Clone: Mohnish Pabrai unit price(Assuming he bought at the bottom): $10
Pabrai is very familiar with the needle coke industry through his investment in Rain Industries. This investment seems similar to his investment in ISPCO, with an emphasis on “similar”, not the exact same scenario. He simply lays out a model for us to use. Skip to 1:25:00 https://youtu.be/_0XPurSI9cQ
“Commodity businesses with heavy reliance on debt are playing with fire. One never knows how prices can change. Unless one is a low cost producer and debt-free, if prices collapse, one is likely to be in trouble.”
Mohnish Pabrai
“Low cost reserves, and low cost operation, putting you at the lowest end of the cost curve, no leverage, and a purchase price which is very low…Let’s say the commodity price collapses…at that point, the best thing to do is focus on these attributes. ”
Mohnish Pabrai
Market Cap: $3.2B($11/share)
Backlog(cash flow) to 2022 less debt: $2.2B($11.50). Backlog is 56% of their capacity. Visibility after 2022 is hazy, but you get your money back and are left with the company, it’s factories, etc. and the earnings from the remaining 44% of capacity.
Plans For Cash: 50-60% Buybacks/Dividends. Debt repayment, Cash Balance.
Metrics I am watching: Additions and cancellations of contracts, capex, price of needle coke, opening of St. Mary’s Plant, **Steel industry(added Q3 ’19)
Operation:
Graftech International produces graphite electrodes(GE) and sells them to steel mill companies. Graphite electrodes are essential in the manufacturing of steel via an electric arc furnace. Needle coke is an essential ingredient needed to make GE.
Petroleum refining process—>needle coke–> ultra high performance(UHP) graphite electrodes–>Electric Arc Furnace–>steel
There is a shortage of needle coke. Needle coke market is at full capacity and in high demand. Demand will most likely go higher via steel and electric vehicle anode demand. Needle coke is a limiting factor.
Low cost producer:
1. EAF is vertically integrated. It is the only company in its industry that produces and consumes 100% its own needle coke via its ownership of Seadrift Coke(supplies 75% of EAF’s GE production).
2. Competitors have to buy their needle coke from third parties. There are only 4 global facilities. Total cash costs/ton to produce 1 ton of GE is $2.6K for Graftech International. Competitors are exposed to the price fluctuations of needle coke which is currently $3-5k for just the cost of needle coke alone per 1 ton of GE. The higher the needle coke price, the worse it is for competitors.
Contracts:
1. Cash flow Backlog to 2022 less debt: $2.2B($11.50/share). Intends to return 50-60% ($6-7) of free cashflow to the shareholders in dividends and buybacks.
2. Take-or-pay contracts(50-70% of remaining contracted revenue).
3. Avg. contract is $10k/ton(70% gross margins), current spot price: $12-15K/ton.
4. Percent of capacity under contract:
2019: 66%
2020: 59%
2021: 51%
2022: 49%
The remaining capacity is available for contracts which could be valued at currently higher spot prices.
5. Contracts have built in inflation escalators. 6. Contracts are split between 100 clients with none being higher than 8% of the pool.
Other Operational Advantages:
1. Increasing GE capacity from 208 to 230 tons(11%) from 2019-2022 via capital improvement projects. Has an idling plant in St. Mary’s. (had plans to open it in 2019, but didn’t, will only start if it has signed contracts it can fulfill and if it can get the necessary needle coke).
Tailwinds:
1. It takes years to build new needle coke and graphite electrode plants(3-5 years per Graftech management.)
2. Increasing China demand for steel. China has no domestic source of high quality petroleum needle coke.
3. High barrier to entry. It is more difficult to build GE facilities in China d/t increasing environmental standards. EAFs are more eco-friendly than Blast Furnaces(BF). Pabrai alludes to this when talking about Rain Industries.
4. Ability to open St. Mary’s plant if demand increases for $10-15M vs $300M to build a new plant for competitors.
I recently found an interview of Pabrai giving the reasons why bought EAF. Here it is from the horses mouth. It starts on page 25.
Click to access Graham_Doddsville_Issue37(2).pdf
Bear:
1. Contracts are weak: d/t clients going bankrupt or spot prices falling below contract prices and clients demand a renegotiation.
