Description

I believe GTI, a graphite electrode supplier to the steel industry, is a short because:

1. World Steel Association estimates the utilization of global steel capacity in 2012 was 78%, suggesting overcapacity. 
2. World Steel Association says steel demand grew by ~1% in 2012; I do not expect this demand growth to accelerate as I do not see China’s demand for steel accelerating and do not believe rest of world will pick up the slack. 
3. GTI’s industrial segment, which supplies the steel industry with graphite electrodes, has generated ~90% of GTI’s total EBIT in each of the last 3 years (rest of EBIT was Engineered Solutions)
4. I estimate GTI normalized EPS of ~$0.30 and believe it should trade near 10x EPS when GTI's utilization is at least 70%
5. GTI states the graphite electrode industry was at 73% utilization in 2012 and that competition “has exacerbated a challenging global graphite electrode industry, which already had excess capacity.” (4q12 results news release, under Outlook)
6. Between 2008 and 2012, GTI’s utilization has changed faster than the industry (both in the downside and recovery), suggesting it is a high-cost producer

Regarding #1 and #2:

If global steel demand growth is 2-3%, I believe GTI still falls 14%.

My reasoning:

With 2-3% steel demand growth over 2-3 years, perhaps GTI utilization can return to the 82% utilization it realized in 2011, during which GTI reported $249MM in EBITDA.

At such EBITDA, I estimate normalized D&A of $105MM and interest expense of $35MM, implying EBT of $109MM.

Using a normalized tax rate of 33% yields GAAP earnings of $73MM, or EPS of $0.54.

Over the last 5 years, the forward twelve month p/e has been 12x. Using such p/e on my estimate of $0.54 implies a share price near $6.50 and hence the 14% downside.

If demand does not improve, however, and GTI utilization stays near 70%, I see normalized EBITDA near $200MM and EPS of $0.30 (using same expenses above). In fact, I believe 2013 EBITDA will be below $200MM. Note 1Q13 EBITDA mid-point guidance of $35MM is due to the high cost inventory GTI produced at 65% utilization in 2H12 that will be delivered in 1Q13. Given such high cost inventory will also be delivered in 2Q13, I suspect $200MM in 2013 EBITDA will be difficult to achieve if utilization stays near 70% for 2013.

If utilization falls to the mid 60% level seen in 2H12, GTI's EPS will be near zero:

In 2009, when graphite electrode industry operated at 60% utilization, GTI EBITDA was $131MM. Now in 2009, GTI only owned 18% of Seadrift, which it now owns fully. Seadrift in 2009, however, generated negative $2.7MM in equity earnings (they owned 19% of Seadrift in 2009).  Even if you assume Seadrift added $40MM in annual D&A (the difference in GTI D&A between 2011 and 2010; GTI acquired Seadrift in November 2010), you get pro-forma EBITDA near $160MM.

Subtracting 2013 interest expense and normalized D&A yields EBT of $20MM and negligible EPS.

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