GrafTech International Ltd. (EAF, Financial) primarily produces ultra-high performance graphite electrodes and sells them to electric arc furnace steel producers via long-term contracts or spot sales.
About GrafTech
One of GrafTech's competitive advantages is the high barrier to entry in the industry, which has a limited set of global competitors. Unlike its other competitors, GrafTech is vertically integrated and also produces petroleum needle coke, the major raw material required to produce the graphite electrodes. Seadrift, a subsidiary of GrafTech, provides at least two-thirds of GrafTech's long-term needle coke, and the production cost is well below third-party prices.
Needle Coke is also used in electric vehicle lithium batteries, meaning that until recently, it was in high demand, creating shortages. This caused GrafTech customers to enter into longer-term "take or pay" contracts to lock in steady prices in exchange for steady business for GrafTech.
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Worry that the Covid-19 crisis has put many of GrafTech's take-or-pay contract counterparties in a dire situation has caused share prices of the company to plunge. Many of them are invoking force majeure clauses to delay or to get out of these contracts. Steel demand and prices will likely plummet in the years ahead if the recession results in less construction activity, which would cause the spot prices for electrodes to crash. The growing consensus is that recovery will be L-shaped or reverse-J-shaped.
Brookfield ownership
Brookfield, a large Private Equity firm, controls the company, as it owns ~74% of shares outstanding. Brookfield acquired GrafTech in 2015 for $1.5 Billion and proceeded to strip it down to its core assets of electrodes and Needle Coke. The company was then loaded down with high debt, and Brookfield extracted a $1.5 billion dividend before selling a minority stake to the public in April 2018.
Brookfield's ownership is both a strength and a weakness, in my opinion. Brookfield is a deep-pocketed investor, but their interests may not always align with those of the minority shareholders. It is possible that Brookfield may take the company private at an opportunistic price. This concern may also be helping to depress the stock.
Pabrai's investment
Some value investors may have followed famous value investor Monish Pabrai into the stock. However, in the first quarter of 2020, Pabrai sold out of his firm's stake in GrafTech.
Pabrai is the author of the best selling book, "The Dhando Investor," in which he articulated the "heads I win, tails I don't lose much" style of investing. Pabrai famously invests in stocks which he believes have low risk but high uncertainty. The risk here would mean the risk of a permanent capital loss, while uncertainty would mean the uncertainty of where we are in the cycle or just plain market volatility.
Pabrai recently disclosed that he out of the stock completely. As for his reasons, perhaps he found better opportunities or saw new risk for the company.
This situation reminds me of Horsehead, a zinc producer in which Pabrai was heavily invested but which eventually went bankrupt. In that situation, Pabrai hung on till the end with bad results.
While Graftech makes an important product for the steel industry, the investment faces the following interlocking risk/uncertainties:
1) The majority investor is a private equity shop (Brookfield) whose interest may not align with minority shareholders and may act opportunistically to take the company private as the crisis deepens.
2) The Covid-19 crisis may result in a prolonged recession.
3) The company has no equity cushion. In fact, it has negative equity, i.e., its debt is larger than its assets. This was because of the large dividend payment made to Brookfield when it issued sharesto the public in 2018 . This dividend was funded with debt.
The company added significant debt incurred during its IPO, but it does not have any with near-term maturity. Most of the debt matures in 2025, so the risk of bankruptcy is small in the near term. However, if cash flow dries up, the company could run into liquidity problems.
Management is currently implementing cost reduction plans across the board and has cut dividends by 75%. The situation has changed very suddenly for Graftech. It looks like it's going to a tough few years for the firm, and not all the risks are tied to the state of the business itself.
Disclosure: The author is long GrafTech. Since I own only a small position I intend to hang on to see what happens.
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