Howmet Aerospace: A Closer Look

May 31, 2022 4:52 PM ETHowmet Aerospace Inc. (HWM)6 Comments2 Likes
Leo Nelissen profile picture
Leo Nelissen
16.17K Followers

Summary

  • Howmet Aerospace is a high-tech aerospace supplier with additional transportation exposure.
  • The company did well during the worst pandemic years and is now about to accelerate free cash flow and EBITDA thanks to accelerating demand.
  • Despite ongoing challenges, investors remain in a great spot to benefit from long-term outperformance.

Industrie-Thema anzeigen. Reparatur und Wartung von Flugmotor auf dem Flügel des Flugzeugs.

aapsky/iStock via Getty Images

Introduction

In March of this year, I wrote an article calling Howmet Aerospace (NYSE:HWM) undervalued. Since then, the stock is down 2.8%, outperforming the market in an environment of supply chain problems, high inflation, growth fears, and a somewhat aggressive Federal Reserve. Given ongoing market uncertainty, it makes sense to discuss stocks to buy more aggressively when economic growth bottoms. One of these stocks is Howmet Aerospace. The company is doing a terrific job recovering from the pandemic as it sees strength across the board with strong pricing power when long haul demand is returning. The valuation is low given future expected growth rates, improving margins, and significant intellectual property.

In this article, I will update my bull case and walk you through my thoughts given new macro and company-specific events.

Let's get to it!

Next-Gen Aerospace Exposure

With a market cap of $15.1 billion, Howmet is the 15th-largest stock listed company operating in the specialty industrial machinery industry. That's right, it's not "officially" categorized as an aerospace company. Prior to the pandemic, the company generated 71% of its sales in the aerospace industry. Other sales are generated in transportation-related industrial segments like truck manufacturing where Howmet supplies light-weight forged wheels.

Despite this classification, I will continue to call Howmet an aerospace company as 70% pre-pandemic exposure is enough to make a huge difference. Besides that, the company is a key supplier of core parts as I will show you in this article.

On May 24, I read that Morgan Stanley was impressed with Howmet's intellectual property.

The company's rich intellectual property is seen as a primary driver for its market leading positions across its businesses, in the form of trade secrets, patents, material developments, and equipment builds.

"The business's strong IP position within the segment may help lead to market share growth as increased composite usage on aircraft has been leading to greater shipset content for HWM's Fastening business."

Morgan Stanley, which assigned a $43 price target is referring to nearly 1,150 granted and pending patents for parts, alloys, designs, and production processes. The benefit that comes with being a global leader in markets with limited competition is pricing power - especially when it comes to supplying smaller parts that are key in larger structures like engines.

2022 Investor Presentation

Howmet Aerospace

In its fastening segment, the company has 2.7x more patents than its biggest competitor (most of them granted). In its engineered structures segment, the company has products in every major western commercial and defense program. Its aluminum and titanium forgings reduce weight, ending up in cost savings of up to 30% for its customers.

The unavoidable problem HWM investors faced since the 2020 spin-off of Arconic (ARNC) is that the pandemic caused aerospace customers to reduce orders as companies used existing inventory to deal with imploding demand and outlook uncertainties.

Yet, cost-savings caused 2021 to improve versus 2020 despite slower sales. In 2021, the company generated $1.36 billion in adjusted EBITDA with an EBITDA margin of 22.8% (+100bps versus 2020). Moreover, back then, the company did $517 million in free cash flow. That's 3.4% of the current $15.1 billion market cap.

HWM financials

TIKR.com

On May 23, the company updated investors on its business and the ongoing aerospace recovery. As the graph below shows, there is a clear difference between short haul and long haul. Short haul rebounded rather quickly as domestic travel (in the United States) benefited from vacation travel and looser pandemic restrictions in a lot of states. Long haul isn't expected to recover until at least the second half of 2024 as a result of global COVID restrictions, lower business travel demand, and related issues that keep people from stepping into a plane even 3/4 years after the start of the pandemic.

2022 Investor Presentation

Howmet Aerospace

Howmet reports that TSA check-ins are now just 10% below pre-pandemic lows.

2022 Investor Presentation

Howmet Aerospace

This is what Fitch commented on aerospace & defense companies in a review published on May 31, 2022:

We expect large commercial aircraft deliveries at Airbus SE to rise by double digits in 2022 (from 611 in 2021), and by end-2023 to be almost in line with the pre-pandemic peak of 863 units. Resumed demand for air travel and the need for fuel-efficient aircraft drive the recovery, although supply-chain constraints are a material short-term challenge and could alter our assumptions. The narrow-body segment will dominate the recovery, with the A220 and A320 likely to represent more than 85% of 2022-2023 deliveries.

