Value Play: GrafTech International (NYSE: GTI)

GrafTech is a leading manufacturer of graphite electrodes and needle coke. Electrodes are used as the heating source to melt and produce steel in electric arc furnaces (“EAFs”). In the EAF steel-melting process, the technology used by all steel “mini-mills,” graphite electrodes are used typically at a rate of one every eight to ten operating hours. In other words, electrodes are like razor blades that need to be constantly replaced, which is good news for electrode manufacturers.

Unlike traditional steel mills that burn dirty coal in a blast furnace and melt iron ore into steel, mini-mills are much more environmentally-friendly. First, the raw material used is scrap metal, which already exists, instead of iron ore, which must be mined. Scrap metal is recycled junk and can come from abandoned kitchen appliances (e.g., refrigerators) and automobiles. Second, instead of burning coal, EAF furnaces utilize electricity. The graphite electrodes are lowered down into the EAF furnace very near the scrap metal but not touching it. A massive charge of electricity is then sent through the electrodes until the electrodes reach a temperature of 5,000 degrees Fahrenheit. Graphite must be used because only graphite can withstand this incredible temperature without melting itself. When the electrodes get hot enough, they throw off the electricity through the air in an arc pattern and the electricity melts the scrap metal. Cool stuff! 

Additionally, GrafTech is a producer of petroleum needle coke, a crystalline form of carbon that is derived from decant oil. Needle coke is the key raw material used in the manufacture of the graphite electrodes. As a result of its acquisition of Seadrift Coke in November 2010, GrafTech’s graphite electrode production is vertically integrated, which provides the company with a substantial competitive advantage not shared with most of its competitors. Seadrift is the world’s second largest petroleum-based needle coke producer.

Mini-mills based on EAF is the future of steelmaking (slide no. 3) and constitute the long-term growth sector of the steel industry. Already in the U.S., two-thirds of steel production comes from EAF furnaces (slide no. 3) and 75% of steel production capacity. Simply put, EAF steelmaking is a cheaper manufacturing technique and is crucial in a cost-competitive market like commodity steel. An EAF furnace costs less than one-third as much to construct as a blast furnace. From a “green” environmental perspective, EAF steelmaking has the following advantages compared to traditional, blast furnaces:

• 97% less mining waste
• 86% less air pollution (65% less greenhouse gases)
• 76% less water pollution
• 2500 pounds less iron ore per ton of recycled steel
• 1400 pounds less coal per ton
• Scrap metal is 4-to-5 times more energy efficient than iron ore
• 10 times more energy efficient than aluminum production
• Recycled steel saves $2 billion per year in solid waste disposal costs per year
• Recycled steel saves 6 trillion BTUs of energy per year (enough to light 18 million households for 8 full years).

There is currently no commercially viable substitute for graphite electrodes in EAF steel making and GrafTech is the leader with a 15% global market share. The company has 20 manufacturing facilities strategically located on four continents.

While steelmaking products constitute 80% of GrafTech’s sales, the remaining 20% of the company’s business is conducted through its high-tech Engineered Solutions division, which develops advanced graphite materials for use in aerospace, solar power, and fuel cells. The company is an intellectual property powerhouse with approximately 733 U.S. and foreign patents and published patent applications which are carbon and graphite related, more than any of its major competitors (in the relevant business segments in which GrafTech operates). Among its competitors, it holds the largest number of patents for flexible graphite, as well as the largest number of patents relating to the use of natural graphite for certain fuel cell applications. These patents don’t expire for up to 20 years! The acquisition of Fiber Materials in October 2011 enhanced GrafTech’s technical expertise in advanced materials even more.

An example of GrafTech advanced technology: the thermal solutions used in the heat shield of the Mars rover Curiosity, which protected it from the intense heat and friction generated during descent through the Martian atmosphere, were developed by GrafTech’s Engineered Solutions division.

One of the most exciting advanced graphite materials is graphene, a carbon material that conducts electricity better than copper and is harder than diamonds, yet is flexible and transparent. In fact, it is the “thinnest, strongest material on earth” and GrafTech is currently hiring scientists to study and market this miracle substance.

