Introduction
In my previous article on Graftech I made the point that, while the company was being hit hard by the pandemic, it was still profitable while executing its long-term plan.
The biggest risks were related to the potential impact of shareholders adverse Brookfield Asset Management's (BAM, Financial) choices, and to the fact that the company still had quite a fair amount of debt on his balance sheet. In this article, we will discuss how those risks have been recently mitigated.
Another potential risk is linked to the future of the LTAs (Long Term Agreements) contracts, most of which are going to expire at the end of 2022 (some volume was shifted to 2023/24 because of contract modifications agreed with financially struggling customers).
Finally, we'll discuss about the possible developments of the graphite electrodes market and its relationship to the steel price dynamics.
Brookfield's share
If we look at Graftech's most recent SEC filings, we see that in the last months Brookfield aggressively reduced its exposition (and control) to the graphite producer.
In the fourth quarter of 2020 alone, Brookfield managed to bring down their share of Graftech's capital from around 65% to 55%.
On Jan. 14, they initiated a secondary offer with the intent of selling up to 20 million shares of Graftech. The sale closure was announced on Jan. 19 (the closing price was $10.72), bringing down the number of owned shares to 127.7 million.
If we consider that the number of outstanding (diluted) shares at the end of the fourth quarter was 267.3 million, then Brookfield currently owns around 48% of Graftech. This means that they are not anymore in (complete) control of the company, which translates into more freedom for management with capital allocation, and (hopefully) more shareholder-friendly friendly choices.
Debt situation
While it's clear that deleveraging must be a priority for Graftech, in the past years the company (probably influenced by Brookfield's control) spent more on dividends and share repurchases than for debt reduction. This was, in my opinion, a mistake, as risk management should have the highest priority (of course, investing for growth and pursuing high-return projects is also very important).
Who cares about a few more dividends or share repurchases if the whole long-term health of the company is put in jeopardy by a too-hazardous capital allocation policy? Only a controlling shareholder that plans to milk the cash cow and then jump ship a la Brookfield.
It seems that last year, under the pressure of the pandemic crisis, Graftech's management realized its precarious financial position and kept their promises. Cash and equivalents raised from around $81 million on Dec. 31, 2019 to $145 million at the end of last year. In the same period, long-term debt was reduced from $1.8 billion to $1.4 billion (short term debt was practically unchanged). Consequently, net debt went down from $1.72 billion to $1.28 billion, a reduction of 26%.
During the most recent earnings call, when asked about the increased possibility to return capital to shareholders in 2021 compared to last year, chief financial officer Quinn Coburn clearly stated:
"I think it's appropriate and in our best interest and in the shareholders best interest to operate from a position of balance sheet strength. We think that gives us financial operational flexibility and is very appropriate for the industry that we are in. So in 2021, we will continue to focus on balance sheet strength. That will be our number one priority. Our number one priority forecast will be to continue on our – reducing our debt level"
That's how a good capital allocator (and shareholder-friendly manager) is supposed to answer, even if for some this may sound too conservative.
Finally, in order to further de-risk the balance sheet, the company raised $500 million with the offer of its 4.625% Senior Secured Notes due 2028. The proceeds have been used to repay a portion of their 2025 term loan.
(Source: Graftech's Q4 2020 Earnings Presentation)
LTAs contracts and the steel market
During the last quarters, the company continued to work with some of its struggling customers to find a mutually beneficial solution regarding the outstanding fixed volume and price graphite electrodes long-term contracts.
As a result, some of the LTAs were extended to 2023 and 2024. Here're the most updated projections, reporting estimated volumes and revenues for the next four years:
I think that the company did a good job in making sure that the total value of the contracts was still acceptable, also helped by the recent steel industry recovery, which certainly reduces customers' financial stress.
The risk here is represented by not being able to lock such lucrative contracts in the future and being consequently exposed to the vagaries of graphite electrodes spot prices (which decreased from $5,700 per MT to $4,900 per MT last quarter).
One possible solution would be, in my opinion, that of structuring the LTAs differently, for example shifting them from a fixed-volume and fixed-price model to something which takes into account the current graphite spot prices.
The current situation clearly favors Graftech over the customer as they're getting much higher prices than spot. Conversely, if prices would shoot higher than $10,000 per MT like they did in 2017, customers would be happy but the company would earn less than what it could by simply selling its electrodes in the open market.
The solution I am thinking about is something like a double-capped model, in which the price is limited both on the upside and the downside, and will simply follow the spot prices when being within a specific range. This way both the customer and the graphite producer would feel they have an advantage in case of extreme prices, while relying on the prevalent spot prices during average market phases.
Improving industry fundamentals
A possible growth catalyst is represented by the recent improving steel industry fundamentals. Late in 2020, both capacity utilization rates and steel prices improved significantly. Various types of steel prices went up from 30% to 75% in the fourth quarter, which signals a very strong demand.
Usually, the market for steel supplies like graphite electrodes follows the steel trajectory with a certain delay, mostly depending on the customers' inventories level. CEO David Rintoul thinks that continued steel industry strength will "positively impact the graphite electrode market later in 2021."
Lastly, even if risks have been reduced and prospects are improving for the steel industry, I would stress that this is still a cyclical business which is strongly depending on external factors, so the intrinsic risk of operating in such industry cannot be further controlled or reduced.
For this reason, and also because of my recent shift towards financial strength as the most important form of protection against investment risk, I recently took advantage of the price increase to take some profits, reducing my Graftech position by 50%.
Conclusion
Graftech's management recently kept their promises and continued with the deleveraging plan, reducing long-term debt by $400 million in 2020.
Moreover, the company reduced its strong dependency from its majority shareholder, Brookfield Asset Management, which pushed down its stake to around 48% of Graftech's capital.
LTAs contracts deterioration slowed down, providing additional revenue stability, also due to recent steel industry fundamentals improvements.
Thinking about risk, even if the vertical integration represented by the owned needle coke producer, Seadrift, represents a competitive advantage and a variable the company doesn't need to control, steel prices are still unpredictable and would lead to very unstable and volatile earnings if the company would not manage to renew its LTAs contracts at competitive prices.
Increased graphite electrodes spot prices and newly (hopefully better structured) signed LTAs will be the proof that management's projections for the next years are getting traction.
Disclosure: The author owns shares of Graftech (EAF, Financial)
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