Question: How does a private equity investment increase in value from $855 million to more than $8.6 billion in less than three years?
Answer: Lollapalooza effects. Take a look at Graftech International, a Brookfield investment.
What is a Lollapalooza Effect? How is Graftech Related?
Charlie Munger mentions this phenomenon several times in Poor Charlie’s Almanac. Simply put, a lollapalooza effect occurs when two or more forces operate in the same direction. The confluence of these forces often results in an outcome that is non-linear or more than a straight addition of the forces.
Graftech International manufactures and sells a product known as the graphite electrode, a mission-critical consumable required by electric arc furnace (EAF) steel producers. Brookfield took Graftech private in 2015, when Graftech’s earnings power had undergone four years of pressure from a steel industry in oversupply for four years. In fact, Graftech was loss making until sometime in 2017.
Brookfield recently filed for an IPO of Graftech’s equity in order to begin crystallizing its enormous win by selling a portion of its holding in the company. Brookfield already refinanced the company for incremental debt of ~$1.1 billion in early 2018, thereby distributing back 130% of its initial $855 million equity investment. Additionally, at the mid-point of the IPO pricing range, the equity is worth about $6.8 billion. With the $1.1 billion distribution from refinancing and a $750 million promissory note to Brookfield, that is $8.6 billion of value, or more than a ten-fold increase (i.e. “ten bagger”) in less than three years.
What was behind this wildly successful outcome? Within a span of two years, the price of graphite electrodes shot from a historic industry low of approximately $2,500 per MT (vs. a long-term average of ~$4,500 per MT) in 2016 to record levels between $15,000 and $30,000 per MT in the first quarter of 2018. Several factors aligned to make this happen.
Driven chiefly by the surge in graphite electrode pricing, EBITDA (earnings before interest, taxes, depreciation and amortization) for 2018 will likely exceed $1.1 billion – this from a loss-making position when Brookfield took control of Graftech in 2015. In other words, Brookfield’s purchase price of $1.25 billion ($855 million equity + ~$400 million debt) turned out to be a mere ~1.1x run-rate EBITDA in 2018. More useful in my opinion is free cash flow (FCF). Based on details from recent filings, I estimate the $1.1 billion translates into roughly $650 million of FCF, which means Brookfield’s initial equity investment equates to 1.3x Graftech’s estimated cash flow for 2018!
What Specific Forces Aligned for Graftech’s Lollapalooza?
Was it all luck? It is difficult to carve the lines between luck and skill here. What is clear is that Brookfield locked in a low purchase price for the company and thus received many free options. Several forces – some uncontrollable and some directly under Graftech’s control – acted in concert to drive Graftech’s earnings upwards. In a nutshell, increased demand from unrelated sources coincided with reduced supply of graphite electrodes, while management made shrewd internal decisions to create value:
Demand for electric vehicles – totally unrelated to graphite electrodes – is driving demand for petroleum needle coke, which is required for both lithium-ion battery and graphite electrode production. The International Energy Agency (IEA) estimates that the global electric car stock doubled to two million vehicles in 2016 from 2015, and projects the number to grow to between 40 million and 70 million by 2025. This is causing a surge in needle coke prices (and hence graphite electrode prices), which in turn is providing Graftech with a cost advantage versus competitors since Graftech produces 75% of its needle coke requirements. Concurrently, the supply picture benefitted from a 20% closure or repurposing of graphite electrode production since 2014, the result of a years-long downturn in the steel industry. New production requires 5-7 years to come to fruition, given the environmental permits and other planning required. Brookfield was able to add “hands on” value since the inception of ownership by reducing annual costs by more than $100 million. Also, Brookfield mitigated the cyclicality of the investment by entering three to five year contracts to fix pricing with customers for 60-65% of production. Such contracts are new to the graphite electrode industry, though a signature practice in the Brookfield toolkit. Clearly, many forces, working in the same direction, are responsible for the lollapalooza result.
The Starvine strategies are invested in Brookfield Business Partners (“BBU”), a spin-off from Brookfield Asset Management that owns approximately 34% of Graftech before consideration of the amount to be sold in the IPO. Graftech is one of several private equity investments owned by BBU, and quite candidly was the segment I (incorrectly) saw the least promise in when I purchased the stock almost two years ago. The immense value creation from Graftech has yet to be, in my assessment, fully reflected in BBU’s share price.
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