I wrote about Graftech International (EAF, Financial) in May earlier this year, when we were still early on in the pandemic. The company's stock had nosedived from the mid $20's in 2018 to about $6.
Well-known value investor Monish Pabrai, known for taking a large concentrated position, had exited the stock. The company's customers, many of which were locked into long-term agreements (LTA), also came under financial pressure and were reneging on contracts. The company was (and remains) highly leveraged, which made this a scary time for minority investors.
I have been keeping an eye on the company and noted that the stock price has started to recover strongly from the pandemic lows and has now clearly broken out of its bottoming pattern.
GrafTech's financial troubles began when a subsidiary of Brookfield Asset Management (BAM, Financial), Brookfield Business Partners, took GrafTech private in 2015, streamlined it, extracted a lot of money from it via a dividend, and returned it to the market in 2018. It still owns a majority (~65%) of GrafTech.
GrafTech is a vertically-integrated manufacturer of graphite electrodes that are essential in the production of Electric Arc Furnace [EAF] steel (EAF is also GrafTechs' ticker symbol). The EAF steelmaking process uses scrap metal and/or pig iron as raw material, unlike blast furnaces which use iron ore. EAF steel is the fastest-growing segment in the steel industry. EAF steelmaking is not as capital intensive as blast furnaces and is more environmentally friendly.
GrafTech's competitive advantage is that it makes the needle coke raw material which it converts to graphite electrodes in its Seadrift, Texas facility. The petroleum needle coke industry is highly concentrated. Only seven producers of size operate outside China, with Phillips 66 (which sells in the U.S. and UK) being the largest, followed by Seadrift in the U.S. and C-Chem, Petrocokes, JX Nippon and Mitsubishi in Japan. Ex-China capacity has remained broadly flat for the past 10 years given the high capital costs, technical expertise and stringent regulatory processes required to bring on new needle coke projects. In contrast, China is not only a net importer of needle coke but also a large producer, primarily through its coal-based production, with Sinosteel the largest producer.
Electrodes for EAF
By far the biggest use of needle coke is graphite electrodes for steelmaking. These electrodes are an indispensable, industrial consumable, used to conduct electricity during EAF steelmaking, and also to maintain the temperature of liquid steel in steelmaking.
Petroleum needle coke, a crystalline form of carbon derived from decant oil, a product of petroleum refineries, is a key raw material used in the production of graphite electrodes. Decant oil is the heaviest product from a cat cracker. It is also called slurry oil, clarified oil, bottoms and FCC residue. GrafTech achieved substantial vertical integration with this critical raw material source through its acquisition of Seadrift Coke LP (or Seadrift) in November 2010, significantly reducing its reliance on other suppliers. GrafTech is one of the largest petroleum needle coke producers in the world. GrafTech's vertical integration provides significant cost advantages over other suppliers. It also has three electrode making plants in Monterrey (Mexico), Pamplona (Spain) and Calais (France).
In an electric arc furnace, the metal scrap to be melted (in a process called smelting) is heated by passing a high voltage current through the material. Electricity flows from one graphite electrode, through the material, and into the other electrode. The resistance to electrical current causes the material to heat up. This is effectively the same process as an electric oven coil, except that the coil is the material being smelted in the furnace. The process of smelting also "eats" up the electrode, and they have to replaced constantly. As the main heating element in an electric arc furnace (EAF, Financial), it takes 2-3 kg of graphite electrodes to produce one tonne of steel. Producers say it takes up to six months to make these electrodes.
Diagram of an electric arc furnace
A typical steelmaking arc furnace is the source of steel for a mini-mill, which may make bars or strip products. Mini-mills can be sited relatively near the markets for steel products, so the transport requirements are less than for an integrated mill, which would commonly be sited near a harbor for better access to shipping.
Electric vehicles – a growing source of demand for needle coke
The demand for petroleum needle coke in lithium‑ion batteries is growing rapidly. This alternative source of demand is a significant development for the petroleum needle coke industry and has disrupted global supply chains for petroleum needle coke.
Graphite is the key material used in the manufacture of anodes (negative electrodes) for lithium-ion batteries. While cathode materials such as lithium cobalt and nickel have received most of the press, graphite is the largest input material by volume into lithium-ion batteries. For example, the Tesla (TSLA, Financial) Model S contains up to 85 kg of graphite.
There are two types of graphite are used in anode production: synthetic (derived from needle coke) and natural graphite. Despite increasing interest in new projects to mine natural graphite, and its lower cost, battery manufacturers have traditionally preferred synthetic graphite due to its higher purity and consistency. In practice, most use a blend of synthetic with natural to balance performance with cost. While EV sales are still low, the ongoing electrification of transportation is set to significantly lift demand for synthetic graphite and needle coke in the coming years.
Q3 2020 results
The company provided the following commentary in its third quarter earnings results for 2020, which is mostly encouraging news:
- Q3 saw steel industry demand trends improving, with Global steel production at ~187 million tons in Q3, excluding China. Production was up 12% sequentially vs. Q2 Global steel manufacturing utilization rates (ex-China) improved to just over 60% in Q3, up from ~57% in Q2
- Steel prices have been increasing globally; the company is optimistic that current trends suggest a continued market improvement
- Customer inventories of graphite electrodes remain elevated and destocking continues. Generally, spot prices for graphite electrodes trended lower in Q3. Sales volumes down due to graphite electrode inventory overhang and Covid-related lower steel production levels.
- GrafTech made substantial progress in completing several "blend and extend" contract modifications, providing customers with near-term relief in exchange for additional volume commitments in future years.
- Prioritizing balance sheet strength, the company put emphasis on reducing debt, lowering it by ~$150 million overall in Q3, ~$60 million in October and ~$313 million year-to-date.
- It expects full-year 2020 capital expenditures of ~$35 million, a ~50% decrease year-over-year.
- The majority of free cash flow in 2020 was used for debt reduction.
- GrafTech had total liquidity of $406 million as of Sept. 30 and no near-term debt maturities.
Conclusions
GrafTech's cash flow is still quite healthy and appears to have stabilized. I agree with the company's own assessment that things should improve with the economy. The company will also continue to deleverage.
I believe Graftech offers a compelling vehicle to ride the economic recovery. The EAF steelmaking market is growing. As the recovery after the pandemic progresses, steel production is going to increase, and that means greater demand for graphite electrodes. Because of the capital intensity and significant technical know-how needed for producing needle coke and electrodes, barriers to entry for new players are significant. This is a moaty business.
In addition, there is an increasing secular demand for Electric Vehicles that have batteries that use graphite.
While the company has a large debt load, it has solid cash flow and is de-leveraging rapidly. Thus, I believe GrafTech's equity has plenty of juice left at the current price levels and expect my investment in the company to easily double from here in the next three years.
Disclosure: The author owns GrafTech stock.
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