GrafTech International: Soft Steel (NYSE:EAF)

In August 2020, I concluded that shares of GrafTech International Ltd. (NYSE:EAF) were continuing to grind on. The company has seen a deterioration of the results since that time, which was not a big surprise, with volumes and spot pricing in the reverse.

The situation remained very uncertain amidst issues around governance and leverage, yet expectations were quite modest at the same time as well.

A Quick Recap

GrafTech is an interesting firm, being a producer of graphite electrodes, which are used by EAF steel producers as a key ingredient for cheaper and environmentally friendlier steel production. This comes as these input costs are limited in relation to the total cost of steel production.

This created a very interesting setup, as the input costs are relatively minimal, while being crucial to end users, while competitors find it hard (technically and financially) to bring new plants online.

The company went public early in 2018, and shares quickly fell from levels around the $20 mark, having fallen towards the $10 mark in the first half of 2019, with shares falling to the mid-single digits during 2020 as the pandemic clearly caused massive concerns on the future of the business.

The timing of the public offering had everything to do with EAF prices which rose from a mere $2,500 per tonne in 2017 to peak around $10,000 per tonne in 2018 and 2019, with the company locking up to $6 billion into contract revenues through 2022. On the back of this move in EAF prices, Brookfield Asset Management (BAM) (who had bought the business for $700 million in 2015) took the company public at a $5 billion valuation, in an IPO which was well-timed.

Some Perspective

GrafTech posted just over half a billion in sales in 2017 and about $100 million in EBITDA at a time when prices came in at between $2,000 and $3,000 per tonne. Revenues rose to $1.9 billion in 2018 as EBITDA exploded to $1.2 billion and decent earnings were reported close to $900 million.

2019 revenues fell a bit to $1.8 billion, yet overall results were still quite strong, albeit that the run rate deteriorated quite a bit in the final quarter of the year. This incredible earnings momentum was great, yet the company was still torching along a huge net debt load (equal to $1.72 billion by year end 2019). Earnings power of $2.50 per share, at a time when shares traded around the $10 mark, revealed incredible profitability and low earnings multiples being applied to these earnings.

First quarter sales for 2020 fell to $319 million, with earnings under pressure on the back of lower revenues as spot prices fell to $6,500 per tonne while net debt fell to $1.66 billion, as long-term contracts should be a counterweight to the big absolute net debt load.

Following these price declines, some clients were forced into bankruptcy already, having locked themselves into high prices with GrafTech in the past. Second quarter sales fell to $281 million, with spot prices down to $5,500 per tonne, with more sequential declines seen in the third quarter.

With shares trading at $6 and change in the summer 2020, when earnings power fell to less than $1.50 per share, I was in doubt. There was little information on the backlog, financial position of its clients, concerns about the near-term prospects, spot pricing, as well as poor governance. These concerns outweighed the appeal of a low earnings multiple, so I was happy to hold onto a modest long position, yet saw no need to alter this position.

Up – And Down Again

Since this former analysis in August 2020, shares of GrafTech have done quite alright, having risen to $13 per share in spring of 2021, yet ever since it has been all downhill from that point in time, with shares down to $4 per share at this moment of writing, near their lows.

What happened, of course, in the meantime was that 2020 has been a tough year, as sales fell to just $1.22 billion for obvious reasons with EBITDA down to $659 million. 2021 results, as released early in 2022, showed a modest recovery in sales to $1.35 billion, with EBITDA up to $670 million, allowing earnings to rise sixteen cents to $1.74 per share as spot prices hovered around $5,000 per tonne. Net debt was down just below one billion, much needed as the long-term contracts are rapidly running off, making that forward looking results likely remain under pressure on the back of spot pricing being lower than (long term) contract pricing.

The company started 2022 on a solid note with first quarter sales reported at $366 million and adjusted earnings up eleven cents on an annual basis to $0.48 per share. Spot pricing recovered to $6,000 per tonne, important as long-term contract values fell below $1.5 billion, about a year´s worth of revenues here. Second quarter sales were stable at $364 million, as adjusted earnings fell to $0.44 per share, with spot pricing stable at $6,000 per tonne, as net debt fell to $875 million.

The third quarter results were hurt by macro conditions and suspension of operations in Mexico (by the end of the quarter), causing sales to fall to $304 million with adjusted earnings per share down to $0.37 per share. The Mexican operations were suspended mid-September following some (environmental) issues. It is key to restart these operations, as they are responsible for nearly a third of total production.

The 257 million shares represents just over a billion in equity valuation at $4 per share, for a $1.8 billion enterprise valuation as net debt fell further to $827 million. This feels like a very low valuation as leverage ratio as EBITDA trends around half a billion here based on the third quarter results, with leverage equal to 1.6 times EBITDA.

What Now?

Having sold out way too early (around $10 per share) during the 2021 run higher, I find myself having to evaluate the potential of the shares here. At the moment of writing, shares have risen to $4 and change as news broke last week that GrafTech has obtained clearance to resume its Mexican operations after two months of production being halted.

This is clearly good news, as the backlog of LTA contracts has fallen to $1.2 billion, leaving some extra profits for some quarters to come, badly needed to keep leverage in check as economic conditions are getting tougher, of course.

For now, GrafTech remains a difficult and quite speculative play, albeit that the run-off in long term contacts and new economic concerns comes after a time when the company has been able to reduce leverage a lot already. This reduction in debt and a renewed start-up in Mexico should still allow for some deleveraging potential in the near term, as long-term upside for GrafTech International Ltd. depends highly on capital allocation and improved governance.