Back in April, I thought that Materion (NYSE:MTRN) shares looked a little too cheap and the stock and the shares have since climbed almost 20%. There really aren't many good comps for Materion, so the performance of companies like Eastman Chemical (NYSE:EMN) or Johnson Matthey (OTCPK:JMPLD) isn't all that instructive, nor is the performance of specialty steel, nickel, and titanium alloy companies like Carpenter (NYSE:CRS) or Allegheny (NYSE:ATI). Basically, this is a case where the cheese stands alone, though connector companies like TE Connectivity (NYSE:TEL) and Amphenol (NYSE:APH) do tend to travel in similar directions and have some shared end-market exposures.
The good news for Materion is that business seems to be recovering, as revenue has logged two consecutive sequential improvements and should do so again in the third and fourth quarters. Margins have held up reasonably well through this downturn and free cash flow has remained positive. While I do believe that improving conditions in smartphones, aerospace, satellites, and telecom infrastructure should help the company post better growth over the next three to five years, it's important to remember that Materion has never been a champion in terms of reported return on invested capital or FCF generation. The shares do look a little undervalued, though, and improving momentum in its core addressed markets could still leave a little room for further appreciation.
The Story Will Sound Familiar
Materion has seen a lot of the same problems that most of those other metal alloy companies have seen, even though the companies' end-market exposures are different. While Materion hasn't been hit all that hard from destocking in aerospace fasteners and components, extreme weakness in oil/gas drilling and completion activity has definitely hurt. Materion has also been hit by weakness in consumer devices like smartphones, weakness in telecom equipment, and lower demand for heavy machinery (like mining equipment) and industrial tooling products.
With that, revenue fell 19% in the first quarter and 10% in the second quarter, and is likely to post only modest low single-digit growth in the third quarter (and still down about 14% from the comparable figure two years ago). The relatively better news, though, is that value-added sales have held up better. Value-added revenue fell 12% in the first quarter and 5% in the second quarter, and the second quarter saw sequential growth accelerate to 7%.
I think it's also worth noting that the company's margins have held up reasonably well. Second quarter gross margin (on a value-added revenue basis) was down about two points from the prior year and down only about a point and a half from two years ago. Adjusted operating margin hasn't held up quite as well (down about three points), but this isn't really out of line with other specialty alloy and specialty metal/material companies (including Johnson Matthey).
Reasons For Optimism In The Coming Years
I believe there is a credible argument that Materion will see its revenue, earnings, and cash flow improve in the coming years, as I expect recoveries in several end-markets.
The smartphone market is a tough one to predict, as high-end sales have certainly slowed and growth from the new iPhone 7 will likely be a driver for only a limited time. That said, a lot of features and components that were once found only in high-end phones are now moving into mid-range phones, including gesture controls and greater GaAs RF components like the filters, switches, and amps made by companies like Broadcom (NASDAQ:AVGO) and Qorvo (NASDAQ:QRVO). Along similar lines, as phones become more and more integrated into daily life, greater use for cameras, payments, and so on is increasing the need for springs, connectors, and other components with higher fatigue resistance.
All of this filters back to Materion. The company's copper-beryllium alloys conduct heat and electricity almost as well as copper, but they are stronger, harder, and more fatigue-resistant than copper. Materion also supplies the targets that are used as source materials for thin film deposition (important in manufacturing wafers and other components used in phones).
Outside of growing content in mid-range phones, I believe Materion is looking forward to growth in aerospace, space, auto, medical, and telecom equipment. Like Carpenter, Materion is seeing aerospace component companies and OEMs using more and more alloys in their new planes and that means more content for Materion in places like fasteners, connectors, hinges, and so forth. On the space side, the satellite market is finally starting to improve, after years of frustrating false-starts. With auto, companies like Valeo (OTCPK:VLEEY), Bosch (OTC:BSWQY), and Continental (OTCPK:CTTAY) have made big commitments to enhanced driver assistance systems, pollution control, and electrification, and that requires a range of optical components and other performance alloys that Materion can provide. On the medical and telecom side, diagnostic applications like diabetes test strips remain a growth opportunity in emerging markets, while telecom is starting to see improvement in base station demand.
There is also at least some possibility for improvement in industrial and oil/gas demand. Heavy equipment demand should be at or near its bottom, and likewise demand for alloys used in molds for tooling. I'm not looking for a strong rebound in oil/gas, and I think there will be more competition here with the likes of Carpenter for alloys that have temperature, corrosion, and wear resistance, but Materion continues to develop and introduce new products and simply seeing rig counts stabilize and start to improve a bit is a meaningful step forward.
Materion is scheduled to report in a week (as of this writing); management previously guided for a stronger second half and I'm still cautiously optimistic on that front. While many other companies have stepped back from similar guidance, I believe Materion's different end-market exposures (less aerospace and energy, more smartphones) should help it out.
I'm also looking to hear updates on its M&A plans and major supply agreements. Sales of performance alloys have been hurt by lower orders from NGK Insulators (OTC:NGKIF) as an old supply agreement comes to an end, but management sounded as though it was close to a new agreement back at the time of second quarter earnings; at close to 3% of revenue, it's not make-or-break but it is meaningful.
As far as M&A goes, the company was negotiating with Heraeus to acquire its target materials business (approximately $70 million to $80 million in sales) and had signed a letter of intent for a bolt-on deal with another, smaller, company. There have been no press releases or filings since (both could arguably be below the threshold of "material"), but Materion has made it clear that it wants to be more active in M&A, and expanding its target materials business (used in thin film applications, including consumer electronics, semiconductors, LEDs, and solar panels) makes sense.
My basic expectations for Materion haven't changed that much. I'm still looking for long-term revenue growth on par with its past history - around 5% to 6% a year on average, but with more volatility/cyclicality on a year-to-year basis. I believe mid-single digit FCF margins are attainable, as well as double-digit EBITDA margins. Discounted back, the cash flows support a fair value of around $31, while a 7.5x EBITDA multiple (consistent with past norms) supports a fair value around $32.50.
The Bottom Line
I do believe that Materion will continue to introduce new alloys and products that offer meaningful performance advantages like enhanced durability and conductivity. But I also expect that specialty materials and alloys will remain a highly competitive market where OEMs have a variety of options that limit Materion's pricing power and market share. So while I think Materion is looking at better revenue and earnings in the coming years, I don't see enough value or growth potential to call it a core holding. There's still some value left here, and I won't be surprised if the market reacts positively to new signs of recovery/momentum, but Materion has never yet shown that it's really a strong option for long-term holders.
Disclosure: I am/we are long AVGO.
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.