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GrafTech International Ltd. (NYSE:EAF)
Q3 2019 Earnings Call
Nov 7, 2019, 10:00 a.m. ET

Contents:

  • Prepared Remarks
  • Questions and Answers
  • Call Participants

Prepared Remarks:

Operator

Ladies and gentlemen thank you for standing by and welcome to the Q3 2019 GrafTech International Earnings Conference Call. [Operator Instructions].

I would now like to hand the conference over to your speaker today Meredith Bandy Vice President of Investor Relations. Please go ahead.

Meredith H. Bandy -- Vice President Investor Relations and Corporate Communications

Right. Thank you Kensey. Good morning and welcome to GrafTech's Third Quarter 2019 Conference Call. On the call with me today is Chief Executive Officer David Rintoul; and Chief Financial Officer Quinn Coburn. Turning to our first slide. As a reminder some of the matters we discuss on this call may include forward-looking statements regarding results performance and strategies among other things. These statements are based on current expectations and are subject to risks and uncertainties factors that could cause actual results to differ materially from those indicated by forward-looking statements are shown here. We will also discuss certain non-GAAP financial measures for which you'll find reconciliations in these slides. The slides are posted on our website at www.graftech.com in the Investors section. For your reference a replay of this call will also be available on our website.

Now I'm pleased to turn the call over to Dave.

David J. Rintoul -- President and Chief Executive Officer

Thank you Meredith. Good morning everyone and thank you for joining us today. GrafTech is well positioned to benefit from the long-term growth of electric arc furnace EAF steelmaking. With low cost vertically integrated production and a long-term contracting strategy GrafTech continues to generate meaningful free cash flow. We are committed to deploying that cash for shareholder returns and balance sheet improvement. Turning to slide four. Let's begin as we normally do with safety. Health and safety excellence is a core value of GrafTech and considered a fundamental requirement of our organization's success. Our year-to-date total recordable injury rate has improved to 1.03 a more than 30% improvement from the prior year.

I'd like to thank all of our team for this achievement. At the same time each and every one of us must remain vigilant so that we can reach our ultimate goal of 0 harm that means everyone goes home safely every day. A safe plant is an effective plant and we strive to be both at all of our locations. On slide five GrafTech delivered solid quarterly results despite challenging conditions in a number of the markets in which we operate. Overbuying late last year and early this year coupled with reduced steel production in some regions has resulted in excess electrode inventory that customers are working through. Steel is a cyclical business and we are seeing that play out in the market today. We expect graphite electrode inventory destocking to continue through the first half of 2020. Inventories should decline and conditions improve as we move into the second half of 2020. Short-term steel manufacturing difficulties will work themselves out.

Longer-term EAF steelmaking continues to take market share as evidenced by the new electric arc furnace rebuilds and builds excuse me we're seeing in the United States. As a reminder the majority of GrafTech sales volume remains on long-term contracts which help reduce the volatility of our earnings and preserve margins. We are able to offer these stable long-term contracts thanks to our substantial vertical integration into petroleum needle coke. Our wholly owned Seadrift facility provides a secure supply of high-quality petroleum needle coke at costs that are meaningfully below current market pricing. Now turning to slide six. In our earnings release we announced a series of operational improvement projects at our Monterrey and St. Marys facilities. These projects are intended to optimize our manufacturing footprint while improving environmental performance and increasing production flexibility.

We expect these projects to be completed in the first half of 2021 at which time we will be able to shift additional graphitization and machining from Monterrey to St. Marys. We estimate that 2020 capital spending would be near current levels which includes these projects as well as maintenance capital projects subject to the approval of our Board. Moving on to slide seven. As I mentioned earlier GrafTech has the majority of our long-term production capacity sold under long-term take-or-pay contracts. These contracts provide profitability and visibility of earnings. In addition to the recent softness in the global steel industry we have also seen a couple of our LTA customers declare bankruptcy. Volumes as shown on this slide have been reduced by approximately 3000 tons per year in 2020 through 2022 to reflect such changes in the financial health of certain customers. GrafTech continues to pursue a blended commercial strategy.

The majority of our sales are under long-term contracts. We also have meaningful volumes under short-term agreements and spot sales. Our ability to offer multiple contract formats for our customers is a key element to our commercial strategy. Short- and long-term contracts offer different advantages for different customers. We expect both to continue to be an important part of our commercial strategy going forward.

