Universal Stainless & Alloy Products Takes A Step Back, Aerospace Recovery Lurches

The recovery in commercial aerospace is real, but it has proven to be considerably less of a smooth upward ramp and more of a drunken lurch, as major OEMs like Airbus (OTCPK:EADSY) and Boeing (BA) struggle to balance uneven production rates and capabilities among suppliers, and those suppliers (and OEMs) continue to struggle with component/supply availability, input costs, labor availability, and just about anything else you care to name. Add in operational challenges (some self-inflicted, others not), and Universal Stainless & Alloy Products (NASDAQ:USAP) (“Universal Stainless”) has struggled to maximize these still-early days of recovery.

Down about 10% since my last update, Universal Stainless has lagged other material and component suppliers to the aerospace industry, but only Carpenter (CRS) has really done well over that time, as ATI (ATI), Hexcel (HXL), and Howmet (HWM) have been more “meh” than magnificent.

I’ve never thought that Universal Stainless was the best operator of the bunch, but I’ve seen over many years across many cyclical industries that secular upswings tend to produce more dramatic improvements at the less-capable operators, and I believe that will still be the case here. By no means is this the cream of the crop, nor a long-term holding, but I do believe this unfollowed and thinly-traded supplier of specialty steels can still produce attractive returns for more aggressive investors.

Uninspiring Third Quarter Numbers Don’t Help

Overall reactions to third quarter earnings in this space haven’t been all that great, with many companies still struggling with costs and erratic production schedules due to the overall chaos in the commercial aero supply chain and the less-than-clear build-rate plans from Airbus and Boeing. Still, Universal Stainless didn’t have the third quarter I’d hoped to see.

Revenue rose 24% year over year and declined 11% sequentially to $46M, with specialty steel sales up 21% yoy and down 13% qoq to $37M and premium steel alloy sales up 36% yoy and down 9% to $8M. Overall volumes fell almost 4% yoy and 19% qoq, with average realized prices up 29% yoy and 9% qoq to $3.90/lb.

Volume was the negative driver, as the company saw some lingering impacts from a metal spill in the prior quarter, struggled to overcome labor and supply challenges, and saw a spike in COVID-19 cases that impacted worker availability. If the company had met my volume growth target, the company would have actually exceeded my revenue target for the quarter, as pricing was a little stronger than I’d expected.

In a volume-driven business, weaker volumes mean weaker operating efficiencies, and that was true for the third quarter. Gross margin did still improve 20bp yoy, but fell 270bp to 6.4%, with the company also seeing a mismatch in metal costs and surcharges that weighed on results by 320bp (lags are not uncommon in the business).

Operating costs remained well-contained, allowing for 11% yoy adjusted EBITDA growth, though this number did decline 35% qoq. Margin was 9.1% in the quarter versus 10.2% a year ago and 12.3% a quarter ago. As an aside, while I’m reporting the company’s version of adjusted EBITDA, I use a different version for my valuation (I don’t exclude share-based comp or cost absorption charges).

Demand Is There, But Delivery Remains Foggy

Universal Stainless saw 42% yoy growth in sales to aerospace customers, but an 11% qoq pullback. That wasn’t bad relative to others in the space, with ATI posting 122% yoy growth, Carpenter up 40%, and Howmet up 23%, though the sequential weakness stood out (all of the others posted sequential gains). Universal Stainless also saw healthy orders, as the company’s backlog rose 97% yoy and 11% qoq to $246M (5.3x quarterly sales), with the backlog for premium alloys up 28% qoq.

Right now, commercial aerospace supply chains are a mess, and it creates ripple effects for everybody in the space. Boeing’s recent investor day didn’t really clarify much, other than to indicate that engines aren’t as much of a roadblock as before, and it’s still unclear as to when the company might lift the production target for the 737 from 31/month to 38/month (likely the second half of next year). Likewise, while Airbus would prefer to build more than 50 A320s a month, they too are having supply-chain challenges.

While Boeing may not be having problems sourcing engines for the 737, that’s not necessarily true of the commercial aerospace market in general. Textron (TXT) is struggling to meet demand due to inadequate engine supply, and other suppliers have talked about titanium component and engine lead-times extending out to close to a year.

Unfortunately, Universal Stainless doesn’t participate in titanium, nor do they have much engine exposure (and no hot-side exposure). They have the facilities to participate, and they’re looking to do so, but certifications take time (typically around two years). This means that Universal Stainless isn’t exposed to the most in-demand materials (like titanium), and it likely will mean a period of ongoing uncertainty with order/delivery schedules, as engine availability will likely be the driving factor in production schedules.

Universal Stainless is also seeing choppy results in its other markets, with double-digit sequential declines in heavy industry, oil/gas, and power. Initially, I had thought that the company might have reallocated capacity to fulfilling aerospace orders, but that’s not consistent with what management said on the call. Still, they’re not the only ones to see sequential weakness in these categories, as results were choppy for others in the space.

The Outlook

I’ve decided to be more cautious with my revenue assumptions over the next few quarters; management has said that labor availability is improving, but there’s not much reason to be aggressive at this point. I’ve reduced my revenue estimate by about 9% for 2022 and 2% for 2023, but I’ve also added some back in later years, as guidance/commentary is leading me to believe that supply challenges are going to lead to a more stretched-out recovery in commercial aerospace. I’m still looking for revenue to double from 2021 to 2025, though, and I still have a high single-digit long-term revenue growth rate on the back of this multiyear aerospace cycle (and the opportunity for Universal Stainless to expand into areas like hot-side engine).

The company shouldn’t see the same level of gross margin pressure in the next quarter, but I’ve still revised my full year estimate lower, as the company won’t get the scale leverage I’d expected. That all still takes more than three points out of my EBITDA margin estimate for this year, but my estimate for 2023 is still around 13% (12.7% instead of 13.2%). As the cycle develops, I believe Universal Stainless can get firmly into the mid-teens, and maybe higher if the company can really drive gross margin – increased sales of premium alloys relative to past cycles could do that.

These shares do still look undervalued on a discounted free cash flow basis, but it’s tricky to model free cash flows in cyclical commodity businesses, so I tend to use DCF-based valuation more as an “undervalued/overvalued” indicator rather than putting a lot of faith in the specific number. Still, I think the shares are more than 20% undervalued by this approach.

My preferred method is EV/EBITDA, and using a 6.5x multiple on my ’23 EBITDA number gets me a fair value of just under $13 today.

The Bottom Line

Stability and predictability in the commercial aerospace market would be nice, but I don’t see it happening until at least the second half of 2023. In the meantime, Universal Stainless really needs to demonstrate that it can reliably ramp up volumes and do so at attractive margins. I think the opportunity is there, and I think the shares remain undervalued on their leverage to this commercial aerospace recovery, but this is a cyclical/thematic trade, and not an idea meant for buy-and-hold investors.