The success or failure of Carpenter Technology (NYSE:CRS) is ultimately going to have much to do with the fate of the commercial aerospace cycle, so how you feel about that market certainly plays into whether this is a worthwhile idea to consider. Apart from that, though, Carpenter has been making moves to broaden its end market mix (including a growing opportunity in energy). Carpenter is also adding high-end capacity ahead of an expected upswing in demand and this move should prove a good one for both sales and margins.
With more than 40% of sales tied to the cyclical aerospace market (and another 20% or so tied to other cyclical markets like autos/transportation and energy), cash flow-based methodologies don't work particularly well here. Carpenter Technology has historically carried a full-cycle EBITDA multiple around 7.5x, but multiples are usually in the low double-digits at this point in the cycle (ahead of a significant pick-up in results). Assigning a 10x multiple to the average 2014 EBITDA estimate results in a target in the high $60s, and I think Carpenter is an idea worth considering today.
Specialty Alloys And High-End Steels
At its core, Carpenter is a metals and alloys company. Unlike a company like Nucor (NYSE:NUE) or ArcelorMittal (NYSE:MT), Carpenter focuses on more advanced, specialty products that meet more stringent performance demands relating to temperature, corrosion, wear, strength and so on. While more than a quarter of the company's product mix is in stainless steel, Carpenter's steel products address only a small (and higher price/margin) portion of the overall steel market where it competes with companies like Universal Stainless (NASDAQ:USAP), Allegheny Technologies (NYSE:ATI), and the high-performance division of Outokumpu.
All told, stainless, tool steel, and other steel alloys make up close to 40% of Carpenter's sales, with specialty alloys accounting for another 45% or so. This business includes a variety of titanium and nickel alloys, as the company has a wide range of melt/remelt, finishing, and shaping capabilities in nickel and titanium.
A significant percentage of these alloy products find their way into the aerospace market, as the company is the leading provider of specialty alloys for aerospace fasteners. Carpenter is also one of three companies capable of making nickel alloys that make the grade for use in jet engines, and Carpenter counts engine makers like General Electric (NYSE:GE) and United Technologies (NYSE:UTX) in its customer list. All told, of the more than 40% of Carpenter's sales that go into aerospace, about half end up as engine components, with a quarter going to fasteners and roughly 20% going to structural components. With that, Carpenter counts not only the engine manufacturers as customers, but also the major airplane builders (Boeing (NYSE:BA) and Airbus) and component manufacturers like Precision Castparts (NYSE:PCP).
New Capacity And New(ish) Markets
Aircraft build rates vary from year to year, but both Boeing and Airbus continue to sport exceptionally large order backlogs that should keep component suppliers busy for years. Carpenter is certainly banking on ongoing growth in this market, as the company has added capacity through the acquisition of Latrobe (which increased its aerospace exposure) and the construction of a new processing facility.
The Athens facility should start ramping up around the middle of next year, and when it does it will add about 70% to the company's premium capacity. Expanding its premium capacity should be quite healthy for Carpenter's margins once the facility is up and running at scale. This new facility also gives the company a new chance to build market share, as Carpenter can commit to production scale at competitive prices at a time when many aerospace suppliers are looking to seal long-term supply agreements.
Carpenter is not just about aerospace, though. Energy is a growing opportunity for the company, and the company has expanded beyond drill collars into other components. As energy companies drill deeper wells and tap more challenging reservoirs (increasingly sour crudes, for instance), demand will rise for drilling and production components capable of withstanding the higher temperatures, pressure, corrosion of those environments.
There's Competition, But Carpenter Is Well Positioned To Grow
There are numerous companies that produce alloys and engineered metals for the aerospace, energy, and industrial markets that Carpenter addresses. In some cases, as with Precision Castparts, customers are also competitors. In others, as with Allegheny Technologies, Carpenter competes with companies that offer a wider array of products and capabilities in titanium and nickel and that have their own long-term arrangements with major customers like Boeing.
None of this should be particularly surprising. Almost any worthwhile market is going to have competition. Carpenter can benefit not only from its leading position in aerospace titanium/nickel fastener alloys, but also in its overall capabilities. Qualification for these markets/projects can take years and only a handful of companies (including Precision Castparts, Allegheny, and to a lesser extent Universal Stainless and Haynes (NASDAQ:HAYN)) can really match the company's capabilities across a wider array of alloy and metal products. Here too is where I believe Carpenter's capacity expansions will help, as the company will have the capacity to meet growing customer needs.
With that, I'm looking for Carpenter to log multiple years of double-digit EBITDA growth from here. This won't go on ad infinitum, but "long term" in this sector usually only means about three years anyway.
The Bottom Line
As I said earlier, Carpenter is trading at a multiple above its full-cycle norm, but I'm okay with that as I believe next year's EBITDA estimate is well below what is likely to be the full-cycle average. Whether I use a 10x multiple to next year's EBITDA or a 7.5x multiple to my estimate for the full-cycle average EBITDA, I end up with basically the same fair value - something in the neighborhood of $65 to $69 per share. Carpenter thus appears undervalued to me today, and I think this stock is worth a closer look provided you share a generally bullish outlook on the commercial aerospace sector over the next two or three years.
Disclosure: I 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.