Now I'll turn it over to Quinn on slide eight for more details on our financial results

Quinn J. Coburn -- Vice President Chief Financial Officer and Treasurer

Thanks Dave. As Dave highlighted third quarter financial results remained relatively solid despite some softening of economic conditions. Third quarter 2019 net sales of $421 million were down 7% from 2018 on lower sales volumes. During the quarter we produced and sold 40000 metric tons of graphite electrodes. As usual third quarter production volumes reflect planned annual maintenance outages. This year we were able to leverage that downtime to manage production to be more in line with recent sales volumes while maintaining cost performance.

We now expect full year production capacity utilization to average approximately 85% as we match production to customer demand and supply chain conditions specifically the inventory overhang that they spoke to earlier. We expect demand to rebound later next year as customers work through inventories. Q3 weighted average pricing was a bit higher than the prior period. As expected Q3 spot pricing was down relative to Q2. Approximately 79% of our third quarter revenues were to customers with long-term agreements. Turning to slide nine for financial results. Third quarter 2019 net income totaled $176 million or $0.61 per diluted share. Q3 2019 adjusted EBITDA was $245 million down from prior-year period due to lower sales volumes and higher raw materials cost specifically related to third-party petroleum needle coke cost. Lower Q4 third-party petroleum needle coke pricing is expected to translate to lower cost of sales in the second half of next year.

Third quarter 2019 free cash flow of $211 million increased from Q2 as favorable working capital changes partially offset lower operational results. As you may recall last quarter's shipments were weighted toward the latter part of the quarter which resulted in higher accounts receivable as of June 30. In Q3 that working capital change was largely reversed. Turning to slide 10. In the past 12 months GrafTech has generated nearly $0.75 billion of free cash flow of which more than 40% has been returned to shareholders to date through dividends and share repurchases. We have also repaid over $150 million of debt during that time. GrafTech has a strong track record of free cash flow generation. Shareholder returns and debt repayment remain the key priorities for uses of cash. Looking ahead on Page 11. As Dave discussed our strategy on future investments is to focus on high returns with payback projects to reduce operating costs increase productivity and develop products that our customers value.

In addition we will continue to invest in health safety and environmental performance. We continue to target shareholder returns of approximately 50% to 60% of 2019 free cash flow with the balance earmarked primarily for debt repayment. Shareholder returns are expected to include dividends and share buybacks as appropriate including the $100 million share repurchase program we announced last quarter. To date we have utilized about $10 million under that program. The timing of future share repurchases will depend on share price traded volumes and other market conditions. We'll also manage our debt levels to align with the visibility that we have to our free cash flow. We repaid $125 million of debt earlier this year and anticipate making further debt repayments by year-end.

I'll now turn it back to Dave on slide 12.

David J. Rintoul -- President and Chief Executive Officer

Thanks Quinn. The steel market will no doubt have its shares of ups and downs but the long-term outlook for EAF steelmaking growth remain strong. Electric arc furnaces continue to take market share from integrated producers. Globally electric arc furnaces make up almost 29% including China of steel production and that share is expected to continue to grow over time. Electric arc furnaces are advantaged relative to integrated mills due to their flexible cost structure lower capital intensity and better environmental performance. In addition GrafTech's vertical integration into petroleum needle coke offers a sustainable long-term competitive advantage. Increased demand for needle coke from electric vehicle batteries has contributed to elevated needle coke pricing. With low-cost vertically integrated production and a long-term contracting strategy we expect to continue to generate meaningful cash -- free cash flow. As Quinn discussed we are committed to deploying that cash for shareholder returns and balance sheet improvement. This concludes our prepared remarks.

We'll now open the call up for questions.

Questions and Answers:

Operator

[Operator Instructions] Our first question comes from the line of David Gagliano with BMO Capital Markets. Your line is open.

David Francis Gagliano -- BMO Capital Markets -- Analyst

I just want to ask some of the I guess standard questions that we tend to be asking on these calls related to the current market conditions. First of all just if you could comment where you see spot pricing now? And then also somewhat related there was a 3000 ton drop and you alluded to it in the prepared remarks for 2020 to 2022 contracts I think it was 3000 a year. What specifically prompted that decline? Was it an actual bankruptcy or a renegotiation? And are there other contracts that are in a similar situation?

David J. Rintoul -- President and Chief Executive Officer

Dave thanks for your questions. I'll start with the first one on spot pricing. I think as everybody is aware of we don't normally provide certainly forward guidance on spot pricing. And as I referenced the steel market is certainly cyclical. And as such it's influencing our industry and that then translates into certainly an impact in a declining way currently on the spot market. Given that we're in the midst of negotiations on Q1 and 2020 business overall I'm not inclined to give specific numbers today and influence those negotiations. However as I said suffice it to say that we do serve as a cyclical market. And as such we're seeing some of those effects to be sure.

