Graftech (NYSE:EAF)One of the most prominent graphite electrode producers in the world. Graphite is used in the production process of steel, using an Electric Arc Furnace technology (EAF). Graftech trades at a valuation of 3.2 x EV/Revenue and 6.3 x EV/Adj.EBITDA, or 8.2 EV/Adj.FCF. We are bullish on Graftech.
Graftech’s current push for a decarbonisation trend within the steel sector and pressure on the supply of raw material put it in a position in which its vertical integration allows it to have a limited downside while still making a profit. This, combined with sector leadership, can be purchased at less than 9x EV/Adj.FCF.
Let’s start at the beginning. Needle coke is required for the production of graphite electrodes. Graftech’s main raw material is needle coke. This primary raw material is derived either from the oil refining or from coal tar pitch. Because of its lower quality and higher impurities, Graftech prefers petroleum needle coke. This makes Graftech highly dependent on its cost.
Graftech acquired Seadrift, a company that produces approximately 20% of the world’s petroleum-based needle coke capacity, in 2010. This acquisition was made to the shareholders’ advantage and gives Graftech vertical integration with its supply chain and visibility into the market. Seadrift supplies enough needle coke to produce approximately 140000 metric tons (MT), or 70% of Graftech’s total capacity (202000MT according to their 2020). 10-k).
Graftech is the only graphite-electrod producer that has vertical integration. From the S-1Graftech’s 2017 document. The COGS (without adding depreciation), for a MT of graphite electrode made using raw material from Seadrift is $2,000. Management has not provided any updates, but we can expect a correlation with oil prices.
Not only is it used to produce GEs but also for the production GEs and GEs, as well as for the production NG and LB, which are two industries that are expected to grow in the current effort to decarbonize society. Sources: Here Here). Consequently, any price pressure resulting from these sectors on needle coke would be passed on to graphite electrodes immediately.
Graftech management has placed special emphasis on the demand arising in the battery industry. The company is experiencing high growth because of the increased demand for EV production. David Rintoul, Graftech CEO, stated that already in the second quarter of fiscal year 2021, he made his initial remarks. (source: Graftech Q2FY2021 earnings calls transcript)
After bottoming in the first three quarters of last year, we are seeing steady improvements in graphite electrode pricing. We are also seeing rising prices for petroleum needle coal.
This dynamic was further confirmed by Jeremy Halford, who insists on the subject during the Third Quarter fiscal year 2021.
We stated that prices were in the $1300 to $1800 range. Maybe something else, or something similar. The trend is up, and we have seen pricing rise in the last quarter. It ranges from $1700 to $2300.
I would guess that we would expect that if availability is continued to be tight, we would continue trending towards the high end.
If we assume that the information is not as current as Rintoul’s Halfords answer (source, conference call transcript for Q3) then we could be seeing needle coke prices ranging from $2200 to $2700 if the QoQ growth between Q2 & Q3 is also extrapolated to Q4.
Graftech is the supplier of raw materials. This is a one-sentence description of the raw material supply segment of the business. There is growing demand for Graftech’s raw materials, not only from the metalurgical sector.
Graftech offers graphite electrodes as a product to its clients. One electrode is produced in 3 to 6 months. It can be consumed within 8 to 10 hours of steel production. About 1.7 kilograms are consumed for every ton of steel. GEs were priced historically at a spread over needle coke, averaging $2200 between 2008-2018.
It is essential that electrodes have certain characteristics to be both functional for customers, and a complex industrial product for suppliers to make.
- Low thermal expansion: An electrode that expands when it heats up can cause it to break and render it unusable.
- High conductivity: Low conductivity (high resistivity) is used for electric currents, such as driving a car using the hand break off. The furnace will run more expensive if it has a high resistance electrode. To get the same amount out, more electricity must go into the electrode. It is in the best interest of the customer to have the highest conductivity.
The future looks bright for graphite electrodes. According to the World Steel Association (source: Graftech 10-K starting 2020). This is partly due to the growth in China, which has decided to encourage the conversion of steel production capacity to EAF using other technologies. This applies to the rest of world, too.