Given all of these positives, why is GrafTech’s stock trading at a four-year low? The reason is that commodity prices – including steel — have declined on average by about 20% since their 2011 peak. Chinese economic growth has cooled, which is bad for commodities because since 2000 China alone has accounted for 80% of the annual growth in global steel demand. Despite the short-term decline, emerging market demand for commodities will by necessity remain strong as these countries push forward with industrialization. Commodity prices are still much higher than their 2001-02 lows. For example, hot rolled steel coils (HRC) currently trade around $600 per ton; triple the $200 per ton price it fetched in 2001, but 25% below its 2011 peak of $800 per ton. As an Australian iron ore mining executive recently put it:

China is the big growth market for steel. It will be some decades to go before we see any reduction in Chinese steel demand.

Chinese demand is the reason I am confident that steel prices are near their low and offer good value right now. According to the SMU Fair Value Model, HRC steel is trading below its fair value for the 10^th straight week. A rebound to fair value should occur soon.

Integrated steel stocks like U.S. Steel (NYSE: X) and Europe-based ArcelorMittal (NYSE: MT) that use traditional blast furnaces have been absolutely crushed, whereas mini-mills like Nucor (NYSE: NUE) that use EAF furnaces have remained relatively stable. Since GrafTech caters to the mini-mills, its future is assured and should not be stigmatized with the problems of the integrated mills.

GrafTech reported first-quarter earnings today, Thursday April 25^th, and results were stagnant. Investors were expecting worse, as they usually do with value stocks, and the stock is actually trading modestly higher on the news. The company called the operating environment “challenging” and reduced its forward guidance for full-year EBITDA “to reflect weaker than previously anticipated demand for graphite electrodes.”

This was not much of a surprise given that in the company’s earlier February Q4 conference call, CEO Craig Shular had warned that there was a supply glut in electrodes and needle coke thanks to increased imports from Asia. Nevertheless, Shular was positive about the future. First, he cited a forecast from the International Monetary Fund (IMF) that global economic growth would be 3.3% in 2013, up from the 3.2% in 2012. Second, the World Steel Association forecasts that global steel demand will grow by 3.2% in 2013, a marked increase from 2012. CEO Shular concluded as follows:

We believe the aforementioned excess graphite electrode capacity could be absorbed by growth in the EAF furnace sector. It’s expected that approximately 100 million metric tons of new EAF steel capacity will come online over the next five years.

We are well positioned to manage through the cycle and will focus on managing those items within our control. We will continue to provide our customers with superior service, quality, and product innovation; we’ll maximize the cost competitiveness of our advantaged backward integrated business model, and finally growing our Engineered Solutions business to diversify our company.

According to Zacks, U.S. home construction, non-residential construction, and automobile production should strengthen during 2013, which will help move more steel.

GrafTech is classic value stock, trading at very low price multiples of earnings (8.6), book value (0.7), and sales (0.8). Such a depressed valuation typically occurs with a very sick, debt-burdened company, but GrafTech is a healthy company with a very manageable debt-to-equity ratio of only 40%. Even during the global financial crisis of 2008, GrafTech was able to earn a profit. In fact, the company has generated positive annual earnings for seven consecutive years (2006-2012, inclusive).

Corporate insiders also think the stock is cheap. On March 15^th, CEO Shuler and CFO Lindon Robertson collectively purchased 54,000 shares at an average cost of $7.30 per share. This marked the first insider purchases in more than four years (November 2008). If people in the know are buying, we should consider buying.

GrafTech International is a buy up to $8; I’m also adding the stock to my Value Portfolio.

Momentum Play: U.S. Physical Therapy (NYSE: USPH)

U.S. Physical Therapy is the only publicly-traded, “pure play” operator of rehabilitation clinics. It operates 431 clinics in 43 states, with the largest concentrations in Tennessee (62), Texas (51), and Michigan (44). The company’s clinics provide preventative and post-operative care for a variety of orthopedic-related disorders and sports-related injuries, treatment for neurologically-related injuries and rehabilitation of injured workers.