On the 3000 tons we made that adjustment because we have had a couple of bankruptcies. It's not represented or intended to imply anything about renegotiation or difficulties in other contracts that is specifically areas where there have been a financial situation that led us to believe that liquidity of the customer in question may be problematic and we thought it was appropriate to make the reduction in the slide so that everyone could be aware of that and what we're seeing.

David Francis Gagliano -- BMO Capital Markets -- Analyst

Okay. That's helpful. So not to put words in your mouth but in terms of the expectations for additional changes to that contract book at this point we should not expect those changes? Again putting words in your mouth I guess.

David J. Rintoul -- President and Chief Executive Officer

Well look Dave your crystal ball might on this subject might actually be better than mine in terms of -- are there any other steelmakers in the globe that are going to go bankrupt. I'm certainly for both their sake and our sake I'm hoping that's not the case.

David Francis Gagliano -- BMO Capital Markets -- Analyst

No. I was actually more asking about the other topic that comes up quite a bit in terms of I guess more directly are you having customers approach you to renegotiate those existing contracts that are in place?

David J. Rintoul -- President and Chief Executive Officer

So our approach to customers that inquire we're flexible in our approach to that as long as the outcome of their needs are such that GrafTech and our shareholders are a whole at the end of the day with the way the initial contract stood. So there haven't been any significant changes heretofore to speak to but I would be -- we would be remiss if we were not as good business people partnering with our customers to be open to things that might be of value to them that still allow us to be in a situation where the value of the LTA is in fact kept intact. So that's our position on that subject.

David Francis Gagliano -- BMO Capital Markets -- Analyst

Okay, thanks very much.

Operator

Your next question comes from the line of Alex Hacking with Citi. Your line is open.

Alexander Nicholas Hacking -- Citigroup Inc Research Division -- Analyst

So just a follow-up on those last comments. I would -- am I correct in assuming that what you're saying there is that you are willing to potentially cut prices on existing LTAs as long as customers are willing to extend those out? So in that sense the customer is getting potentially a lower near-term price but you guys are locking in more volume into the future is -- would that be an example of the kind of flexibility that you were talking about?

David J. Rintoul -- President and Chief Executive Officer

Alex not quite. I was very deliberate in saying that the outcome of those discussions would have to be that the value of the existing LTA is kept intact. So that would mean if you look at the net present value or the value of the LTA at this point in time whatever changes we want to make would have to preserve obviously for the -- in the interest of our shareholders that NPV. So it's not quite as simple as your example might suggest.

Alexander Nicholas Hacking -- Citigroup Inc Research Division -- Analyst

Okay. Could you give an example of what you're talking about be more specific I guess? Or you don't want to do it?

David J. Rintoul -- President and Chief Executive Officer

I don't think on this call that I want to put out into those and the marketplace suggestions on such modification because I think it's an individual one-on-one. We've had discussions with certain customers. And at the end of the day some have decided to think through and others have said no we'll just leave the LTA in place. There are a number of combinations and permutations that can allow us to assist the customer in a near-term request to preserve the net present value of the LTA. So I don't think it's inducive or good business for us to try and align on this call the combinations and permutations that could exist in that. It's really a customer-by-customer preference and personal. What matters to one customer might not matter to another in terms of how they might view that. So I don't expect that there'll be a great number of those things transpire. But as good business people we are always willing to work with our customers to find an optimal solution that works for both parties.

Alexander Nicholas Hacking -- Citigroup Inc Research Division -- Analyst

Okay. I appreciate the color. That's helpful. I guess just a couple of others if it's OK. You mentioned that you expect the destock to continue through 1H next year and then normal business to pick up in the second half. I guess why -- what makes you think that this is going to be another 6- to 7-month process? Is there a certain amount of tonnage that you're looking at that you think there's too much out there?

David J. Rintoul -- President and Chief Executive Officer

So I think it's a twofold component: one we're looking at the recovery of the broader steel group and thinking that that will happen in the New Year. And as that transpires the inventory that we think is on the ground by our major accounts anyway as the steel business returns to healthier levels in the first part of 2020 they'll begin to burn down that inventory and we're estimating that as we get into the second half that the graphite electrode business will return to a more normal state if you will. So it is a combination of trying to estimate the return of the steel industry as well as our estimate on inventories and doing a little math on all of that and believing that the second half they should have burned through most of its inventory in the first half of the year.

