Alan_Lagadu
Will the real commercial aerospace market please stand up?
Air travel continues to recover, and airlines continue to look to refresh and expand their fleets, but the progression of the commercial aerospace recovery in 2022 has been choppier than expected. Orders continue to come in and lead-times continue to stretch for key materials and components, but unreliable supply chains and component availability has led to a slower ramp than initially expected.
None of this is particularly good news for ATI (NYSE:ATI) (formerly known as Allegheny Technologies) in the short run, but there is good news in an expanding order book, improving margins, and a multiyear opportunity to leverage strong commercial aerospace demand into cash flows.
ATI shares have risen about 7% since my last update, good enough to beat the market, as well as most other material and component suppliers like Carpenter (CRS), Howmet (HWM), Hexcel (HXL), and Universal Stainless & Alloy (USAP) over that time. Valuation is still relatively appealing, and I think these shares still offer upside.
Positive Core Trends In Q3, But With Some Challenges Denting Guidance
In a mixed quarter for aerospace suppliers, I’d call ATI’s third quarter “good enough”, though the Street was clearly spooked by weaker guidance for the next quarter (more on that in a bit). Importantly, orders continue to come in and the core profitability of the business looks attractive as those orders scale into revenue over time.
Revenue rose 42% year over year and 8% quarter over quarter to $1.03B, beating expectations by around 10% on strong demand from aerospace customers. The Advanced Alloy & Solutions (or AAS) segment saw 35% yoy and 2% qoq growth despite ongoing disruptions to its Asian operations from China’s zero-COVID policy, while the High Performance Materials & Components (or HPMC) business posted 53% yoy and 16% qoq growth on strong orders for materials and components used in jet engines.
Gross margin improved 640bp yoy to 17.8%, but did decline 50bp sequentially, with ATI undertaking some maintenance outage issues, but also not getting the 70bp lift to margin that it saw in the second quarter. EBITDA rose 77% yoy and declined 1% qoq, while segment-level EBITDA rose 72% yoy and declined 2%, with a margin of 15.7% (versus 12.9% a year ago and 17.2% in the prior quarter).
By segment, AAS saw 34% yoy adjusted EBITDA growth (and 28% sequential contraction) with margin of 13.2%, while HPMC posted 129% yoy and 42% growth (with an 18.8% margin and roughly 30% incremental margin).
Guidance was less robust for the fourth quarter, with management taking EPS guidance down about 4% at the midpoint relative to sell-side estimates going into the report. Management expects ongoing pressure from China’s zero-COVID policy, as well as some lingering maintenance outage impacts. The company is also making the decision to curtail some production to run down surplus inventory that it built up earlier in the year in response to Russia’s invasion of Ukraine.
Commercial Aerospace Is Recovering, But The Path Has Been More Erratic Than Expected
Commercial aerospace activity is definitely recovering, but the recovery has been more volatile and unpredictable than initially expected. At the most basic level, neither Airbus (OTCPK:EADSY) nor Boeing (BA) have accelerated build-rates at the pace that analysts (and many suppliers) expected earlier this year, and Boeing’s most recent guidance on 737 production was still pretty foggy – the company wants to “stabilize” production at 31/month before increasing to 38/month, and it sounds like that will now be a 2H’23 event.
This isn’t hurting ATI’s business, though. ATI reported 122% yoy and 25% qoq growth from its commercial aerospace customers this quarter, with engine-related revenue up 143% yoy and 26%. Although Boeing has said that engine availability isn’t an issue with the 737 at this point, other suppliers have reported growing lead-times for engine components, and ATI management is seeing lead-times for titanium products moving out into 2023. At this point, production ramps at Airbus and Boeing are being constrained by inconsistent performance among suppliers, but as inventories normalize and companies overcome component and labor challenges, this should start resolving in 2023.
In response to strong demand, and the opportunity to take business that used to go to VSMPO-AVISMA (a Russian titanium supplier, and the largest titanium producer in the world), ATI is investing in additional capacity. In the near term, a new vacuum arc furnace should increase titanium melt capacity by 25%, while management is looking at electron beam melt capacity to help drive an overall 60% increase beyond 2025. In the interim, management will also be directing more of its capacity toward aerospace customers and away from other end-markets.
It’s also worth noting that the ramp seen so far in commercial aerospace production has been heavily concentrated in narrowbody aircraft. ATI’s airframe components business is more leveraged to widebody, so as production starts improving more meaningfully in 2023 or 2024, it will further leverage ATI’s capabilities.
The Outlook
As commercial aerospace demand accelerates (however unevenly that may be), other markets are looking a little less robust. Energy sales were down 4% sequentially, and this is the second-largest market behind aero/defense at close to 20%. I believe the slowdown is more tied to inventory-building/normalization than any fundamental deterioration in activity, though I do believe the 2% decline seen in electronics (about 5% of revenue) will likely get worse from here. Given capacity constraints and higher-margin opportunities in aerospace, that likely won’t hurt ATI that much, and may actually be something of a relief that they don’t have to actively turn down business.
I’m still looking for around 8% long-term revenue growth from ATI, but I do believe there’s a risk that the cycle will stretch out a little more – I don’t see any evidence that Parker-Hannifin’s (PH) prediction of 18,000 planes being built by 2030 will be wrong, but it looks as though it may be more weighted to 2025 and beyond than I’d previously expected.
As far as margins go, while the near-term headwinds didn’t help investor sentiment, I don’t see anything at this point that changes my baseline assumptions further down the cycle – I still believe high-teens EBITDA margins in 2025+ are attainable, along with double-digit FCF margins.
The Bottom Line
Given what has proven to be a choppier ramp for the commercial aerospace upcycle, I’ve chosen to push out my valuation to use my 2025 EBITDA estimate and a 9x multiple, and then discount back at a double-digit discount rate. That process gets me to a $37.50 fair value, but I freely acknowledge the risks and challenges that go with valuing a stock on the basis of an estimate several years out.
I continue to believe there is room for further appreciation in the stocks of companies leveraged to the commercial aerospace cycle. Clearly there are still uncertainties regarding production schedules, competitor share/capacity, and margins, but as a supplier of key materials where there is really no surplus capacity, I think there is more upside for ATI from here.
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