The company grows its business organically through de novo development; approximately two-thirds of clinics are start-ups and they typically become profitable within the first 6-12 months of operation. A website – www.ownyourownclinic.com – solicits potential franchisees. Acquisitions of pre-existing clinics (1/3^rd of growth) are structured like the de novo partnerships, with significant ownership retained by the selling founders, and are always earnings accretive from day 1.

The aging of America, combined with an explosion of additional healthcare spending under Obamacare, as well as an increased focus on outpatient care to contain healthcare costs, are a potent profit cocktail for physical therapists.  People are not just getting older, but they are remaining healthy longer through increased physical activity – study after study demonstrates that the negative effects of aging can be significantly reduced through regular exercise. With exercise, however, come injuries and the older you get the more likely it is that increased activity will result in an injury like a muscle pull or a ligament tear.

With age-related issues accounting for 90% of patients who see a physical therapist, the Bureau of Labor Statistics estimates that jobs for physical therapists will jump from 198,600 in 2010, to over 276,000 by the year 2020:

Employment of physical therapists is expected to increase 39 percent from 2010 to 2020, much faster than the average for all occupations.

Demand for physical therapy services will come, in large part, from the aging baby boomers, who are staying active later in life than previous generations did. Older persons are more likely to suffer heart attacks, strokes, and mobility-related injuries that require physical therapy for rehabilitation.

According to U.S. Physical Therapy, the U.S. market opportunity for physical rehabilitation services is greater than $10 billion per year (slide no. 3), maybe as high as $19 billion, with projected annual growth of at least 5 percent. The industry is highly fragmented with 16,000 rehabilitation clinics nationwide, and no single company has more than a 6-percent market share:

Given that U.S. Physical Therapy’s 2012 revenues were only $252 million, a $10 billion market opportunity provides exciting growth potential. Simply growing to the size of market leader Select Medical would more than double the company.

I like U.S. Physical Therapy as an investment more than market leader Select Medical for two reasons: (1) much less debt; and (2) much lower reliance on Medicare. Whereas 50% of Select Medical’s business comes from Medicare/Medicaid, only 24% of U.S. Physical Therapy’s does:

The federal government is squeezing Medicare to help pay for Obamacare, and lower Medicare reimbursements for physical therapy are a risk factor. The company estimates that Medicare cuts will reduce earnings per share by $0.22 in 2013.  CEO Chris Reading remains optimistic about the future and suggests that the Medicare cuts may squeeze weaker players, which would actually be beneficial for the market leaders like U.S. Physical Therapy:

Our team is working real-time on a number of initiatives in order to mitigate the impact of this unfortunate Medicare reimbursement reduction. This is a significant challenge but one that I am confident that we can ultimately overcome. The impact of this change will be felt across the outpatient rehabilitation industry and will be especially difficult for less well-resourced providers.

The company’s financial results have been consistently strong and management has proven itself to be shareholder-friendly. Fiscal 2012 marked the sixth consecutive year of record operating earnings. The company initiated a dividend in March 2011, raised it 12.5% in March 2012, paid a special dividend in December 2012, and raised the dividend 11.1% in March 2013. The current yield is only 1.7% but has plenty of room to grow.

Earnings per share have been positive each year over the past decade, with 3-year annualized growth of 14.7% and 5-year annualized growth of 15.0%. Profitability is high with return on equity at 16.0% and return on invested capital at 13.2%.  Since 2005, free cash flow per share has risen every year but one and is up five-fold. Debt is a non-issue at only 15% of equity.

In terms of valuation, the stock is trading right around its 5-year average for P/E, price to book, and price to sales. Its PEG ratio is below 1.0, which is a good thing because it means that its future annualized growth rate is higher than its current P/E ratio.

Last year, the stock significantly outperformed its medical industry sector and the S&P 500 by 16.2% and 27.8%, respectively, but so far this year it has underperformed both benchmarks in the wake of the Medicare cuts. I think the stock’s momentum from 2012 will soon reassert itself as the company demonstrates that its growth is based on powerful demographic trends and can continue without help from government entitlement programs. U.S. Physical Therapy should close out 2013 on a strong note.

U.S. Physical Therapy is a buy up to $26.25; I’m also adding the stock to my Momentum Portfolio.