Needless to say, HWM is back on track. In its 1Q22 quarter released on May 2, the company reported $1.32 billion in revenue, 10% higher compared to 1Q21. Both sequential and year-on-year growth was strong in all segments, except for defense aerospace.

1Q22 Earnings Presentation

Howmet Aerospace

Defense sales were down due to customers adjusting their F-35-related inventories. This defense program accounts for 40% of HWM's defense sales. This year, it's estimated that between 148 and 153 F-35's will be delivered. Next year that number is expected to be 156, which could mean that inventories will have to increase again.

In all aviation segments, narrow body (short haul) demand supported sales growth. Engine products sales were up 18% to $631 million, with 31% adjusted EBITDA growth to $173 million. Fastening systems saw 3% slower sales on long haul issues (mainly Boeing's 737 program), defense inventory issues, and high inflation, which prevented the company from growing EBITDA in this segment.

Forged wheels was a bit different. Sales rose 9% thanks to high commercial transportation demand. Unfortunately, adjusted EBITDA fell by 16% as margins in this segment fell from 35.2% to 27.1%. The company encountered lower volumes and input prices it was unable to pass through. Also, unfavorable foreign currency translations made things slightly worse.

Yet, despite challenges, the company expects (midpoint guidance), $5.64 billion in revenue (up 13% year-on-year), $1.3 billion in adjusted EBITDA (up 15%), and $624 million in free cash flow. This implies a FCF conversion rate of 110%, which is terrific news underlining the company's ability to turn earnings into cash.

1Q22 Earnings Presentation

Howmet Aerospace

On a side note, these midpoint expectations are more or less equal to the analyst consensus estimates I showed in this article using the TIKR chart.

Additionally, the company has a very healthy balance sheet. Net debt is expected to end this year at $3.2 billion. That's 2.5x EBITDA. Even in 2020, net debt was $3.5 billion, which was 3.0x EBITDA, despite imploding demand.

In 2023, net debt is expected to fall to $2.8 billion or 1.8x EBITDA. This opens the door for higher dividends, buybacks, and even M&A if the company finds interesting opportunities. This expected net debt decline is only possible thanks to high free cash flow, which the company is partially using to buy back its own shares. In 1Q22, the company bought back $175 million. This includes $100 million in buybacks announced in February and $75 million in additional buybacks. These buybacks equaled roughly 1.2% of the company's current market cap, which is remarkable at this stage of the recovery cycle - and it's completely sustainable.

Valuation

Next year, the company is expected to lower net debt to $2.8 billion. I'm going to use that number as I'm very positive that the company will achieve its targeted free cash flow result. When adding the $15.1 billion market cap and $900 million in pension-related liabilities HWM ends up with a $18.8 billion enterprise value. This is roughly 14.5x expected 2022 EBITDA (midpoint guidance) and 12.2x next year's expected EBITDA (consensus estimates).

Chart
Data by YCharts

Takeaway

In my last article, I made the case that HWM should trade at $50. I stick to that. The company is undervalued and poised to not only reach "fair" value, but also to deliver long-term outperforming gains. EBITDA growth is strong, its customers are not only ramping up production, but also requiring (ultra) light weight and advanced materials for new projects. Add to that the expected pickup in F-35 deliveries and eventually fading pricing issues in transportation, and we have a stock that can aggressively buy back its own shares thanks to high and sustainable free cash flow.

HWM Finviz Chart

FINVIZ

For now, it seems that the company is stuck in a very volatile sideways trend, which causes bargain buying below $33 and selling close to $37.

The best way to deal with HWM is buying a small position and adding on weakness. While 2022 might be a mess, I have little doubt that HWM will deliver high value for its shareholders on a long-term basis.

(Dis)agree? Let me know in the comments!

This article was written by

Leo Nelissen profile picture
16.17K Followers
I'm a Buy-Side Macro Expert/Financial Markets Analyst. On Seeking Alpha, I discuss a wide range of topics including long-term dividend (growth) investments, mid-term trading opportunities, commodities, rates, and related. My DMs are always open. Also, I'm on Twitter (@Growth_Value_) in case you want to say hi! Long-Term Dividend HoldingsPSA, DUK, HD, PEP, RTX, UNP, VLO, DE, ABBV, CAT, HBAN, NSC, LHX, XOM, HII, AAPL, XEL, CVX, CP, LMT, NOC, NDAQ, CME, DHR
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Disclosure: I/we have no stock, option or similar derivative position in any of the companies mentioned, and no plans to initiate any such 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.

Additional disclosure: This article serves the sole purpose of adding value to the research process. Always take care of your own risk management and asset allocation.

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