GrafTech Stock: Failure To Deliver

Today, I follow up on an article published 11/14/2021 titled GrafTech: The Time To Deliver Is Now. In that article I outlined the bull case for the investment and several key issues for the company where investors needed to see progress from the company to be confident in the stock. Unfortunately, in the last 9 months I don’t believe any significant progress has been made and the stock price has justifiably floundered as a result. I move from a Hold to a Sell on GrafTech (NYSE:EAF), which is now a turnaround story that is not an attractive investment until we see significant improvement in the results.

Key Issues for GrafTech

To quickly recap my last article, I said there were three key headwinds for GrafTech that seemed to be subsiding:

• Brookfield’s ownership stake had declined below 25% and the final earnout payment to Brookfield had been made, meaning much less selling pressure on the stock going forward
• COVID did not cause buyers to default on long-term agreements (LTAs) as feared, meaning the LTAs would provide significant cash flow and allow the company to pay down the upcoming debt wall
• Management was beginning to look toward re-negotiating the expiring LTAs

I then outlined three key risk factors going forward that investors needed clarity on to increase confidence in the bull thesis:

• Chinese steelmaking capacity and demand are both mostly a black box, making it hard to forecast market dynamics
• The company had not communicated how LTAs fit into its long-term sales strategy
• The company had not communicated its preferred long-term capital allocation strategy

My position was that the company was attractive only if it could successfully leverage its competitive position to lock in higher-than-spot rates for the long term. This was illustrated by the company’s performance through the 2020 COVID trough. GrafTech reported $123M of cash flow in Q3 2020 when spot prices were at ~$4600/ton, but all of this cash flow came from their LTAs (at ~$9500/ton) – if all their volumes were sold at spot, they would have been essentially cash flow neutral.

Failure to Deliver

In the last 9 months, the outlook for GrafTech has not substantially improved, and in my opinion, there are a number of indicators that things are worse than they looked when I first covered the company.

First of all, the company has not been clear about its long-term capital allocation strategy. The debt wall continues to be paid down slowly and the company has engaged in some buybacks rather than increasing the dividend, which is surprising given the issues we’ll discuss below. There are no indications that capacity will be expanded, either via construction of new facilities or expansions of existing facilities, making it hard to see this as a “growth” story in the way that some may have hoped. While it’s understandable that the company is still focusing on debt paydown to an extent, it would be helpful to understand what the board sees as long-term priorities for GrafTech.

Most importantly, as the LTAs continue to phase out, the company’s statements on this issue have not been particularly inspiring. Below, I’ll link the CEO’s full response to a question about the LTAs on the most recent earnings call:

So, maybe, first of all, it’s important to point out that GrafTech has been providing graphite electrodes for a very long time before entering into any LTAs. So, I think, we’re fully prepared to handle this change.

Now, we continue to believe that there is a role that multi-year agreements will play in our portfolio. And they can be a win-win for our customers and for us, providing our customers with a hedging mechanism and surety of supply while locking in a portion of our cash flow. So, I think, as we move forward here, we will look to offer our customers a variety of contract terms tailored to their needs.

Specifically to your question, so we have had discussions with some customers already, and we’d expect to have some new multi-year agreements in place by the end of this year and into next year. Now, in general, we would expect those new agreements to be based on the current market conditions at the time that they are that they’re entered into, although we may consider a variety of pricing structures that suit the needs of both us and our customers.

However, it is important to note that while we will continue to offer multi-year agreements as an important part of our commercialization strategy and value proposition, we do not anticipate that they will make up the majority of our portfolio moving forward.

– Marcel Kessler, GrafTech CEO, 2022 Q2 Earnings Call

What we can probably take away from this is that:

• The company will be much more dependent on spot market prices going forward
• The company doesn’t see the LTAs coming in significantly higher than spot at the time of agreement (“…we would expect those new agreements to be based on current market conditions at the time that they’re entered into”)
• The company sees the LTAs as more of a hedging mechanism than a profit mechanism, which is what they’ve been since IPO

This suggests to me that what investors feared about the Brookfield LTAs is reality – essentially, that the company simply got lucky signing these LTAs at a high price before the spot market collapsed. If this is not a repeatable trick, there is no reason to believe that cash flows that came from LTAs will be consistent going forward.

Recent Results Don’t Impress

This is particularly concerning when we look at the most recent results GrafTech has reported with LTAs still in place. Recall that at the COVID trough in Q3 2020, the company sold about 65% of their volume under their LTAs at ~$9500/ton, and about 35% of their volume at spot prices of ~$4600/ton. In the most recent quarter, GrafTech sold about 57% of volume under LTAs at ~$9600/ton, and the remaining 43% at spot prices of ~$6000/ton.

Well, in Q3 2020 the company reported FCF of $123M (with $137M of excess revenue generated by the LTA volume), but in the most recent quarter GrafTech was only able to generate FCF of $48M (with $86.4M of excess revenue generated by the LTA volume)! What gives? The simple answer is that inflation is hitting GrafTech hard on the cost side, with major impacts on the cost of energy, freight and materials.

This is a huge problem for the GrafTech bull case, which was supposed to be based on their vertical integration into petroleum needle coke, one of the key inputs to the EAF-making process. This was meant to allow the company to weather cost pressures and guarantee access to their key inputs, two big competitive advantages. And yet, during a period of high inflation and rising spot market prices, the company is failing to improve cash flow generation (no cost pressure resistance) and the CEO is saying that LTAs will be a decreasing part of their strategy and sold near spot prices (no benefit from guaranteed access to inputs).

Furthermore, the company says it was forced to increase working capital because of supply chain issues:

Inventory builds occurred during the second quarter in advance of planned third quarter outages at our European electrode facilities and our Seadrift needle coke production facility. Also in anticipation of upcoming outages of certain oil refineries that supply decant oil. Additionally, early in the second quarter in response to market disruptions related to the conflict in Ukraine, on-hand quantities for certain raw materials that are essential to our manufacturing process were increased above our typical safety stock levels.

These actions were taken proactively to enable us to meet the electrode supply needs of our customers despite the current uncertainties in the global supply chain. As we move beyond the outage windows in the third quarter and as our visibility in the supply chain continues to increase, we anticipate beginning to unwind the inventory build as we proceed through the back half of 2022.

– Timothy Flanagan, GrafTech CFO, 2022 Q2 Earnings Call

But wasn’t the vertical integration meant to provide supply chain visibility and be a key source of GrafTech’s competitive advantage? It’s difficult to see the GrafTech pitch playing out in any of the company’s reported results.

Conclusion

In my mind, GrafTech’s results over the past year have failed to give investors any reason to be excited about the company’s future. Maybe the company performs well if steel prices go up, but as I said in my last article, there are hundreds of investments you could make that would benefit from rising steel prices. GrafTech is only interesting if its competitive position lets it weather down markets better than other steel industry competitors, and nothing about its recent results suggests that this is happening.

Along with the expiring LTAs, GrafTech now faces headwinds relating to a possible upcoming recession, and is navigating this with a brand-new CEO who just joined the company in July. This is not a combination that inspires confidence and I am recommending staying away from this name. If the company can successfully renew LTAs at higher-than-spot prices or pursue a different selling strategy that insulates them from spot market fluctuations, that might be a sign to get interested again.