Alexander Nicholas Hacking -- Citigroup Inc Research Division -- Analyst

Okay. And then just one more if it's OK. Just on the buyback how are you -- I guess any color on how you're planning to deploy that? I guess I had assumed that you would have been a bit more aggressive this quarter. I think you only spent $9 million out of the $100 million that was authorized. So any comments there?

Quinn J. Coburn -- Vice President Chief Financial Officer and Treasurer

Yes. Sure Alex. It's Quinn. We continue to believe that share repurchases are very attractive use of our cash flow. Obviously we repurchased very opportunistically during the quarter we believe creating value for our shareholders. And we do have the $90 million remaining and we do plan to continue repurchases in future quarters. So that's -- probably that's the level of detail that I can provide.

Alexander Nicholas Hacking -- Citigroup Inc Research Division -- Analyst

Okay, thank you.

Quinn J. Coburn -- Vice President Chief Financial Officer and Treasurer

Thank you.

Operator

Your next question comes from the line of Arun Viswanathan. Your line is open.

Arun Shankar Viswanathan -- RBC Capital Markets Research Division -- Analyst

I guess first question is just a little bit more details on this inventory situation. Can you share maybe the level of days of supply at your customer level or producer level or tons? And I guess -- or maybe even the industry kind of utilization rate that you see right now in the market?

David J. Rintoul -- President and Chief Executive Officer

Arun I think what I would answer to that is that we attempt to the best of our ability to keep a handle on inventory and -- of different customers in different regions in the world. And it's a very mixed bag in terms of the degree of inventory across-the-board with a pretty large standard deviation. So for that reason I'm not -- I don't think I'm going to be inclined to say that we're going to provide an exact number where we think inventory is at other than to say that we know that people have enough inventory on the ground that we think working through their current and our expected run rates as we go into 2020 that we expect the first half of next year to see that begin to burn down and the spot demand reflecting the fact that these players are in the process of burning down inventory as opposed to building inventory.

Arun Shankar Viswanathan -- RBC Capital Markets Research Division -- Analyst

And then just on...

David J. Rintoul -- President and Chief Executive Officer

[Indecipherable] what it is.

Arun Shankar Viswanathan -- RBC Capital Markets Research Division -- Analyst

Yes. And just on the needle coke side could you provide some color? You saw some increased costs there. How needle coke prices are trending? And what your expectations are in the next year?

David J. Rintoul -- President and Chief Executive Officer

Sure. Look we're careful not to comment on other companies' numbers i.e. in this case whether it's a P66 or others. It's probably not for us to disclose what they're doing or say what they're doing. However we will direct you to and I'm sure you've read the same public reports that we have that needle coke pricing has in fact dropped. And that's not something that hasn't in the last couple of weeks become more or less public knowledge and you can read about it and the reports that I've seen in public places seem to have the number about right.

Arun Shankar Viswanathan -- RBC Capital Markets Research Division -- Analyst

And just lastly on the capital return side are you still projecting around 50% to 60% of free cash flow to be deployed into capital return to shareholders?

Quinn J. Coburn -- Vice President Chief Financial Officer and Treasurer

Yes absolutely. That remains our target with the balance used to repay debt as we mentioned we do plan to repay debt by the end of the year. We pay additional debt by the end of the year. With regards to the capital return we don't have any specific time line or deadline but absolutely that 50% to 60% remains our target.

Operator

This concludes the Q&A session for today's call. I will now turn the call back to David Rintoul for closing remarks.

David J. Rintoul -- President and Chief Executive Officer

Thank you very much. In conclusion GrafTech is a leading provider of highly engineered graphite electrode services solutions and products to the EAF steel market. Our vertical integration is a significant sustainable competitive advantage and our long-term contracts continue to provide profitability and visibility. We have a proven track record of cash flow generation and returning cash to our shareholders. Again thank you for your interest in GrafTech and we look forward to speaking with you next quarter.

Operator

[Operator Closing Remarks]

Duration: 27 minutes

Call participants:

Meredith H. Bandy -- Vice President Investor Relations and Corporate Communications

David J. Rintoul -- President and Chief Executive Officer

Quinn J. Coburn -- Vice President Chief Financial Officer and Treasurer

David Francis Gagliano -- BMO Capital Markets -- Analyst

Alexander Nicholas Hacking -- Citigroup Inc Research Division -- Analyst

Arun Shankar Viswanathan -- RBC Capital Markets Research Division -- Analyst

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