Shares in one of Mohnish Pabrai (Trades, Portfolio)'s favorite U.S. equity investments, GrafTech International (EAF, Financial), plunged by around 10% yesterday after the company reported its fourth-quarter and full-year 2019 results.
Pabrai holdings
According to Pabrai's latest 13F filings, the value investor owned 5.5 million shares in this industrial business at the end of September 2019. This position was worth a total of $71 million, which I estimate makes it about 10% of Pabrai Investments' overall equity portfolio.
Based on Pabrai's past history and comments, it seems that this is one of his is high uncertainty low-risk investments.
GrafTech is dealing at a low single-digit price-earnings multiple, but has around two-thirds of its earnings guaranteed through 2022 on take-or-pay contracts, which guarantee a set level of income for the producer of graphite materials.
These contracts helped the company achieve relatively impressive results in 2019. GrafTech reported fourth-quarter earnings of $0.61 per share on revenue of $414.61 million, beating expectations for $0.55 per share in earnings on revenue of $402 million.
On top of this, GrafTech said it generated more than $800 million in cash flow from operating activities, returning $360 million to shareholders via dividends and share repurchases and also paying down $350 million worth of debt.
So far, so good. $800 million of cash flow on a $3.1 billion market capitalization looks extremely attractive. The existence of the take or pay contracts should guarantee that this profitability lasts, or that is the theory anyway.
Bankruptcy problems
Unfortunately, it looks as if the company is running into some problems with these contracts.
Take-or-pay contracts are always contentious because they force customers to commit to a set purchase level. This can cause financial instability and even bankruptcy for customers because they have to keep buying the product even if they do not need it.
This is good news for GrafTech but bad news for its customers, and as economic uncertainty bites, customers are collapsing. This could mean lower revenues for GrafTech.
As management explained on the company's 2019 earnings conference call:
"GrafTech has sold about two-thirds of our cumulative capacity via long-term take-or-pay contracts. These contracts provide profitability and visibility of earnings. As you know, certain of our customers have filed for bankruptcies and other customers are experiencing some financial difficulties. With both developments, we expect to impact contracted sales volumes to a degree moving forward. In response to this, along with some variability permitted within certain LTA provisions, we have adjusted our 2020 estimate shipments of volumes."
GrafTech says that it stands ready to help customers that fall into financial difficulty. Management's comments on the calls suggest that the company is happy to renegotiate take-or-pay agreements if customers suffer financial distress.
Difficult to tell
The problem for shareholders is that it is difficult to tell how much of an impact this will have on the bottom line.
Possible customer bankruptcies have always been a risk for the company, and it is something management warned of last quarter as well, so this is nothing new.
Nevertheless, it'll be interesting to see how the situation develops over the next 12 months and what sort of impact bankruptcies will have on revenue and income.
Having said that, right now shares in this electrode producer are dealing at such a low valuation, the risk-reward ratio will continue to look attractive even if earnings fall by 50% or more.
Management is planning to continue returning cash to shareholders in 2020 and reducing debt at the same time. This appears to be a very positive capital allocation strategy and only improves the investment case.
Overall, while the market seems to think the risk of investing in GrafTech has increased over the past 24 hours, the risk of customer bankruptcies is something that business has always had to deal with. Its low valuation reflects that. Further cash returns and debt reduction over the next 12 months should improve sentiment and could drive a re-rating of the stock.
Disclosure: The author owns shares in GrafTech.
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