Most specialty alloy companies have enjoyed a good run over the past year, and Materion (NYSE:MTRN) has certainly been among them with a 40%-plus move since my last update on the company. Not only has aerospace demand come to life, but Materion has also seen stronger momentum from its industrial and consumer electronics customers. Making things even better, the company’s cost-reduction/efficiency moves seem to already be paying dividends, and the company’s efforts to expand its new product contributions appear to be ahead of schedule.
Materion has done better than I’d expected it would last summer, but the valuation gives me some pause. I’m not surprised that the shares look pricy in DCF terms, but the EBITDA-based valuation is a little more limiting to my enthusiasm. Materion trades at around 12x forward EBITDA and I’d be reluctant to pay much more than that (frankly, I’d be reluctant to pay that much). Strong end-markets and ongoing margin improvement can still drive higher estimates, but the multiples already look pretty fair.
Although the segment-level contributions move around from quarter to quarter, all in all I would say that Materion has been posted strong core growth. Revenue was up 14% in the first quarter on an organic basis (led by 27% growth in Performance Alloys) after a similar result in the fourth quarter of 2017. The Precision Coatings business has been lackluster (up 1% in the first quarter and up 4% in the fourth quarter), hurt in part by weaker diabetes testing strip demand.
New products made up about 17% of Materion’s first quarter value-added revenue and the company is on pace to reach its 20%-plus target. Along similar lines, Materion has continued to find success growing its ToughMet business – ToughMet alloys are high-strength copper/nickel/tin alloys that don’t contain beryllium, and the company is seeing growing demand in products like bearings, bushings (especially for aircraft), plate (for injection molding), welding, brazing, and so on.
Ongoing new product development remains a key focus for management, but this has become a more focused process in recent years. Instead of trying to develop a wide array of products, throwing them out into the market, and seeing what catches on, the company now seems to be taking a “less is more approach” where it focuses on a smaller number of products that are better-targeted at particular use applications.
Unlike many other alloy companies, including Carpenter (CRS) and Universal Stainless (USAP), aerospace isn’t a major end-market for Materion. The company did see over 50% yoy growth here in the first quarter, and the company is seeing growing demand for ToughMet components (like bushings) and specialty alloy connectors, but this is still a relatively small part of Materion’s mix.
On the other hand, relative to Carpenter and Universal, consumer electronics and industrial end-markets are major contributors to Materion’s revenue. In a quarter where consumer electronics-related demand was wobbly for many companies, Materion saw 6% yoy organic growth even with customers running down inventory, and the company continues to see good demand for connectors, contacts, phosphor wheels, and targets used in the chip manufacturing and packaging processes. On the industrial side, growth is being driven by a wide range of product types, including welding products, injection mold materials, and copper-beryllium rod and wire.
Materion has been at work for some time trying to restructure its Performance Alloys business, and it looks like those efforts to reduce fixed cost overhead are paying off. Segment margins have picked up from the low single-digits (in some cases near zero) to the mid-single-digits and now more recently almost into the double-digits. On a long-term basis, management is hoping to drive operating margins into the mid-teens, largely by improving sourcing, streamlining manufacturing, and shifting toward a more variable cost structure across the operation. A higher-margin mix could also help this process, with new products typically offering better margins and management trying to move toward supplying more semi-finished cast products (as opposed to “bulk” alloy).
Opportunities like IoT, with potentially millions of devices with sensing and communications capabilities, autos with more electronics, and commercial aerospace all offer Materion a chance to outgrow its end-markets, and management has done a commendable job of delivering on past targets for new product development and product mix enrichment. Coupled with ongoing cost reduction/efficiency initiatives, I think this management time is basically doing all the right things today.
The issue is what investors should pay for that. Today’s share price already anticipates double-digit long-term FCF growth and a meaningful sustained improvement in FCF margins. Likewise, the shares also already trade above 12x forward EBITDA – specialty alloy companies can trade close at multiples up to the mid-teens, but typically not for long stretches of time.
I underestimated the potential of Materion’s shares a year ago and I’m reluctant to make the same mistake again, particularly when the aerospace and industrial markets are delivering strong revenue and order growth. Even so, that growth seems well-understood by the Street (even though this isn’t a widely-followed name), and I think it’s risky to count on a lot of multiple expansion from here. Additional beat-and-raise quarters could still move these shares higher, but I’d prefer to wait in the hopes of an opportunity to buy on a pullback.
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