On the whole, you haven't missed much if you sat out the specialty metals space since December. Carpenter Technology (NYSE:CRS), Haynes International (NASDAQ:HAYN), and OM Group (NYSE:OMG) are all pretty close to flat over the last eight months, while Universal Stainless (NASDAQ:USAP) has fallen about 15%. Allegheny Technologies (NYSE:ATI) and Materion (NYSE:MTRN) have done much better, up more than 30% over that stretch, though Materion's performance puts it closer to the pack on a trailing one-year basis.
Valuation keeps me from being unreservedly bullish on Materion, but I really like this business. The business isn't wholly (or even mostly) dependent upon beryllium, nor any particular end market, but still has enough exposure that if beryllium supplies tighten further, it can benefit the company. I like the return to 10% order growth and management's goals for ongoing margin and capital efficiency improvement. Again, valuation is a little iffy but it's not ridiculous, and the underlying quality of the business keeps me positive on its prospects.
From A Tough 2013 To A Stronger 2014
It may seem a little atavistic to talk about 2013 in July of 2014, but it was a challenging year for the company on weak demand in markets like aerospace and consumer electronics, and made worse by the theft of some silver inventory, gold price volatility, and challenges with its beryllium pebbles plant.
I would argue that if you're going to struggle, you may as well get it over with in a tougher market. Materion has moved past those issues and is looking stronger moving into the second half of the year. Orders are up about 10% yoy on a trailing 10-week basis, with growth everywhere except for defense and mining, and even in a weak defense market, the company announced an agreement in June to supply Lockheed Martin (NYSE:LMT) with aluminum-beryllium castings for the F-35 program.
Outside of defense and mining, Materion has seen improving conditions in consumer electronics, auto electronics, aerospace, energy, and telecom. Just as in the case of smartphones or cars, Materion's alloys (beryllium and non-berylium) are used in multiple applications, and demand for the company's ToughMet alloys is increasing in applications like energy as more drilling is done in harsh environments.
Supply Shortages Could Aid Materion
Materion's significance in the beryllium market varies with the source and subject, but ranges from around 40% of the world's master alloy to about 60% of the value-added products and 70% of the virgin ore. There are some Chinese suppliers and at least one notable Russian company (MBC Corporation), but not surprisingly, it is hard to track their production. With newbuild beryllium hydroxide plants costing upwards of $200 million, though, it is not a simple matter to bring new capacity on line.
This is relevant, as it looks like global supplies are dwindling. According to KeyBanc, the U.S. government stockpile fell 50% from September 2009 to September 2013, and Urba Metallurgical, a Kazakh company, is the only other major source of master alloy - and nobody seems to be entirely sure how much it has.
With that backdrop, it wouldn't take much to tip the supply-demand balance to a point where prices start moving up significantly, as happened years ago with rare earth metals. This would no doubt get Materion's upstream operations moving again, but would also provide strong pricing support for downstream value-added products (about 40% of which include beryllium). There is a catch to this, though - while Materion may be rooting for stronger prices, management likely doesn't want them to get too strong, lest customers do what they did in the face of the rare earth element price spike and start adjusting production processes and product designs to use less.
Self-Improvement, Complemented With Improving Markets And M&A
The market for specialty alloys is highly competitive, with Carpenter, Allegheny, Precision Castparts, Universal Stainless, and Haynes all developing and sampling new alloys and new products for the aerospace, auto, energy, industrial, and medical markets. Qualification processes can often take two or three years, and customers consider not only the performance characteristics of these products, but also the price and availability of alternative supplies.
Materion is something of a "specialty generalist", with capabilities including precious metals, copper, nickel, tin, and other metals in addition to beryllium. With those broad product offerings and wide addressable markets, management believes it can grow revenue at a long-term rate of 6% a year (organic), and 10% or more with further incremental M&A transactions.
Management is looking to pair this internal growth potential with ongoing operational improvements. Utilization and margins at the pebbles plant is improving, and the company is targeting further operating margin improvements. Capital efficiency is also an area of attention, with management hoping to get working capital to below 20% of sales and generate more free cash flow.
I'm comfortable with management's long-term growth expectations, though I'm not including that potential M&A-derived growth in my model until actual deals materialize. I'm also hesitant to assume that those margin and working capital improvements will all reach the FCF line, as specialty alloy companies rarely hit 5% FCF margins and don't sustain them for years at a time. With that, I think my estimates of sustained FCF margins of 4% to over 5% are plenty bullish for Materion.
The Bottom Line
Discounting the cash flows back, I come up with a cash flow-based valuation of $36 to $40. EV/EBITDA isn't much better right now, as an 8x multiple to forward EBITDA (a slightly higher multiple than the historical norm) leads to a $38 target. With the shares around $38, that's not huge upside, though I freely acknowledge the possibility that improving end-markets and pricing could lead to upward revisions to revenue and margins over the next 6 to 18 months.
I like Materion, but it's hard to get really excited about paying up for a company with a spotty history of returns on invested capital and plenty of competition. Again, I think the arrows are pointing up for this company today, but I can't fairly say that the market isn't already incorporating those improving conditions into the valuation.
Disclosure: The author has no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.