Universal Stainless & Alloy Products May Be Bottoming, But The Future Remains Murky

| About: Universal Stainless (USAP)
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Summary

While the year-over-year comparisons remain difficult, USAP has been seeing some sequential improvements in its business, including the all-important aerospace segment.

A lot of alloy capacity was added in anticipation of the aerospace cycle and USAP may find it difficult to gain meaningful share and/or achieve the hoped-for margin/mix improvements.

USAP still looks undervalued on an EBITDA basis, but aerospace growth is uncertain and this remains a highly competitive commodity industry.

When I last wrote about Universal Stainless & Alloy Products (NASDAQ:USAP), I thought this struggling specialty alloys company had some speculative appeal but only for aggressive risk-seeking investors. The shares have since risen about 30%, on par with fellow alloys company Carpenter (NYSE:CRS), better than Haynes (NASDAQ:HAYN) (up 15%), and worse than Allegheny Technologies (NYSE:ATI) (up 56%). I believe these gains have been fueled by optimism that the "perfect storm" of weakness in aerospace, power gen, oil/gas, and heavy equipment has largely bottomed and that sales and margins should improve from here.

I think USAP could be 10% to 20% undervalued today, and that's assuming the company doesn't regain prior peak sales until 2023 and prior peak gross margins until 2021 (the difference being a mix shift toward higher-margin products). On the other hand, I don't think the company is exactly out of the woods with respect to its debt position and there is ample capacity in the specialty alloy market. Add in wobbliness in aerospace order books and persistent low energy prices, and this remains a stock that's really only suitable for the risk-seeking investor.

A Quick Look Back

I suppose there are two ways to look at USAP's financial performance since my last update - the company has reported 29% and 17% year-over-year revenue declines on punishing weakness in aerospace, power gen, and oil/gas. On the other hand, sequential revenue growth has been around 25% and 3% as the company's key markets do seem to be bottoming out. Aerospace, for instance, posted 4% sequential growth in the second quarter and is far and away the largest contributor to the business (over 60% of revenue).

Unfortunately for USAP, the demand for premium VIM remelt products still hasn't materialized, and that has limited the long hoped-for margin uplift from these higher-value products. Along those lines, utilization rates in the high-value operations remains lackluster (though it has been getting better on a sequential basis). Orders remain sluggish (a book-to-bill of about 0.93 in Q2 and 1.04 in Q1), lead times are uncommonly short, and management is expecting the second half to more or less resemble the first half of the year (versus a prior expectation of improvement/strength in the second half).

Can Aerospace Drive A Rebound?

Aerospace remains a frustrating market for many of its participants, with Honeywell (NYSE:HON) recently lowering quarterly expectations due in part to the aerospace business. Demand for widebody planes has been weakening, and with that, it seems more likely that production schedules are going to be revised down in the coming years. Making matters more challenging, a lot of service centers and distributors have been focusing on leaner, more disciplined inventory management.

On a more positive note, USAP does have working relationships with key engine makers like General Electric (NYSE:GE), Rolls Royce, and United Technologies (NYSE:UTX), and these companies have remained generally positive on the long-term outlook for their aircraft engine businesses. There is also the oft-repeated fact that these new aircraft and aircraft components contain more high-value alloys than before.

On the other hand, USAP's customer relationships aren't typically direct (only about 10% of sales go to the OEMs directly), so inventory management and order lead times are still significant factors in play. It's also worth noting that Carpenter and Allegheny are also big players in specialty alloys for aerospace and while they don't all compete head-to-head across the board, they do have a lot of capacity and a lot of long-standing OEM/supplier relationships.

And The Rest?

Aerospace turned up in the second quarter on a sequential basis, but oil/gas and power-gen remain stubbornly weak. With lower drilling and completion activity at current prices leading to less equipment replacement and minimal new equipment deployment, there's much less need for the corrosion and temperature-resistant alloys that USAP produces. Companies like Schlumberger (NYSE:SLB) and Halliburton (NYSE:HAL) have been suggesting that the worst is over (or nearly over), but that doesn't mean a strong rebound is just around the corner. Power-gen, too, has remained stubbornly soft, though GE continues to make bullish projections for the long-term demand for turbines.

I would also note that USAP saw its heavy equipment/auto business turn up on a sequential basis in the second quarter (up 8%). Cutting tool demand is still weak overall in the manufacturing sector, but several auto companies (including Ford (NYSE:F) and General Motors (NYSE:GM)) are gearing up for new model launches that requiring retooling and new equipment.

Where To From Here?

I don't expect the third quarter results from USAP to hold a lot of great news. I do think the company's efforts to better align its cost structure with actual demand will support better gross margins in the third and fourth quarters, but 12% gross margins may prove harder to reach without better capacity utilization. I'm also worried that aerospace orders could disappoint, translating into lower orders for USAP and ongoing weakness in the backlog.

Longer term, I think the outlook is uncertain. Between rivals like Carpenter, Haynes, Allegheny, Outokumpu and others, this is more of a commodity business than some investors seem to realize. There is, likewise, enough capacity out there for high-value melting operations that competitive pricing pressure could limit USAP's mix/margin uplift from a greater shift toward premium products. Keep in mind, this aerospace cycle was predicted many years ago and a lot of specialty alloy companies added capacity in anticipation. What wasn't expected was the sharp decline in oil/gas, mining, and heavy industry, so there is a lot of unused capacity out there.

The best thing for USAP would be for this "perfect storm" to reverse and for aerospace, energy, power-gen, and heavy industry to all stage strong rebounds simultaneously. That would take up a lot of excess capacity and push alloy prices back up. I don't think that's likely, though, as the commentary from Boeing and Airbus hasn't been that strong and the commodity businesses don't seem poised for a sharp rebound in exploration/production activities.

For USAP, that means a longer path to recovery. I've lowered my expectations for the next two years by about 15% on the revenue line and likewise lowered my expectations for margin leverage. Management is doing well with managing its cash flow, though, and that's a positive.

The Bottom Line

A fair value of around $12 makes sense on the basis of a 7.5x multiple to my 12-month EBITDA estimate. The biggest risks to that look to be slower sales to the aerospace market and/or less gross margin leverage. This remains a very risky derivative play on aerospace, oil/gas, power-gen, and heavy industry. While the margin potential of an improved mix of high-value alloys is significant, investors should at least consider the risk that overcapacity will compete away that opportunity through lower pricing and/or that markets like aerospace will disappoint. While I think management here is doing about the best that can be expected, it remains a high-risk play on a tough cyclical industry.

Disclosure: I am/we are long SLB.

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.

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