GrafTech International Ltd. — Looking Good but Not Great

Ascendere Associates Relative Valuation Note:  December 9, 2010

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GrafTech International Ltd. (GTI) — Looking Good but Not Great
From a purely quantitative perspective GTI looks good, but not good enough to make it into our model portfolios.  As experienced investors know, there are plenty of exceptions to any quantitative rule.  Our models tend to work well on average over time from the standpoint of a tool that helps with the systematic management of an overall portfolio.  In our opinion, from the standpoint of individual stock picking, our models capture nearly everything relevant to determining the relative attractiveness of a stock, but work best as a useful starting point for deeper fundamental research.

We have optimized part of our systematic portfolio management approach based on backtests to 12/31/2004, using monthly updates to fundamental data and daily updates to stock price data.  The backtest includes 18 months of data collected in real time.  We frequently backtest new ideas with small refinements, so any backtested “returns” that we may write about could change frequently as well.

We rank stocks on scores of fundamental data points, which can be summarized into four key factors, with a score of 5 being the best and 1 the worst:

1. Relative Value.
2. Operating Momentum.
3. Analyst Revision Momentum.
4. Fundamental Quality.

Note that cash and debt in this particular table do not reflect the Nov 30 acquisitions of Seadrift Coke L.P and C/G Electrodes LLC, or any estimated impact of its 4m shelf registration on Nov 30 related to its equity incentive program.

GrafTech has good relative value and ranks highly for quality (working capital management, asset turnover, margin expansion and other data points), but scores weakly for operating momentum and analyst revision momentum.  This indicates that on a relative basis and by our measures, there are other stocks in the Industrial sector that have stronger fundamentals than GTI at the current moment.

As you can see in the table above, there are six other Industrial stocks that look particularly stronger in our rankings.  We own five of these stocks in our portfolios.  During our holding period Avery Dennison Corp (AVY) has performed well and United Airlines (UAL) poorly.  One could argue about whether these stocks are fundamentally comparable or not or even belong in the same sector, but as far as we are concerned as it relates to our systematic approach to portfolio management and long-term idea generation it is an irrelevant discussion.

Incidentally, United Airlines (UAL) was named as a long Research Tactical Idea at Morgan Stanley today — more than 5 weeks after we mentioned it as a buy in our newsletter and we purchased it for ourselves.  This is the fifth occasion this month in which our model portfolio ideas have presaged major ratings actions by major sell side institutions, and compares to more than 16 sell side actions we presaged in November (see our report, “Getting in Before Sell Side Institutions Follow“).

Take a look at the next two tables, which provides some fundamental details about GrafTech and our best performing Industrial holding, Avery Dennison.  We have adjusted the GrafTech's forecasts in the table below to take into account lower cash, higher debt and higher operating assets following the November 30 close of two acquisitions.

Potential Integration Issues, ROIC Stagnation and Selling Pressure May Hold GTI Back in the Short-term
On the preceding two tables, notice that the historical sequential improvement in margin expansion and ROIC for GrafTech is better than Avery Dennison, but the forecast margin and ROIC expansion is better for Avery Dennison.  This is because margin expansion may flatten and ROIC is likely to fall off in the near term as GTI integrates its recently closed Seadrift Coke and C/G Electrodes acquisitions.

On November 30, 2010, GrafTech completed the acquisition of its remaining 81.1% stake in Seadrift Coke L.P. and 100% stake in C/G Electrodes LLC by issuing 24m shares, $86m cash, drawing $165m from its revolving credit facility and issuing $200m in non-interest bearing five-year Senior Subordinated Notes (current discounted fair market value of $144 million).  Also on November 30, GrafTech filed to sell 30m shares in three separate shelf registrations, including 26m shares from existing shareholders and 4m shares related to its equity incentive program.  There are only 2m shares remaining in its existing share repurchase program.  Our data source has current shares outstanding at 121m.

The recent acquisitions will raise operating assets and operating capital, with risk of a disproportional rise in cash flow.  In addition, share dilution will be minimal at about 4m, but likely pressure from selling shareholders of the 26m shares may hold the stock down in the near term.  Analysts will likely be cautious in raising estimates for GTI until the company has convincingly shown it has integrated the acquisitions.  The forecasts for GTI in the above table could prove to be optimistic if it has any trouble integrating the acquisitions.

On the positive side, GTI currently has net cash on its balance sheet, having finished paying down an enormous amount of debt over the last few years.  It will probably use its free cash flow to do the same going forward as quickly as possible.  A dividend issue would be a nice addition as well because that would attract a new group of investors while it took the time to integrate its acquisitions, but that seems unlikely to occur for at least the next 12 months or so.

Conclusion
In summary, GTI has solid relative value relative to its fundamentals and relative to other stocks in the Industrial sector.  However, operating momentum and analyst revision momentum has stalled.  For investors that rebalance their portfolios on a monthly basis, it makes sense to sell GTI and purchase an alternative and revisit the story again in one or two quarters.  Long-term investors should probably hold the stock because of its proven management team and its strong strategic position in the graphite electrode industry, made stronger by these recent acquisitions.

About this report
This company report is a supplement to a monthly report dated November 30, 2010 that details the model portfolio strategies of Ascendere Associates LLC (“Ascendere”).

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