Companies – The Rational Cloner

This document is a collection of Pabrai’s own words on Graftech from his lectures/interviews with Graham and Doddsville”” Boston College Lecture() Manual of Ideas[]. Citation is made via punctuation respectively notated above.

Where he found the idea
“There’s a fan of Mohnish in Canada who sent me the full write-up and thesis on GrafTech. All I had to do was to have mastery of the English language, and thankfully the education system did teach me that. I read it and I said “Okay, let’s verify the facts.” And the facts all checked out.”

What it does:
“GrafTech makes ultra-high performance electrodes, which go into electric arc furnaces that are used in mini-mills to make steel. Nucor, for example, is a customer. There are two ways to make steel: you can either make it with iron in a blast furnace or you can melt scrap in an electric arc furnace. To melt the scrap, you need these graphite electrodes able to withstand the 2,000- or 3,000-degree heat in the furnace. GrafTech makes these electrodes.”

Constrained Capacity
“There are only three or four other manufacturers of these electrodes in the world. It takes three to five years to construct a new ultra-high performance electrode manufacturing facility for greenfield expansion, so supply is very constrained. On top of this, GrafTech is the only manufacturer in the world that is backward-integrated. There is a very critical raw material required to make these electrodes called needle coke and, again, there are just three or four manufacturers of needle coke in the world. (Outside of China there are only 4 needle coke producers in the world, 2 are in the U.S. and 2 of them are in Japan. The one in the U.S. is Graftech, in Texas). “It’s a byproduct of refining petroleum; for example, ConocoPhillips is a big supplier of needle coke…It takes a long time to construct a new needle coke facility, maybe five years or more. To sum up, there are number of factors in this industry that make it challenging to instantaneously raise capacity. ” ( So if someone were to try to bring in new capacity of needle coke, there are a number of challenges…One of the challenges is that the last needle coke plant built in the world was…the Graftech plant….40 years ago. The know how to build..and run those plants are…non existent. Pretty much..the only players who could even go there would be the existing players…The time it would take from the time you said, let’s go build a plant to the time you have production coming out the other end is close to 7 years. And the cost would be several $100M. So its very hard to justify the capital required, let’s say $500M…and the gestation period of the seven years, with no crystal ball to tell you what the market looks like 7 years from now. So, as far we know, the none of the non china players are planning any…capacity increase or new additions. So this tightness of needle coke may continue well past 5 years… Needle coke has another application which is in EV batteries, and that demand…is skyrocketing….It could cause significant tightness.)

Cycle
“In 2018, prices for these electrodes went crazy. Historically, they were $2- 3,000, maybe $4,000, a ton. Last year, they went all the way to $25,000 or $35,000 a ton. They just went bonkers. Of course, all the electrode manufacturers reaped incredible profits.”

Contracts
“These electrodes represent only 3% to 5% of the total cost of making steel. It’s a small part, but it’s a critical one. The chemistry of these electrodes is very important, and so is the consistency of the supplier. GrafTech went to their customers and said “Hey, these electrode prices are going crazy, it’s hard to get supply. Do you want to sign a contract with us where we’ll guarantee the supply and the price for the next three to five years?” All kinds of customers took them up on that. As a result, 70% of their production for the next several years is already sold, at a known margin and a known selling price. These are locked in, take-or-pay contracts. Unless the customers go bankrupt, these are enforceable contracts. Furthermore, they’re spread across hundreds of customers, so the revenue stream is very diversified. If you look at that 70% of revenue which is locked-in over the next several years, it covers the market cap. It’s IPSCO 2.0. Now it’s not coming in two years because it’s not 2004 – it’s coming in five years. But such is life; that’s still okay… The other 30% of production is sold on the spot market. This gives you a variation on what can happen. If electrode prices go crazy again, they will make super profits. They’ve only sold the production where they know what their costs are. No other ultra-high performance electrode manufacturer can offer their customers these types of contracts because they don’t have control of the raw material, so they don’t know what their cost of raw materials is going to be three years from now. GrafTech is the only manufacturer that can offer this.

Moat
“GrafTech is the only electrode manufacturer which owns a large needle coke facility.” (They pretty much have a lock on the production cost of needle coke…They are the low cost producer of needle coke. So for example, today, if you are an UHP producer, you would be paying $4,500 to $5,500 per ton per needle coke, in the case of Graftech, their production cost, needle coke and everything they need to make their electrodes is $2,750 per ton. So while the other producers may be at…$6,000 or $7,000 per ton, Graftech is at $3,000 or $2,700 per ton. That’s a pretty significant delta….for about 70% of the production.)

Improving Efficiency
(Before Brookefield bought them, they had six plants, what Brookfield did was take 6 plants down to three…they honed in on a whole bunch of manufacturing efficiencies… and streamlined those plants and their cost structures…It’s not a business where they’re looking at huge tailwinds and just flying on those tailwinds…they went into the details of manufacturing to get efficiencies..and even..today, Graftech had an earnings call, they have two plants…one is in Monterrey and one is in Pennsylvania. Pennsylvania has been mothballed and could be brought back to life. They are moving some work from Monterrey to Pennsylvania, it’s a 2-3 year project for them to do these movements, it doesn’t increase capacity, but it definitely takes it’s cost structure down. This is a business that is doing continuous ..blocking and tackling to improve their efficiencies.)

