SGL is the world’s largest manufacturer of carbon graphite (CG) electrodes used in steel and aluminum mills. The company also provides corrosion protection services to industrial plants, and markets carbon graphite-based products. Unlike its closest peer Graftech, SGL has been and remains shunned by capital markets even though the company’s core CG business is on an uptrend thanks to industry capacity cuts and positive pricing environment. More importantly, a slew of restructuring measures, as well as imminent disposal of loss-making businesses, will transform this company into an entity which we think can generate normalized EBITDA well in excess of 180 million euros (with 50 million in capex). SGL is meanwhile valued at 457 million euros in market cap (with 354 million in financial net debt), a valuation which does not reflect the structurally high margins, the built-in earnings growth, or wild card potential of the graphite technologies division.
We believe SGL should trade in line with its closest peer (and only relevant comp) Graftech International given SGL’s superior margins in the core division, and similar earnings growth prospects. Valuation parity would place the stock at 17 euros, implying over 100% upside from current levels. A valuation in line with European peers values the stock at 13.6 euros, implying over 70% upside form current levels. The shares have been accumulated by activist-value shareholders and the CEO feels the pressure to consummate a successful restructuring. (See "Catalysts" below.)
SGL operates 4 different divisions:
* Carbon & Graphite 52% of sales (620 million euros), 15% OM (2004), historical OM range: 10 - 24%
Second largest global manufacturer of used by steel mill manufacturers, also sells electrodes used in aluminum production.
Given recent spikes in steel prices, as well as bankruptcy of 2 out of 6 global players, carbon graphite rod prices have been increasing over the past year and remain on an uptrend. SGL sells forward its production by 10 to 12 months, hence current prices will not feed through to the P&L until H2 04 / H1 05. The core CG division is therefore set for structural earnings growth thanks to pricing increases. WE expect the current 15%+ EBIT levels to expand towards 18% in coming quarters.
* Specialty Graphite 15% of sales, 4% OM (2003), historical range: 2 – 13.5%
Sells CG-based products for industrial applications, e.g. carbon brushes used in motors and generators, bearings, and automotive applications. Largest client is semis industry (25% of sales).
Recent cost cuts, combined with sales recovery into semis and autos industries, makes for meaningful margin expansion in H2-04 and into 2005.
* Corrosion Protection 17.5% of sales, -2% OM (2003), historical range: -2 – 6.2%
Provides CG-based protection against corrosion in variety of end user industries such as chemicals, engineering, and environmental protection companies. Management has recently split the division into a profitable CP division and non-profitable surface protection business, the latter being ear-marked for disposal before year-end.
* SGL Technologies 15.3% of sales, -10% OM (2003), historical range: -25 – 10%
Develops high tech products such as brake disks for high end German cars (Posrche / Audi), defense applications, fuel cell technology. The division has developed an array of attractive applications, many of which are on the verge of meaningful commercialization (for example, SGL company is in negotiations with a large partner for the provision of 500,000 brake disks pa (current sales: 15,000). This alone could double the division’s sales within 2 years.
A little History:
SGL, Graftech and 4 other large CG electrode manufacturers were found by US anti-trust department to have colluded on CG prices over the 1990’s. SGL was imposed a $144 million fine by US authorities and 132 million Euros by the European counter-part. SGL has paid all but 61 million to US authorities (balance payable over 3 years). The company is disputing the 132 million euro penalty imposed by European commission and has agreed in principle to pay 1 of 3 imposed fines of 28 million euros, which it has provisioned. We look for further reductions in imposed fines in coming quarters (as per company’s guidance, a first cut having been announced in June-04). The company redressed its balance sheet via a rights issue in Q1-04. Note: We include the full potential antitrust liability in our net debt calculation, although it could be reduced on appeal.
EV/EBITDA 04: 7.4 EV/(EBITDA-Capex) 04: 11.7 PE 04: 34 (nm)
EV/EBITDA 05: 5.7 EV/(EBITDA-Capex) 05: 8.4 PE 05: 10.7
EV/EBITDA 06: 5.0 EV/(EBITDA-Capex) 06: 7 PE 06: 9.9
If stock were to trade in line with European cyclical sector EV/EBITDA average of 7.8, fair value is 13.6 Euros (and higher in 05 as company begins to decrease debt). Our net debt includes over 130 million in European anti-trust penalties due, which management is confident will be dramatically reduced after legal disputes are concluded over the course of 2004. If the fines are halved, our price target increases to over 14 Euros, implying 60% upside from current levels. If it trades in line with its closest comp, Graftech (which trades at 9 times 05 EV/EBITDA), SGL would be worth 17 Euros.
If management is successful in reducing monetary working capital by 100 million euros (the company carries 200 million euros more in receivables than it owes in payables), and disposes of the surface protection division for 10 million euros (10% of sales), the price target based on average peers’ multiples is 16 euros, and 19 euros based on Graftech’s valuation.
The greatest catalyst is the transformation of company fundamentals over the past 6 months. At the beginning of the year, SGL was within a hair of breaching its debt covenants. CG spot prices were 15-20% lower, and management was committed to loss-making divisions. Since then, the company has successfully concluded a rights issue which raised over 250 million euros, CG prices have continued to climb, and management has agreed to dispose of loss-making CP divisions and to enlist industrial partners to commercialize an array of CG-based products. Yet the stock is down 39% ytd. We believe that the change in paradigm for management, as well as strong improvement in P&L in Q1 and Q2 (and even better outlook in H2 of 2004) will force investors to re-consider SGL.
Tangible events to look for are:
* Disposal of loss-making Surface Protection division within corrosion protection
* Pricing increase in carbon graphite division (where production is sold one-year forward) coming through the P&L in H2-04
* Decrease in European anti-trust penalty (ongoing negotiations)
* Recruitment of industrial partner to expand graphite technologies division and commercialize array of applications such as brake disks, fuel cells, light-weight CT fuselage for aerospace applications, thermal heat dissipators for consumer electronics, etc.
* Unlocking of up to 200 million euros in working capital tied up in mis-matched duration of receivables vs. payables
* Sudden and unforeseen drop in demand in specialties / corrosion protection due to cyclical downturn (although both divisions have already registered double-digit revenue declines into cyclical downturn in 2003/04)
* Continued increase in raw material costs as CG electrode prices are locked in (although 75%+ of raw material costs are hedged forward)
* Continued decline in $ vs. Euro (though $ has stabilized at current exchange rates)
February 04 de-leveraging rights offer; new activist-value shareholders; reduction of working capital; sale of Corrosion Protection division