These first quarters of the commercial aerospace boom have been challenging, with OEMs forced to revise their production schedules in response to unpredictable component availability from their suppliers. This sets the stage for elevated return risk in the short term, as quarter-over-quarter production may deviate from expectations, but I remain optimistic about a multi-year trend of increased construction of narrow and wide-body aircraft.
carpenter technology (New York Stock Exchange:CRS) shares are up about 15% since my last update on the company, making them an outperformer in a space where rivals like TO YOU (TO YOU), hexcel (HXL), Howmet (HWM), and Alloy and universal stainless steel (USAP) have seen a bit more turbulence in results and sentiment. I continue to believe that Carpenter is well positioned to capitalize on that growing aerospace demand in better finance and valuation, and I think the stock is still worth considering here.
A decent neighborhood despite some interruptions
Carpenter’s fiscal first quarter results (the September quarter) were generally good, particularly considering some external disruptions to the business.
Revenue was up 35% year-over-year, as reported, but fell 7% sequentially to $523 million, while value-added revenue (revenue net of metal surcharges) rose 20% year-over-year and fell 7% quarter-on-quarter. Total shipments increased 3% YoY and decreased 13% QoQ, with the company not shipping at full demand due to disruptions caused by Hurricane Ian. Average realized prices increased 16% year over year and 7% quarter over quarter (based on value added or VAR).
Gross margin improved 400 bps YoY and contracted 230 bps to 10.5% on reported revenue and increased 650 bps YoY and contracted 330 bps QoQ to 14.6% on a VAR basis. Input cost inflation remains a problem, and the hurricane did not help operational efficiency either. Looking at gross profit per pound shipped, Carpenter saw a 111% year-over-year improvement, but a 12% quarter-on-quarter contraction. Adjusted operating income reversed a loss from the prior year ($8.3M versus $17.5M), but contracted from $14.9M in the prior quarter, with a margin of 2.2%. Total segment profit reversed a loss from the prior year ($26.2 million vs. $3.7 million), but fell 7% sequentially to $26.2 million, with a stable sequential margin at 7.0%.
By segment, Specialty Alloy Operations (or SAO) saw 18% YoY growth and 7% QoQ contraction in VAR, with underlying volume up 4% YoY and down 14% QoQ and revenues rising. prices of 14% year-on-year and 8% quarter-on-quarter. Performance Engineered Products (or PEP) revenue increased 19% year over year and contracted 6% quarter over quarter. Volume contracted 2% year-over-year and 17% quarter-on-quarter (a further impact from the hurricane), while realized prices increased 21.5% year-on-year and 14% quarter-on-quarter.
Improved profitability for both segments. SAO earnings reversed a loss from the prior year and were down slightly from the prior quarter (to $19.9 million, with a 6.5% margin), while PEP earnings were up significantly from a small figure from the prior year and decreased 23% quarter-on-quarter to $6.3 million, with a margin of 7.2%.
The aerospace industry is recovering in fits and starts
The recovery in the commercial aerospace industry has been more chaotic than analysts expected in 2021 or early this year. While flight hours are increasing and fleet operators still want to renew and expand their fleets, the reality on the ground has been more complicated.
Airbus (OTCPK: EADSY) and boeing (BA) have blamed their suppliers squarely, claiming that the uneven and unpredictable availability of components has forced them to be more conservative in expanding production.
Looking at the results of vendors like ATI, Carpenter and others, it would seem that they show up in a greater variety of results: basically all see their aerospace business grow, but with some significant differences year-over-year and quarter-over-quarter growth rates. Engines continue to be a pain point in the supply chain, and companies that supply engine manufacturers (particularly with hot-side components) are experiencing strong demand.
To that end, Carpenter saw revenue growth of 36% year-over-year and 3% quarter-over-quarter in revenue from aerospace and defense clients, with aerospace clients growing 40% year-over-year and 7% quarter-over-quarter, and growing 45% year-over-year. and 24% quarterly from aerospace engine customers. Management has also noted that lead times are stretching, and I have heard reports of lead times for some engine components stretching up to close to a year. At the same time, Carpenter’s order book continues to grow, growing 155% YoY and 10% QoQ this quarter, including 190% YoY and 11% QoQ growth in the aerospace industry.
I expect more turbulence through at least mid-2023. Boeing didn’t add much clarity to its production plans at its recent investor day, aside from noting that they wanted to stabilize 737 production at 31 a month before reaching 38 a month (probably in the second half of 2023).
Given his influence on special alloys that can be used in hot side engine components, including titanium, and given the limited capacity for titanium in the industry, I don’t think Carpenter will be in short supply. Management’s own comments reflect that, with the CEO defending the belief that the aerospace recovery is accelerating and indicating that the company is and will be prioritizing capacity for aerospace customers as needed.
I expect a continued acceleration in aerospace demand as production schedules become more predictable and production accelerates into 2023 and beyond. In the meantime, I think there could be some weakness in the non-aero end markets. Demand in the oil/gas, transportation, medical and industrial markets remains healthy, but I think Carpenter benefited recently from orders outpacing end-user demand growth as customers looked to rebuild inventories and stabilize their own production schedules.
I haven’t made that many significant changes to my model, although advancing a fiscal year does reduce my long-term revenue growth a bit, to about 7%. Given the challenges with aircraft production, I have weighted back more of my revenue growth, taking more of it out in a few years.
In the longer term, I think the company’s underappreciated efforts in additive manufacturing (industrial 3D printing) and soft magnetism (useful in higher-output engines) might still have an advantage, but commercial aerodynamic recovery will most likely dominate the multi-year narrative.
The margin improvement has not been a smooth upward curve, but I see continued progress in management’s efforts to make the business fundamentally more profitable through the cycle. With the recovery picking up less sharply than I had previously assumed, my short-term EBITDA margin estimates are a bit lower, but I still see mid to high teen margins in the next few years.
The bottom line
Between discounted cash flow and EV/EBITDA, I continue to believe that Carpenter stock is undervalued and offers a good upside for the ongoing aerospace turnaround. An 8.5x multiple on my estimated FY2024 EBITDA (discounted one year back) gives me a fair value of just over $50, while a discounted cash flow model with long-term revenue growth of almost 7% and long-term average FCF margins in the mid-singles also support upside from here.
I don’t really like Carpenter as a long-term core holding as I think it’s just too cyclical for that but I still see more leverage in this aerospace cycle and I think this is a good name to consider although one is likely have above-average volatility, as it is more at the mercy of the ordering patterns and supply chain gymnastics of other companies further down the production chain.