**Idea Source: Massif Capital**

GrafTech International (EAF) is a leading manufacturer of high-quality graphite electrode products that are essential components to the production of Electric Arc Furnace steel. The company sports a vertically integrated, highly differentiated business model with supply-side advantages giving it pricing power over competitors. Reduced supply of electrodes coupled with increased demand and long-term contracted revenues present large tailwinds to double one’s investment. We believe current share prices signal extreme misunderstanding from Wall Street on the future of GrafTech’s business. Existing contracted revenues provide a path to over $3B in FCF over the next five years (almost 70% of the current market cap), all of which the investor can own for under 5x EBITDA. If that’s not good enough, management has a history of returning high percentages of those cash-flows back to its shareholders in the form of dividends, buybacks and special dividends.

Industry Background and Overview

Electric Arc Furnace steel production is the fastest growing sector within the overall steel industry, growing around 8 – 10% in 2017 compared with Blast Furnace production at around 3.5%. EAF has grown at higher rates mainly due to greater resilience, a more variable cost structure, lower capital intensity and less taxing on the environment. In order to run Electric Arc Furnaces, producers rely on graphite electrodes as an essential part of production. That the electrodes generate enough heat to melt the scrap metals (and other materials) while being able to sustain composition without breaking down makes GE the only product on the market capable of fulfilling EAF requirements. In order to make these graphite electrodes, you need petroleum needle coke to serve as your largest raw input. Without getting too deep into the weeds on this, it’s important to know that petroleum needle coke is a final-stage carbon and highly essential for the production of electrodes using the EAF technique.

Petroleum Needle Coke & Vertical Integration

The petroleum needle coke industry is extremely concentrated with Phillips 66 and Seadrift Coke, LP accounting for more than 50% of the overall market. Demand for needle coke is growing rapidly due to two structural changes: Supply shortages & increased product demand. Since 2014, the needle coke industry has consolidated and retired plants resulting in a 20% reduction in overall supply. This makes intuitive sense given that in 2016, graphite electrode prices per metric ton were just $2,600 – causing most firms to retire (in some cases permanently) plants that were running at losses. GrafTech is now well positioned, capturing both the supply side — with the petroleum needle — and the demand side — finished electrode products.

GrafTech acquired Seadrift Coke in 2010, significantly reducing their dependence on third-party needle coke providers. Seadrift Coke provides GrafTech with over 60% of its required needle coke material to produce their electrodes. This vertical integration provides GrafTech with incredible cost savings compared to its competitors as well as a more secure source of materials when supply runs tight (like current conditions). In doing this, GrafTech enjoys a 26% margin advantage against its competitors that use third-party suppliers to source their needle coke. To put that into numbers; GrafTech spends roughly $2,500 per metric ton on producing electrodes while their competitors spend over $5,000 to produce the same electrodes.

The supply/demand discombobulation resulted in skyrocketing prices for graphite electrodes. Between 2006 – 2016, graphite electrode (GE) price per ton floated around $4,500. With the renewed vigor from the demand side, GE prices per MT ranged from $15,000 – $30,000 in 2018. These record prices won’t stay around forever, and the GrafTech management teams knows that. In order to capture as much of this price hike as they can, the company changed their sales strategy, focusing on long-term take-or-pay contracts.

The Power of Contracted Revenues

Before 2018, GrafTech ran on 100% short-term contracts (less than a year), mostly six months in duration. Given the price hikes and demand for their product, switching to long-term take-or-pay commitments provided the company with high visibility into revenues over the next five years. GrafTech has over 100 existing long-term agreements — 87% of those of the five-year type – for a total contracted supply of around 636,000 metric tons, locking in an average price per MT of $9,700. That’s a contracted revenue backlog of over $6.2B over the next five years.

