Note: We have used “GrafTech” to represent the company, while EAF is used for electric arc furnaces.

GrafTech International Ltd. (NYSE: EAF) is one of the largest producers of graphite electrodes in the world. These electrodes are used in the production of steel using a technology called an electric arc furnace, or EAF.

We’ve covered this stock before and the last post was about 6 months ago where we decided to hold off and let things play out. We didn’t like that Brookfield Asset Management Inc. (BAM) was selling stocks in a price-insensitive manner, nor did we think the valuation was attractive. Since then, GrafTech gave bulls and bears some hope, but ultimately didn’t move much.

We take a look at Q4-2021 results and tell you where we stand on this one.

Q4-2021

The fourth quarter showed continued improvement in net sales which amounted to $363 million. Production and sales volumes in metric tons also increased sequentially.

The company’s total adjusted EBITDA net earnings per share also increased significantly, even as free cash flow fell.

GrafTech attributed this to higher levels of inventory and accounts receivable. Overall, 2021 marked a year of key improvement, with GrafTech paying off $400 million in debt. This is quite a substantial amount and its net debt to EBITDA grew to 1.6X at the end of the year. The company is on track to clear its 2025 debt maturity by the end of 2023 at the latest.

It is also on track to have net debt to EBITDA below 1.0X by the end of 2022. Assuming it reaches consensus EBITDA levels, it only needs to erase the three-quarters of the debt it wiped out in 2021 to hit that benchmark.

This should be easier to do, given that interest charges have fallen and its EBITDA rates are higher.

Why does it always trade so cheap?

GrafTech trades at around 5.0 times earnings and that’s hard to call expensive, however you calculate it. He also got out of debt in style and gets no praise for it.

If it reduces debt to less than 1.0x EBITDA by the end of 2022, as we expect, we wouldn’t be surprised to see another credit upgrade for discipline. This all sounds good, but there are a few hurdles here to making the bullish case and we go over them below.

The first issue here is that the 5.0XP/E multiple is artificially depressed through long-term deal or LTA price selling. These were put in place at a time when spot prices were above $10,000 per ton versus around $6,000 today and $5,000 in Q4 2021.

Our fourth quarter shipments included 29,000 metric tons of graphite electrodes under LTA at an approximate average price of $9,400 per metric ton and 15,000 metric tons of non-LTA sales at an approximate average price of $5,000 per metric ton .

Source: GrafTech Q4-2021 press release

If we value the total volume of 44,000 tons at $5,000 a ton, keeping everything else constant, the pre-tax income drops to $20 million from the current $163 million.

That could get you around 6 cents of earnings per share and the P/E would be closer to 40X. Of course, investors can point to the fact that prices are improving with forecasts of $6,000 per ton in the first quarter of 2022 and that long-term agreements will provide support in 2022. No argument from us on these points, but keep in mind that we are at the end of LTA pricing after 2022 and at some point these will all be spot prices.

GrafTech is also experiencing strong inflationary headwinds, despite strong vertical integration.

Like most other industries, we too are experiencing inflationary pressures in some aspects of our business and we expect this to impact our cost per metric ton in the range of 7% to 9% from the fourth quarter.

Electricity and natural gas costs remain high, particularly at our European sites. However, we are well placed to effectively manage this environment. GrafTech’s significant vertical integrations allow us to manufacture a significant portion of our key raw material at a relatively stable price, which is a major competitive advantage over our peers.

Source: GrafTech Q4-2021 conference call transcript

The market is trying to assess this on its own merits and a lot depends on what the gross margin outlook will be after 2024. Commodities sector games can become, and remain, notoriously cheap, if the market believes that the structure of current price is unsustainable. US Steel (X) is a prime example of a company trading at a P/E ratio of 1.52.

US Steel is even further ahead of its debt repayment schedule and will likely be in a net cash position by Q2-2022. So during GrafTech looks cheap, we can make a few counter-arguments as to why this might not be a great setup as it appears.

Verdict

If we are in a secular commodity bull market and we believe we are, rising tides will lift all boats, including GrafTech. EAF demand is expected to improve in 2022 and at a minimum, the current price of $6,000 per ton looks sustainable. The current debt structure has improved significantly and we clearly see a line of sight to less than 1.0X debt to EBITDA. The EAF steel industry should continue to grow in importance, thanks to its much lower carbon emissions and we wouldn’t be surprised to see that redeemed down the line. The main risks remain on energy and electricity prices where, paradoxically, the extreme push for green power could actually harm GrafTech. Unlike last time, we believe we are far enough along in this deleveraging exercise to start taking a more constructive stance. Current and future EV to EBITDA are now in the “buy zone”, thanks to the gradual repayment of debt and a slightly weaker stock price.

We love it now here and are ready to upgrade it to a “low buy” rating. Riding this bull however will require nerves of steel and so a slow build up to progressively lower prices will be our modus operandi. We will be looking to sell our first cash secured put options in the coming days.

Please note that this is not financial advice. It may seem, seem, but surprisingly, it is not. Investors are required to do their own due diligence and consult a professional who knows their objectives and constraints.