GrafTech International Ltd. — Q2 2010 Form 10-Q
Business context and reporting period. This unaudited filing covers the quarter and six months ended June 30, 2010, compared with the corresponding 2009 periods. GrafTech makes graphite electrodes and refractory products (Industrial Materials) and advanced and natural graphite products (Engineered Solutions). Results improved as customers resumed ordering after 2009 destocking and steel production recovered.
Financial performance
| Metric | Q2 2010 | Q2 2009 | Six months 2010 | Six months 2009 |
|---|---|---|---|---|
| Net sales | $254.9m | $157.8m | $470.5m | $291.8m |
| Gross profit / margin | $74.7m / 29.3% | $45.7m / 29.0% | $142.8m / 30.4% | $77.8m / 26.7% |
| Operating income / margin | $39.2m / 15.4% | $19.5m / 12.4% | $82.3m / 17.5% | $27.9m / 9.6% |
| Net income (loss) | $39.3m | $(37.1)m | $72.9m | $(28.6)m |
| Diluted earnings (loss) per share | $0.32 | $(0.31) | $0.60 | $(0.24) |
| Operating cash flow | — | — | $13.9m | $60.4m |
| Capital expenditures | — | — | $30.3m | $30.0m |
Amounts are in U.S. dollars; cash flow and capital expenditure figures are for the six-month periods. Q2 sales rose 62%; six-month sales rose 61%. Volume was the main driver: Q2 Industrial Materials and Engineered Solutions sales increased 61% and 65%, respectively. For the six months, they rose 67% and 38%. Higher volume and improved fixed-cost absorption supported margins, while Q2 graphite electrode price/mix and currency reduced Industrial Materials sales growth.
- Segment income: Q2 Industrial Materials operating income was $34.3m versus $16.4m; Engineered Solutions was $4.9m versus $3.1m. Six-month figures were $76.2m versus $23.2m and $6.1m versus $4.7m, respectively.
- Cash and working capital: Cash was $63.4m at June 30, up from $50.2m at year-end 2009. The six-month operating cash flow decline reflected a $60.9m working-capital use, including increased receivables and inventories associated with higher sales. Cash flow after capital expenditures was negative $16.3m.
- Liquidity and debt: Current assets were $496.0m and current liabilities $223.5m. The reported current ratio was approximately 2.2. GrafTech had $1.2m of long-term debt, no short-term debt, and no borrowings drawn on its $260m revolving facility; $255.0m was available after letters of credit. Supply-chain financing liabilities increased to $44.0m, bringing total financing liabilities to $45.2m. Management said liquidity was adequate and the company was compliant with its credit covenants.
Material changes and unusual items
- Profitability recovered sharply from 2009, when a $52.8m noncash impairment of the Seadrift investment contributed to the loss. Q2 2010 included $1.7m of equity earnings from the affiliate, compared with the prior-year impairment charge.
- Six-month other income included $12.7m of currency gains, mainly from remeasurement of intercompany balances; Q2 included $9.0m of currency gains. These gains boosted reported pretax results and may not recur.
- Production began using needle coke purchased in late 2009 at costs approximately 45% above material used in the first half of 2009. The negotiated 2010 price per metric ton from the largest supplier was flat with 2009; the timing of higher-cost inventory flowing through production still raised cost of sales.
- Six-month selling and administrative expense included $6.7m of transaction costs for the proposed acquisitions. Acquisition costs were $6.6m in Q2. Six-month interest expense declined to $2.2m from $3.1m, while cash flow was pressured by working-capital investment and incentive compensation payments.
- At June 30, the Seadrift investment was carried at $64.2m. Its valuation uses Level 3 discounted cash flow assumptions; management cautioned that weaker volumes, pricing, or profitability could require further impairment.
Outlook, risks and contingencies
- 2010 targets, excluding the proposed acquisitions and related transaction costs: operating income of $170m–$180m; selling, administrative and R&D expense of $105m–$110m; capital expenditures of $75m–$80m (raised from $70m–$75m); depreciation of about $38m; effective tax rate of 23%–25% (lowered from 24%–27%); and operating cash flow of $100m–$110m.
- Management expected Q3 operating income to be below Q2, reflecting seasonally lower volumes, including the European holiday period. It expected electrode prices to weaken slightly in Q3 and stabilize in Q4; higher volumes were expected to partly offset softer prices.
- GrafTech agreed to acquire the remaining Seadrift interests and C/G Electrodes. Consideration for each includes 12m shares and $100m of non-interest-bearing subordinated notes due in 2015, plus cash of $78.5m for Seadrift and $152.5m for C/G, each subject to debt and working-capital adjustments. Approximately $185m of cash consideration was expected to be funded by revolver borrowings. The transactions remained subject to antitrust and other closing conditions; the DOJ had issued second requests for information. Management continued to expect closing in 2010, but acknowledged possible delay, opposition, or imposed conditions. Failure to close could involve a termination fee of up to $30m in certain circumstances.
- Key operating risks include global steel/EAF demand, electrode pricing and competition, raw-material and energy costs, and the ability to pass cost increases to customers. GrafTech purchased 70%–80% of its needle-coke needs from one supplier, and warned that the Seadrift deal could affect supplier relationships. Other risks include acquisition integration and financing, covenant compliance, currency movements, taxes, environmental and legal matters, and customer credit.
- The Clarksburg, West Virginia collective bargaining agreement expired in June 2010. Employees continued working while negotiations proceeded; no disruption had occurred, but a stoppage remained possible. The company reported various legal matters but did not expect their ultimate disposition to materially adversely affect its financial position, results, or cash flows.
- Unrecognized tax benefits were $35.1m; GrafTech was under U.S. federal audit for 2007 and an Italian audit for 2006. Management reported that disclosure controls were effective as of June 30, 2010 and that no material change in internal controls occurred during the quarter.
Important facts for investors to verify
- Whether the Seadrift and C/G acquisitions closed, on what final terms, and how resulting debt, share issuance, integration costs, and benefits compare with expectations.
- Whether the 2010 operating-income and cash-flow targets were achieved, especially given the first-half working-capital outflow and negative cash flow after capital expenditures.
- Whether electrode volumes, pricing, and margins stabilized as forecast, and how higher-cost needle coke affected costs and customer pricing.
- Whether currency gains materially affected subsequent earnings, and whether Seadrift’s valuation assumptions or tax valuation allowances changed.
- Whether liquidity, covenant headroom, supplier relationships, and Clarksburg labor negotiations remained stable.