I bought GrafTech International (EAF, Financial) for my portfolio in August 2019 at an average price of around $11.80 per share. Looking at my notes, there were three reasons why I thought the stock looked like an attractive investment for a holding period of the next five to 10 years:
- Fixed take-or-pay contracts provided a predictable level of cash flow generation that was easy to value.
- The company was committed to reducing debt with excess cash flow, which would have improved the balance sheet, removing one of the main risks hanging over the business.
- Electrical arc furnaces are cleaner than traditional blast furnaces, suggesting the demand for the graphite electrode products the business produces for the industry will only grow as the world tries to move away from higher-polluting technologies.
However, when the pandemic began at the beginning of 2020, GrafTech was one of the first stocks I sold. I sold at the end of March 2020 for a 31% loss (excluding dividends). It seemed at the time that those attractive take-or-pay contracts weren't so valuable when the bankruptcy of customers was a possibility.
I do not want to get into whether or not I made a mistake here. If I had held on, I might have been able to sell without a loss, but this ignores opportunity cost of using that money to invest in other stocks. Instead, the purpose of this article is to determine how the company has performed compared to my initial expectations.
The business has been through a lot over the past 24 months, although it has held up relatively well. Net income fell 42% last year, but sales and profits are rebounding. Sales jumped 21%, and income rose 27% in the third quarter of 2021. Looking at the company's earnings reports, it is clear that my original thesis about pricing holding up due to long-term contracts was mainly correct.
For the third quarter of 2021, the company sold "28 thousand MT at an average approximate price of $9,500 per MT and non-long-term agreement volumes of 15 thousand MT at an average approximate price of $4,600 per MT." I estimate this gives a weighted average price of $7,785. For the nine months to the end of September 2018 and 2019, the average weighted prices were $9,811 and $9,977, respectively.
These figures indicate that the company has lost some pricing power over the past two years. This can be explained by the fact that the business has had to renegotiate several long-term agreements throughout the pandemic as clients have suffered financial stress. It seems the corporation has been placing more output on the spot market as a result.
Management has said that there will be a significant uplift in prices throughout 2022. A double-digit increase has been mentioned, suggesting prices could rise back to pre-pandemic levels by the end of the year.
Production capacity has remained constant over the past two years, although capacity utilization has fallen around 85% to 70%. So, GrafTech is selling fewer products at lower prices.
To a certain extent, this decline is to be expected considering the stresses in the steel sector. Even though utilization and prices are lower, the enterprise is still paying down debt and returning cash to investors. Long-term debt has dropped around $2 billion at the end of 2019 to $1.1 billion at the end of the third quarter of 2021.
Management has also been returning cash to investors. It recently announced a $150 million stock repurchase program, on top of an existing program to return cash to shareholders. On the topic of market growth, estimates suggest that the electrical arc furnace market is expected to grow at a compound annual rate of 11% through 2025.
All in all, it looks as if my initial investment thesis for GrafTech's business remains intact despite the turbulence of the past two years, though whether or not it would have been a good idea to hold on to the stock is anyone's guess.
