to three years are all acceptable.
I see the purchase of the company shares at current prices as a low-risk proposition with a nice margin of safety. In Pabrai´s words, this is a “heads, I win; tails, I don’t lose much” kind of company. As a sign of high confidence in its prospects, in December, the company bought back $250 million worth of stock from Brookfield Asset Managment (BAM, Financial) (the current majority shareholder).
For investors who have the patience to wait for the market to “destock” and restore more normal supply and demand levels, and for the needle coke price pressures to kick in, the rewards could be huge. Time will tell.
Disclosure: The author owns shares of GrafTech International.
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