Has Universal Stainless & Alloy Products Bottomed?

| About: Universal Stainless (USAP)
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Summary

Weak volumes, pricing, and mix resulted in a very weak fourth quarter.

USAP saw significant order growth in Q4, and management remains committed to improving the mix of high-margin specialty alloys.

The end of inventory destocking should lead to higher orders from the aerospace market.

When last I wrote about Universal Stainless & Alloy Products (NASDAQ:USAP), I was bullish on the long-term potential of the company's efforts to upgrade its product mix, but skeptical about the valuation of the stock. Since then, the shares are down about 7%, having spent the last six months chopping between $32 and $38. In that time, that company's progress on volume growth and mix has been frustratingly inconsistent.

I have a nerdish interest in metallurgy and companies like Allegheny Technologies (NYSE:ATI), Carpenter Technology (NYSE:CRS), A.M. Castle (NYSE:CAS), and Haynes International (NASDAQ:HAYN), but following companies and science is a completely separate issue from the stocks. I do generally like the potential for advanced alloy growth in aerospace, power machinery, and oil/gas, and I also do believe that vacuum induction melting (or VIM) products will skew USAP's mix higher over time. Here and now, though, it's hard to call the shares undervalued, with an apparent fair value around $33 to $37.

Prices Going Up… But So Are Costs

USAP recently announced a 5% base price increase on various melted grades from its Bridgeville, Dunkirk, and Jackson facilities. Given recent price increases at Carpenter (5%) and Haynes (3% to 5%), that's not surprising nor out of line.

I'm hesitant to assume a big near-term benefit to the company, though. Severe winter weather has led to higher electricity prices, and natural gas prices are about 10% higher than the start of the year. Metal prices are moving higher as well, with nickel prices up over 15% on the LME from the start of the year. With a weaker product mix and risks in price/cost mismatches between inventory and sales, that could well weigh on results in the first half of the year.

Still Waiting For That Rich Mix Shift

The fourth quarter of 2013 was hopefully the low point for USAP for the cycle, as a lot of negative factors intersected. Tons shipped declined, as did ASPs, and the company's mix worsened. Weak activity levels in the oil and gas market led to a 50% decline in tons shipped to that market, with negative price/mix shifts piling on to make the sales figure even worse. Aerospace was also soft on a sequential basis.

All told, the company's mix is not where management wanted it to be. A large part of the reason to be bullish on USAP is to benefit from the company's planned migration from having more than half its production in tool steel and stainless steel alloys to only about one-third of volume in these lower-margin alloys and nearly two-thirds from much higher-value alloys produced through argon oxygen decarburization (or AOD remelt) and VIM remelt.

The differences in ASPs are significant, as company-provided slides point to $2/lb and $3.50/lb ASPs in tool steel and stainless versus $5/lb and $9/lb in AOD and VIM. It's also worth noting that there is an impact on end-market exposures as well; there are certain highly demanding must-have alloys for applications in aerospace and power that can really only be produced by those processes, and improving the mix would improve USAP's position on the value curve.

Said differently, USAP is trying to transition away from more commoditized alloys, where it is much more of a price-taker, and toward specialty alloys that have fewer global producers.

Strong Order Growth Should Help

Improving the mix of high-margin premium alloys is a long-term company goal, as is bringing more forge and capabilities in-house. In the near term, the company still has substantial exposure to the vagaries of deeply cyclical markets like aerospace, power generation, and oil/gas.

Orders were up 42% yoy and 26% sequentially in the last quarter, and that should at least be good for improved capacity utilization. Other alloy companies like Allegheny and Carpenter have been biding their time as aerospace companies worked through their inventory of parts, but it looks like the destocking process is close to the end. Boeing and Airbus both have thick order books right now, and companies like General Electric (NYSE:GE) and United Technologies (NYSE:UTX) have likewise been bullish about the prospects for their engine businesses. GE has also been bullish regarding long-term demand for power generation and oil/gas equipment, though acknowledging lumpy and unpredictable cycles.

What this all means for USAP is that 2014 should get stronger as the year goes on. As Boeing and GE work through their order books, that should result in better aerospace sales for USAP, as well as customer/competitors like Carpenter. It's also worth mentioning that USAP and Haynes established a working partnership, wherein USAP will provide VIM capacity and forging services to Haynes on a conversion basis, while getting back some of Haynes technology and know-how in advanced nickel-based alloys.

The Bottom Line

I like that USAP has started work on a long-term contract with Rolls Royce, and recently got LCS approval from United Technologies' Pratt & Whitney division. While USAP does have an outsized exposure to aerospace, that's one of the leading end-markets for specialty alloys and likely a major future customer for the company's VIM products.

USAP has been a laggard in the space over the past six months, but it is not exactly cheap. EBITDA could grow at a compound rate of over 50% over the next three years, but even pricing the shares on the high end of industry multiples for 2016 EBITDA and discounting back only gets me to a fair value of around $37 or $38. It's certainly true that USAP could make better/faster progress on its business mix and see those EBITDA estimates head higher. Likewise, this past quarter may well be the bottom for the cycle. I'd like a little better margin of safety on this one, but $32 looks like a point of strong support, and this may be where USAP's rebound begins.

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.