Valuation & Downside Protection
“There is a company called GrafTech that recently showed up on my radar. It’s similar to IPSCO in many ways. We don’t know the trajectory, but I think the odds of losing money are pretty muted, while there’s a built-in element that could give me a nice double or triple in not too long. What’s not to like about that? ” (So if you look at it very simply… the company has, let’s say, realistically, maybe the ability to produce 180,000 or maybe 190,000 tons of UHP electrodes a year. And approximately 145,000 of that, they have this low cost advantage. Maybe there is about 30,000 to 40,000 tons where they don’t have the low cost advantage. Those 30,000 to 40,000 tons, even in today’s environment where profits are good for everyone, it’s probably like, maybe $60-80M in..EBITDA…from that non captive of 30%. And the captive tonnage which is the 145,000, that’s before you take out corporate overhead and everything else, your at $2,750 and you’re selling at close to $10,000….You’re at north of a billion in margins and then you can take out $60-70 million of overhead, and another $60-70M of capex,…and maybe another …..$125M for debt. So you take out $300M and then you take out taxes, you still have about..$500-600M[which is locked] for several years. Between their cashflow in the next 5 years, is..approximately equal to the market cap. This advantage…with needle coke, could extend well beyond 5 years. The bottom line, is the bet i made, is …We’ve got a very prudent capital allocater, and owner of Graftech in Brookfield…Brookfield understands buybacks..capital allocation…really well, they own 80%of the stock…and three of their guys are sitting on the board…I would expect that the cashflow that comes out of Graftech, in the next few years, will have some very efficient usage. probably, most likely, a large portion is going to get returned to shareholders, because they don’t have any other need for the cash…It looks like…heads I win, tails I don’t lose much. the downside is quite well protected, the upside is kind of hard to gauge. But i think if you can make bets…where you cover the floor…that’s much of the battle.) “From my point of view, it’s the same thing as IPSCO. Who knows what’s going to happen here? I certainly don’t. But why do these opportunities exist in the first place? It’s because markets hate uncertainty. The market, just like me, has no idea what the other 30% of production is worth. And Mr. Market has no idea what cash flows look like for 100% of production after five years. But we’ve got the downside covered, so we just sit on it. If at some point we get a deal done with China, we get a deal done with the rest of the world, if the world starts humming again, maybe things go crazy. But maybe none of that happens and we get our money back. There’s a wide range of outcomes, but virtually all are acceptable.” (There are scenarios under which, we can lose money on Graftech, there are scenarios under which Graftech can go to zero, there are many things that can happen which can destroy the thesis. That doesn’t mean it’s a bad investment. There are business where you could make 10x your money and it would not have been a prudent investment. And there are businesses you would have lost a lot of money and it was absolutely correct to make the investment. And… as long as we have done our homework and try to assess the probabilities correctly, you can not always tell the score by what’s on the board. you have to go deeper than that to tell the score.) [I don’t know whether I should mention this but I’ll go out on a limb: one of the businesses that I think we’re almost at the tail end of buying, is a company which in the next five years will generate cash flows equal to or probably higher than its market cap. It’s like with IPSCO — they are contracted cash flows. They’re locked in. It’s not just giving a multiple. You actually have visibility into 2022, 2023-type numbers. The company is probably going to dividend out these cash flows as they come out. If I invested, say, $50 million in this business, and $50 million or $70 million of cash flow will come in in the next five years, and that entire $50 million or $70 million gets pushed out, then in five years, I’ve got my money back. In fact, some of that is starting to come back a year from now, but I still own the business, and I still own all the assets and plant and equipment and all of that, just like IPSCO. I like those types of bets. I cannot tell you what that business is worth, but I can tell you what the floor is, and we’re buying below the floor. That’s quite exciting. Anytime we get to make these kinds of bets where we have very low risk with very high uncertainty, then the next part of the equation, which is a likely high reward, is on the cards. I have more experience now than I had when I was doing Frontline, but we’ll see how it actually plays out. If it doesn’t play out with a bull case, then we won’t lose any money. We’ll probably make some money, if it works out with a bull case, then we’ll make a lot of money.]

His conviction in the company
“At the end of the day, price matters. I wish I can get better at this. I think many times companies that look expensive are actually cheap. It’s all a matter of the future cash flows. But I am such a cheapskate, as you saw with IPSCO and GrafTech. Should I buy GrafTech or should I take a flier on MasterCard? GrafTech or Amazon?” … “But I think if you had something like GrafTech, someone like Charlie Munger would say if you had two other positions, you’ll be fine. In fact, Charlie would probably say that if you were 1/3 Berkshire, 1/3 a compounder like Costco, and 1/3 GrafTech, that’s probably okay”

Category: Companies

MU

JPM, BAC

BRK.B Financial Fortress

ADS triple clone

EAF from Pabrai

FCAU PE2 PCash1

EAF Contracts of Gold