Carpenter Technology: Strong End-Markets Driving Better Results

These are good times to be an aerospace supplier. While defense-related spending has been a little softer, commercial aerospace is rebounding strongly, and taking demand for specialty alloys along for the ride. That’s driving better volumes, pricing, and margin leverage for Carpenter Technology (NYSE:CRS), and the company is having to retrench a bit to train workers and keep pace with the growing demand (and growing backlog) for superalloy, specialty stainless, and titanium products.

I remain quite bullish on Carpenter as a company, as I expect a few years of double-digit sales growth, as well as EBITDA margins ramping toward 20%, but the shares are up about 20% since my last update and the valuation argument isn’t as simple as before. I do still see upside, and the possibility of beat-and-raise quarters, but this is now more of a “story stock” than a turnaround/valuation call.

Strong Growth On The Back Of Robust Demand

Carpenter accomplished a lot of what I expected in the quarter. Margin leverage wasn’t what I’d hoped for, but there were some valid explanations for that, and I’d still call this a good quarter.

Revenue rose 46% year over year and 11% quarter over quarter in reported terms and about 34% yoy and 12% qoq adjusting for surcharges. Growth was driven by double-digit contributions from volume (up 17% yoy and more than 12% qoq), pricing (up 14% yoy ex-surcharges), and surcharges.

Gross margin improved almost nine points year over year and about 140bp qoq in reported terms (to 12.1%) and 1,240bp yoy and 200bp qoq (to 16.6%) on an ex-surcharge basis, and the gross profit per pound sold grew 356% yoy and about 13.5% qoq. Still, margin was a little short of my projection, with management noting the need to expand its worker training efforts. Operating income reversed a year-ago loss, with a margin of 5.4% ex-surcharge, up 140bp sequentially.

By segment, the Specialty Alloy Operations (or SAO) business grew 50% yoy as reported, or 38% ex-surcharges (and up 13% qoq). Volume improved 20% yoy and 2% qoq, with pricing up 14% yoy and 11%. Performance Engineered Products (or PEP) revenue grew about 25%, or 17% ex-surcharge (and up 11% qoq), with volume up about 7% yoy and 28% qoq. Pricing was up about 9% yoy, but down close to 13% sequentially. Management didn’t address this, but I suspect mix was the main factor.

Few Issues In The End-Markets

Carpenter’s primary market remains the aerospace market, where the company is already enjoying a strong rebound in demand as Airbus (OTCPK:EADSY) and Boeing (BA) resume more normal production schedules and as companies like GE (GE) and Raytheon (RTX) ramp up jet engine production. Revenue rose 50% yoy and 9% qoq, with engine-related revenue up 78% yoy and 19% qoq. Boeing’s recent guidance confirmed a stable outlook for 737 production (at 31/month), while also looking for 787 production to ramp up at around 5/month later this year.

The next-largest market, Industrial and Consumer, saw 18% yoy and 15% qoq growth. While I’m generally more cautious on the outlook for short-cycle industrial and consumer products this year, Carpenter should see healthy demand for alloys from the semiconductor industry (where a 2023 slowdown will be driven far more by pricing than production volumes) and likewise for specialty materials used in electronics.

The medical end-market grew 55% yoy and 26% qoq for Carpenter, with growing demand and backlog for titanium products as elective procedure volumes recover.

Transport revenue declined 4% yoy and rose 15% qoq on what I would expect to be some destocking; while I’m generally positive on the auto sector this year, I do have some concerns about demand from commercial vehicle manufacturers (trucks and construction). I also remain bullish on the company’s leverage to EVs and ADAS, with soft magnetics products used in traction motors (used in EVs) and sensors (for ADAS).

Last and not least, energy was up 41% yoy and 23% qoq, and while I expect this to remain a strong market, Carpenter has meaningfully reduced its exposure to this market.

The Outlook

At this point the biggest risks around Carpenter have to do with investor expectations (trees don’t grow to the sky and more capacity will be coming online in specialty alloys) and management’s ability to execute on this sharp upturn in demand. Improved training efforts will suppress gross margin in the near term (FY’23), and I’ve reduced my FY’24 estimate as well out of caution, but none of this really changes the fundamental outlook all that much. I’ve increased my revenue estimates for FY’23 and FY’24 (and beyond) to account for even stronger pricing, but I’ve reduced my FY’23 FCF estimate on changes to my working capital assumptions. This works itself out over time, but does have a modest suppressive effect on valuation in the near term.

I don’t find Carpenter particularly cheap on discounted cash flow, but that’s to be expected at this point in the cycle. The shares do still have some value on a forward EBITDA basis. I’ve bumped up my forward EBITDA multiple from 8.5x to 9.0x to account for more certainty on aero builds, and that drives my fair value to a little over $55.

The Bottom Line

Stocks don’t go up just because they’re cheap and they don’t stop going up just because they’re expensive. To that end, I don’t rule out future beat-and-raise quarters that drive even higher numbers for FY’24 and beyond, and correspondingly higher fair values. With more room to go in the aerospace cycle, I still like these shares.