2023-08-15 13:33:35 ET
Summary
- GrafTech International Ltd.'s performance in the first half of the year falls short of expectations, with leverage and high interest expenses impacting the bottom line.
- The company, which makes graphite electrodes for steel production, saw a boom in spot pricing in 2018 but has since experienced declining revenues.
- With steel production remaining constrained and a high level of debt, it is not yet a good time to invest in GrafTech shares.
In February, I believed that it would become a tough year for GrafTech International Ltd. ( EAF ) in 2023, amidst volume declines, higher costs and lower output prices. Even as leverage has come down a lot in absolute manners, relative leverage ratios might increase rapidly, and with a tough year upcoming on many fronts, I was rather cautious.
This has turned out to become reality in the first half of the year, as the performance falls short of my estimations, meaning that leverage and high interest expenses have quite a big impact on the bottom line.
The Business
GrafTech makes graphite electrodes which are used by EAF steel producers as a key ingredient for both cheaper and environmentally friendlier production. These electrodes cost relatively little in the total cost price of steel production, creating an interesting situation from the outset.
This moreover comes as the industry is rather consolidated, with financial and technical barriers to bring new supply online being relatively high. It are these conditions, and a boom in spot pricing (from $2,500 per tonne in 2017 to $10,000 per tonne in 2018), which decided that Brookfield Asset Management to bring the company public. They made huge returns on their money after they bought the business ahead of the price boom.
A $500 million business, which posted $100 million in EBITDA in 2017, saw operations explode to $1.9 billion in sales in 2018 with EBITDA reported at $1.2 billion, and that is not a typo. Earnings power was badly needed, as Brookfield saddled the firm with $2 billion in debt, roughly three times the purchase price in 2015!
With earnings power reported at $2.50 per share and shares trading at $10, it was clear that earnings were not sustainable at those levels, yet the company locked in many of these profits through long term supply contracts. Despite that, spot prices slipped and revenues were reported at $1.2 billion in 2020 and $1.3 billion in 2021, still accompanied by higher margins. The long-term favorably priced volumes were rapidly running off, yet by 2021 the company had cut net debt below the billion mark, making it a race to deleverage while earnings were under pressure.
Here is where I picked the story up in February of this year, when shares traded around the $5 mark, after fourth quarter results revealed revenues of just $248 million, EBITDA of $80 million and adjusted earnings of $45 million (equal to $0.17 per share). Part of this was that production volumes of 29,000 tonnes were lower than the pro rate portion of the 157,000 tonne number for the year, due to disruptions of its Mexican operations.
Net debt fell to $787 million, but this leverage ratio could still become an issue as 2023 was set to become a tougher year from a profitability point of view while the value of long term favorably priced contracts fell to just $300-$400 million, to be realized in 2023/2024.
Believing that production might fall to 100,000 tonnes in 2023, with pricing of $6k per tonne, I believed that revenues might fall to as little as $600 million, likely pushing down EBITDA to $200 million, and thus making debt a potential issue, on top of the overall situation and poor governance structure with Brookfield still ¨controlling¨ the business.
Under Pressure
Since February, shares of GrafTech have traded in a $4-$5 trading range, now trading near the lower end of the range. The first quarter results, as released in April, were terribly soft.
Sales volumes of just 17,000 tonnes, and production even coming in a thousand tonnes lower, made that revenues fell to just $139 million, as EBITDA came in at just $15 million and an adjusted loss of $6 million was reported. While the results were little inspiring, the company guided for sequential improvements during the year, badly needed as this rate made my outlook for 2023 look highly optimistic.
The pain of such lower operational performance was seen in a $450 million note issue in June. The company placed $450 million in notes due in 2028 and while the notes carried at 9.875% coupon, they were priced about 2.5% under par, raising the effective interest rate to more than 10%.
In August, the company reported sales of 26,000 tonnes, again coming in a thousand tonnes ahead of production, as revenues rose to $186 million. While the improvement was noted (on a sequential basis, as revenues were still cut in half vs. this period last year), adjusted losses were stuck around $6 million, although EBITDA improved to $26 million.
Net debt was posted at $818 million after these tough quarters, and to preserve cash even the nominal $0.01 per share quarterly dividend was eliminated, saving the business about $10 million per annum. This is badly needed as second quarter interest expenses came in at $14 million, yet they are set to rise sharply following the June note placement.
Worse is that steel production will remain constrained because of global economic uncertainty. Full year sales volumes are seen at 100,000 tonnes now which indicates that just incremental improvements are seen from the second quarter numbers, not enough to be really profitable here or allow for some deleveraging, as it appears. One positive green shoot, the company believes that cash cost of production will come down in the second half of the year.
A Final Word
Given the very tough operating conditions, the high indebtedness (relative) and the complicated relationship with Brookfield, I think that it is absolutely too early to go bottom fishing here. Therefore, I have no interest yet to get involved with GrafTech International Ltd. shares again at prevailing levels.
Further sequential improvements (on the bottom line) are needed, but moreover a healthcare capital structure, before the risk-reward might become attractive.
For further details see:
GrafTech International: Tough Times Continue