Moving from BOF to EAF is a key part of any serious plan to decarbonize the steel industry. Based on Asset Resolution’s asset level data, a traditional Basic Oxygen Furnace, (BOF), used to produce steel from iron ore, has a carbon intensity of approximately 1.6kg for every kilogram of raw steel produced. This compares to 0.3kg of EAF tech steel which produces 0.3kg of carbon per kg (source: Asset Resolution asset level data).
It is important that BOF and EAF have the main difference. BOF makes steel from iron ore. This is what comes directly from the mountain. EAF instead uses scrap metal and recycles it. EAF can mix ore and scrap depending on the quality of each.
Source: ETP2020 documentIf we were aligned with the Paris Agreement 50% of steel production would be from scrap. This is if we use EAF by 2070 volumes. Currently, it is 32%. The 50% is not a result of current steel consumption, but the 2070 steel consumption, which can be modelled as an increase in volumes.
Graphite electrodes will be in high demand if EAF steel is in demand.
We’ve seen that there could be pressure in the raw material side which could raise the price of graphite electrodes, or directly limit their supply. Graftech is protected from this pressure because of its vertical integration. We also saw that the demand for EAF steel will increase with the current goal to decarbonize the planet. Let’s summarize this into numbers.
Graftech places a high value on long-term agreements. They can provide a source of free cash flow. Unfortunately, they are rare. We will use their lower guidance range in this analysis. This is 95 MT, at an average price $ 9500/MT for 2022. We split the 2023-24 volume into two equal LTA volumes at 17.5MT at $ 10 000/MT (source: Press release for Q3).
As we mentioned, each MT of GE’s made from Seadrift needle coke has a cost of goods sold (COGS) of $2600. We can thus use that number to calculate the LTA gross profits. Seadrift needle coke is also used for the remainder of the production. Assuming that we run at 85% capacity (171700 MT GEs), 140000 units will be produced at a COGS $2600, while the remainder will have a COGS using spot-needle coke. The following prices for needle coke are for FY2022: $2700; for FY2024, $3000 and $3300 respectively.
To price the ton GE, we use the historical spread of $3200 above the needle coke as a reference point. These spreads will rise if there is tightness in the market as indicated by management in their quarterly call. We chose to input the following spreads due to the conservative nature of this model: FY2022, $3000, FY2023, 3200, and finally FY2024.
Based on the assumptions made above and taking into account the LTAs effect, the average GE selling prices are $7800, $6500, and $7100 for FY2023, FY2023, and FY2023.
We assume the following values for the rest of this model (Effective tax rates of 15%):
|R&D||$ 4,000,000.00||$ 5,000,000.00||$ 5,500,000.00|
|S&A||$ 70,000,000.00||$ 72,000,000.00||$ 74,000,000.00|
|Depreciation||$ 62,000,000.00||$ 62,000,000.00||$ 62,000,000.00|
|Taxes||$114,240,000.00||$ 79,941,000.00||$ 92,017,500.00|
|CAPEX||$ 50,000,000.00||$ 60,000,000.00||$ 60,000,000.00|
The following assumptions would result in a Free Cash Flow:
The high LTA volume, which is still valid for 2022 and commands a price of almost $10000 per ton, explains the difference in FCF between 2022-2024.
As visibility decreases, we don’t like to extend the life of our models more than a few decades. So we look at the next three years to see if they make sense. We believe it does in this instance.
Graftech is a worthwhile investment despite having conservative assumptions. Graftech will generate $1.6B in FCF over the next three year without any terminal value.
If Graftech can continue to operate at an average rate of $450 to $500 millions of FCF over the foreseeable future, we could purchase Graftech at a current valuation of 8x EV/FCF. We assume a market capital of $2.7B and a $1B debt, for a total EV $3.7B.
Graftech’s current efforts to decarbonize the world could have a long-term positive impact on both the input and the output side of the business. The demand for needle coke is increasing due to electric vehicles and nuclear power, which puts pressure on graphite electrode production. Graftech’s Seadrift ownership affords it vertical integration, which provides protection against this dynamic and gives it an edge against the rest.
These same decarbonisation dynamics will ensure that Graftech’s product is in demand.
Graftech yields 8 times EV/FCF, which is conservatively calculated. Management has already stated that the yield will go to debt repayments. However, stock repurchases would be possible if the value does not rise. If the stock price rises, the repurchases may be distributed as dividends to shareholders.