Summary
- GrafTech sees volume declines, higher costs and lower prices in 2023, creating a very tough setup.
- While leverage has come down a lot, relative leverage ratios might increase quite rapidly here.
- The upcoming year will likely be tough on a number of fronts, making me very cautious.
Shares of GrafTech ( EAF ) have taken a leg lower as quarterly results did not meet rising expectations in recent weeks, amidst a market in which beaten-down names and cyclical players have seen a huge recovery in their share price.
In November, I called GrafTech a soft steel play, as investors were dealing with the implications of slower demand as well as a production suspension in Mexico, creating additional uncertainty amidst leverage and governance concerns.
The Base
GrafTech is inherently an interesting firm as it produces graphite electrodes which are used by EAF (hence the ticker symbol) steel producers as a key ingredient for both cheaper and environmentally friendlier production. With the cost of these electrodes being relatively a small component in the cost of steel production, this situation from the outset is quite interesting.
The latter is certainly the case as it is hard for outside players to enter this consolidated industry, with technical and financial barriers to bring new capacity online being quite high.
The company went public in 2018, a time at which EAF prices had risen from a mere $2,500 per tonne in 2017 to spot prices around $10,000, creating an opportunity for its owner Brookfield Asset Management to bring the business public. Brookfield made a killing, after buying the business at a mere $700 million valuation in 2015, while shares were appraised about $5 billion at the time of the IPO (even excluding debt).
A mere $500 million business in 2017, posting about $100 million in EBITDA, had seen financial results explode in 2018 amidst the price moves of the electrodes. Revenues rose to $1.9 billion in 2018, with EBITDA reported at an unheard $1.2 billion. Such earnings boom was welcomed as the company operated with around $2 billion in net debt at the time. This leverage and envisioned non-sustainable earnings, made that shares only traded at $10, even as earnings power came in around 2.50 per share, and even as the company has secured these profits with multi-year contracts at high prices.
Spot prices fell from about $10,000 to $5,000 per tonne in 2020, as demand waned, yet price transparency has been very little. Nonetheless, earnings and sales fell, yet leverage had gradually come down as well. In the end, 2020 sales fell to $1.2 billion, with EBITDA margins still seen above 50%, as 2021 results show a modest recovery with sales up to $1.35 billion, although EBITDA was up a fraction.
The volume of higher-priced long-term contracts was rapidly coming down, but at the same time, net debt was reported below a billion by the end of 2021. With sales trending at $1.5 billion in the first half of 2022, net debt fell below $900 million, as third quarter results were a bit soft and GrafTech was hurt by suspension of its Mexican operations, key as it was responsible for about a third of production.
With 257 million shares awarding equity just over a billion valuation at $4 per share, the enterprise valuation of $1.8 billion was low with EBITDA still trending around half a billion. Besides these concerns mentioned above, there were the long term concerns on governance with Brookfield as a major shareholder.
Recovery And Coming Down
After issuing a concerning take in the fall, shares have risen to $6 and change in January amidst optimism on the economy, as shares fell overnight to $5 and change in February with the fourth quarter results revealing some negative surprises.
In November of last year, GrafTech announced that it resumed its Mexican operations. Despite the resumption of production, the impact on the fourth quarter results was clearly seen. Production volumes of just 29,000 tonnes fell way short of the 157,000 ton number for the entire year. Revenues did still come in at $248 million for the quarter on which EBITDA of $80 million was reported and adjusted earnings of $45 million.
The temporary suspension of the Mexican production was only in part to blame as lower prices, demand and higher costs were attributable as well to lower margins, albeit that spot prices appeared firm (yet the composition of spot prices versus long-term contracts keeps rising). Adjusted earnings came in at $0.17 per share, but the 2023 comments provide no illusion that this should be expected to improve this current year.
Net debt has fallen to $787 million, with leverage reduction being badly needed given the lower profitability as long-term contracts have largely run off now. In fact, the value of these contracts is only seen at $300-$400 million in the coming two years, hardly providing support here anymore.
This is worrying as the company specifically cites that the production suspension in Mexico has created long-term uncertainty with a key client, so even as production has been restarted, it does not create an automatic recovery. Lower anticipated volumes and general inflation makes that the margin profile is set to worsen as well, setting the company up for a challenged year, in fact, sales volumes are set to half in the first half of this year versus 2022.
Pegging volumes at 100,000 tonnes this year while seeing average prices at $6,000 per tonne (with long-term contracts running off) one should not be surprised to see a run rate of just $600 million in revenues by year-end with margins coming down amidst deleveraging and higher costs. This makes a run rate of $200 million in EBITDA by year-end quite realistic, and in that sense, debt remains on the high side.
Given the discussions above, I can only conclude that the 2023 outlook is softer than I expected late in 2022, making me very cautious here as I see not a reason to get involved just yet.
For further details see:
GrafTech: Very Soft Heading Into 2023