Couple these revenues with the cost advantages the company enjoys through its wholly-owned subsidiary and you end up with 65% gross margins on that $6.2B in revenues. After netting out capital expenditures (which are around 8% of total revenues) we’re left with $3.1B in free cash flow over the next five years. Even if you subtract out debt, the company is still projected to crank out over $2B in unlevered FCF. If we use today’s market cap value of $4.1B (as of 02/15) that means 75% of the company’s market cap will be generated in FCF over the next five years. These figures are only for the take-or-pay contracts, we still haven’t talked about the spot price sales business that churns out cash, which we’ll touch on soon.

What Will Management Do with The Cash?

It certainly is a great thing that GrafTech can generate large amounts of cash, but if management is lousy at allocating, what good are those cash flows? Luckily management has shown a track record of being extremely shareholder friendly since its IPO back in April. Before its last earnings report, the company generated Post IPO FCF of $595M. Of that $595M, $203M went into special dividends, $225M went to share buybacks, $69M went to standard quarterly dividends and $56M went to debt repayment. In other words, management has returned 84% of its FCF to its shareholders.

Looking forward, management laid out a similar plan for 2019 capital allocation in their last earnings call. Share buybacks and regular dividends are on tap for 2019, but management will allocate more capital to paying down debt – adding $100M in repayment on top of their $28M minimum requirement. I like the idea of splitting the allocation between buybacks and debt repayment. In fact, I wouldn’t mind seeing them chip away at the dividend to pay back debt and increase buybacks – both of which would be more accretive to shareholders compared to a dividend.

Valuation

With a business like GrafTech, it makes better sense to value its two sales components as a sum-of-the-parts valuation. Let’s start with contracted revenues segment. The company is expected to generate roughly $3B in FCF. If we assume 65% gross margins – in line with the cost and price at which their revenues are contracted – we arrive at around $970M in 2022 EBIT. Taking out taxes, capital expenditures, D&A and changes in working capital we achieve 2022 FCF of $753M. Assuming a terminal growth rate of 1% we get an Enterprise Value of $7.6B and an 8x EV/EBITDA multiple. Adding in net debt of roughly $1.4B and dividing by shares (290M) we get an intrinsic value range around $21 – $22. We can cross-reference this with a multiple valuation, at 10x and arrive at $24/share for the contracted revenues – giving us a near 40% margin of safety.

Moving on, GrafTech generated roughly 30% of revenues from spot volume sales. To be on the conservative side, we’ll assume spot prices mean revert to the lower end of their range (roughly $7K/metric ton). Keeping spot volumes close to 25% of revenues gets us 2022 EBIT of $226M. After backing out taxes we’re left with FCF of $178. Keep in mind GrafTech doesn’t incur any cap-ex costs for their spot volume sales. After taxes, all incremental increases in revenues drop straight through to FCF. Assuming the same growth rate of 1% and a 10% discount rate, we get an EV of $1.5B – giving us fair value range around $5/share.

So, not only are you getting the core contracted revenue business for a substantial discount, but you’re thrown in a $5/share spot volume business for free. In fact, you can get all of this for less than 5x forward earnings and 5x EBITDA.

Risks

I couldn’t get away writing about a steel producer without mentioning China. The steel industry has experienced cyclical headwinds, notably in 2008 – 2009 when EAF steel production cut 17%, as well as between 2011 – 2015 when production declined another 10%. These production declines were mostly the result of Chinese BOF steel over-production. However, the China risk seems mitigated for two reasons. First, China doesn’t manufacture Electric Arc Furnace steel – they work mostly with BOF steel. Secondly, China has no direct source for petroleum needle coke – so even if they wanted to start producing EAF steel, they would have to first find a way to obtain the raw material in a tightening supply market.

Other risks would be a sharp decline in the price of graphite electrodes (like the prices around 2016 at $2,600/metric ton). A decline in the use of Electric Arc Furnace steel production would cascade into reduced demand for the electrodes, causing downward pressure on margins and profits. Another risk would be continued selling pressure from Brookfield (who acquired GrafTech in 2015), which controls a healthy portion of shares outstanding.