Carpenter Is Seeing Good Demand Growth, But Operating Leverage Remains A Work In Progress

While it has been frustrating at times, specialty alloy company Carpenter (CRS) has been making progress. The shares are up 11% from when I last wrote about the company, beating the S&P 500 over that time and matching Allegheny (ATI), but lagging Haynes (HAYN) and Universal Stainless (USAP). Along the way, the company has been posting some good revenue growth, though margin leverage has been more of a laggard than I’d hoped.

Carpenter shares do still look undervalued, though the 20% or so gap in valuation I previously saw has now shrunk to around 10%, and I’m a little concerned that my out-year margin assumptions are a bit too aggressive. Still, demand is taking off in the aerospace market, the company is still doing well in the medical and transport market, and oil/gas demand continues to recover. What’s more, there seems to be a real sense of urgency on the part of customers to get the company’s Athens facility qualified, something that should lead to meaningfully higher utilization and significant margin leverage.

Revenue Growth, But Lackluster Leverage

Carpenter’s 21% reported revenue growth was a strong result for the company’s March quarter (its fiscal third quarter), and likewise with the 14% surcharge-adjusted growth. The Special Alloy Operations segment saw 26% growth and 18% ex-surcharge growth on 10% volume growth, while the Performance Engineered Products business grew more than 9% on 4% volume growth.

Gross margin declined 70bp as reported and rose 20bp on a surcharge-adjusted basis. Part of the point of the surcharge is to help the company recover raw material costs, but there is a lag between when the company must pay those costs and when they can recognize the surcharges. Even so, I was expecting to see a little more gross margin leverage at this point.

Likewise, while the 13% growth in adjusted EBITDA and 26% growth in operating income were enough to drive a small bottom-line EPS beat, the leverage hasn’t developed like I was expecting. PEP segment margins improved slightly in the third quarter, while SAO margins worsened by 150bp, and the PEP business is being held back by costs related to repairs after a fire back in January.

The Business Is Building

The good news is that Carpenter’s story was never about a single quarter or two in isolation (nor even a full year). Carpenter’s story is about matching the rising demand for specialty alloys, particularly in aerospace, with improved capacity utilization, overall operating expense efficiencies, and a mix shift toward higher-premium alloy products.

On the demand side, things are going more or less to plan. Aerospace sales were up 22% in the quarter (with engine sales up 32%), and the company reported back in February that it was getting capacity-constrained for products for the aerospace market. Likewise, the medical, transport, and industrial/consumer end-markets are growing nicely, with only power gen seeing real weakness (and offsetting 35% growth from oil/gas customers in the “Energy” end-market). With this strong and growing base of demand, backlog is up 27% yoy and 13% from the prior quarter.

Capacity utilization and mix shift is still a work in progress. The Dynamet fire didn’t help the capacity situation, and the company’s Athens facility is still only at 40% capacity utilization. Metalworking facilities don’t generate good profits at such low utilization rates, and Carpenter is no exception. It does seem like customers are stepping up their qualification activities, though, as the company got three more approvals at Athens this past quarter, and I continue to believe that management is not going to miss the cycle. Still, this slow walk toward greater utilization at Athens has been one of the most frustrating parts of the story, particularly as the nickel-based alloys produced at Athens are higher-margin products.

Adding More Capabilities Doesn’t Change The Near-Term Story

Carpenter acquired CalRAM relatively recently, adding more capabilities in additive manufacturing. CalRAM’s business is focused on high-end additive manufacturing (using a powder-bed fusion process) for prototypes and small production runs. It does add some vertical integration to Carpenter, expanding its capabilities on the finished part side, but I don’t see this as a meaningful move at this point.

The Opportunity

Carpenter has historically enjoyed a good position in the aerospace market, built in part around its strong share in superalloy fasteners. New aircraft designs and new engine designs mean new opportunities and new challenges – the specialty alloy content of this newest generation of aircraft and engines is higher, but there are plenty of companies competing to supply companies like General Electric (GE), United Technologies (UTX), and Precision Castparts with the alloys they need.

Along those lines, I have some concerns about the slow pace of qualifications and capacity uptake at Athens, but recent results from Allegheny don’t suggest that Carpenter is being left in the dust. Universal Stainless saw stronger growth in its aerospace business in the March quarter (up 36%) and stronger overall premium alloy sales growth (up 103%), but I don’t want to exaggerate the comparison, as Carpenter’s aerospace business is more than seven times larger than that at USAP.

My biggest modeling concern now is on the margin line. I’ve raised my revenue estimate for the full year a bit (I started off at a higher level than most, if not all, sell-side analysts), but I’ve trimmed back my gross margin assumptions. I don’t want to overcorrect, as I still believe Athens will ramp up and that it will have significant margin impacts, but I also don’t want to create a “garbage in, garbage out” model where Carpenter looks cheap because my assumptions are unattainably high.

I still think there will be meaningful gross margin leverage from here, but at a somewhat slower pace and with a lower peak. Likewise, I still expect very strong EBITDA growth over the next few years, but not quite at the same pace as before.

The shares do not look undervalued on the basis of discounted cash flow, but that’s no surprise, as stocks in this sector tend to only look cheap on DCF at the low points in the cycle and/or if you forget to model cyclical declines. Turning to EV/EBITDA, I’m still using a multiple that’s higher than the long-term average because I still believe that Carpenter is a couple of years away from mid-cycle. At 9.5x forward EBITDA, I get a fair value of about $65.

The Bottom Line

Specialty alloy stocks have enjoyed a good move this year, and over the last year, as demand has materialized in end-markets like aerospace and better volumes are driving operating leverage. I’m not quite as bullish on Carpenter now, due mostly to the combination of higher valuation, less margin leverage, and a slower ramp at Athens, but I still believe the shares are undervalued and can offer more upside from here.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

SeekingAlpha