-Rebuttal: The resilience of the contracts is the most important thing: (A) Contracts are already well below spot prices. The spot market would have to fall well below the contract price for it to be an issue. If spot prices do tank, I don’t know how the courts will rule, but I assume there has to be a legitimate reason to be able to dissolve the contract other than current spot prices are lower than the contract price.(B) If somehow they do renegotiate or act on “take or pay” at 1/2 the price of the contracts you are paying $11/share to get cash $5.75/share less debt by 2022. Investment goes from great to mediocre. (C) GE are a tiny fraction of the cost(around 2-5%) of the end product, steel. It is not the limiting factor for the clients (D) I have no idea how they will get their money if a client goes bankrupt, perhaps they will be considered a critical vendor due to their importance to the steel industry.
2. Risks that do not affect the contracts:
A. Decrease in spot GE prices
B. Decline in Steel production reducing decline in GE demand***Changed Q3 ’19
C. BAM Selloff of position
D. Competitor capacity addition
E. Electric Vehicles moving from needle coke to silicon compounds
3. Risks that can affect the contracts:
A. Limited needle coke supply outside of Seadrift production
B. Delays in production
C. Unforeseen costs in production or capex
4. When is St. Mary’s going to contribute: It was supposed to start in 2019. Q2 ’18 earnings call revealed that they weren’t sure if they could get enough needle coke for it. Q3 ’18 earnings call, management brushed it off saying it’s too early to talk about it, and that the environment isn’t primed for it saying “we want to take the environment the market gives us.”
Rebuttal: High needle coke prices is better for the vertically integrated EAF because it eats into their competitors margins. Anything beyond the current contracts from St. Mary’s is extra stuff that falls off the truck. However management is being vague about St. Mary’s and that is a red flag.
5. Debt: The cash flow vs debt ratio isn’t excessive and well managed.
Q3 ’19
I think EAF is still a good investment, however, the conference call dampened my confidence in it due to the managements lack of clarity. I added buybacks, which is outside of the metrics that I’m watching, mainly to illustrate that management is not being clear.
Contracts: Their 2018-2022 contracts in MT have had a steady decline from a high of 674 to 663 due to renegotiating contracts and clients going bankrupt. From 2020 to 2022 the decline is 9, about 3 a year. I initially thought that the contracts were independent of the steel market, but it appears that the company has no way, or it is not worth their time or resources to collect on the contracts from their bankrupt clients. When asked if they are renegotiating contracts to alleviate stress on their clients, the CEO said that he did not want to talk about it because it could give leverage to other clients in renegotiating their contracts. This is reasonable to me, I liken it to it being in the employers best interest if employees don’t talk about their pay, to reduce giving them leverage to negotiate higher pay for themselves. Also, The cost of GE to the steel mills are 2-5% of their costs. Very unlikely that renegotiating the contracts would save the clients anyways.
Steel Industry: The industry is currently softening and the CEO thinks it will rebound in the second half of 2020. When asked why he thought that, the CEO gave a half answer saying that he thinks that the clients will burn through their current GE inventory during the 1st half of 2020. When asked level of days supply the customers have the CEO said their was too much variability among the 100+ suppliers they have.
Needle Coke: When asked how the prices of needle coke are trending, the CEO instructed the analysts to read public reports and that prices haven’t changed much from those reports. Why not just say the prices or trend?
St Mary’s: They extended their plans to open their St. Mary’s Plant from 2019 to the first half of 2021. However they previously stated that they will only open the plant if they have the demand. They haven’t been consistent on this issue. I will use the opening of St. Mary’s plant as a proxy to estimate demand. They are currently at 85% production capacity for the year.
Buybacks: When asked why they have only spent $9M of the $100M approved on buybacks, the CEO gave a non answer saying that they made opportunistic repurchases and that’s all he detail he could provide.
I still think it is a good investment. However there is more hair on it than I thought such as the opaque management and aspects that are different than what I initially thought, such as the durability of the cash flow(contracts), and being independent of the cyclical steel market. I take solace in that during the softening of the industry will hurt Graftech’s competitors more than it will hurt them.
The Rational Cloner 