Universal Stainless & Alloy Stock: Ignored On The Runway

The last six months or so have been increasingly frustrating as an observer and analyst of Universal Stainless & Alloy Products (NASDAQ:USAP) (“Universal Stainless”). Other providers of alloys and specialty materials to the aerospace industry have seen their share prices outperform Universal Stainless, ATI (ATI) in particular, but Universal Stainless has been frustratingly weak since my last update despite improving orders, pricing, and margins.

Given aircraft production schedules and guidance from major OEMs like Airbus (OTCPK:EADSY) and Boeing (BA), I believe USAP is about to see a significant ramp in revenue and expansion in margins. On top of that, the company is poised to benefit from recovering oil/gas activity, as well as efforts to upgrade the product portfolio (including participating in “hot side” engine components). Even at a significant multiple discount to ATI or Carpenter (CRS), I see upside into the low-to-mid teens as USAP delivers on the growing demand from aerospace customers.

Readers should note that USAP is very small (less than $100M in market cap), fairly illiquid (fewer than 20K shares traded per day, on average), and not followed by Wall Street analysts. Consequently, it’s fair to assume that this is a riskier stock.

Orders Growing, Volumes Starting To Ramp

Universal Stainless was held back, at least in part, in the second quarter by an accident (a metal spill), but there is growing evidence of building momentum. Even with the accident, volume increased 1% year over year and 7% quarter over quarter, and management is working all out to increase production volumes. Things as they are, management has quoted lead-times out to the third quarter of next year for new orders.

At the same time, orders continue to roll in as aerospace companies scramble to get the materials they need to meet the growing demand of major OEMs like Airbus and Boeing, as well as bizjet OEMs like Textron (TXT) (the bizjet/regional market has been quite strong of late too). Backlog rose 125% yoy and 10% qoq in the second quarter, and USAP continues to see higher-margin premium products creep up as a percentage of that backlog (now at 26%) versus a Q2’22 revenue mix that favored lower-margin specialty alloys to a level of more than 80%.

Aerospace sales rose 67% yoy and 19% qoq in the second quarter (making up 68% of revenue), but are still over a quarter below the most recent peak for the company. That growth is at least directionally consistent with what others like ATI, Carpenter, Hexcel (HXL), and Materion (MTRN) are seeing, and the general expectation is that OEM build-rates will continue to grow from here, particularly when widebody builds recover in late FY’23/2024.

Other markets are showing more mixed performance. Although oil prices have eased off some, offshore exploration activity is picking up and that’s good for USAP’s oil/gas business (revenue was up 21% yoy and 7% qoq in the second quarter). Heavy industry and general industry were surprisingly weak in the quarter, though, (down 11% qoq and 35% qoq, respectively), and while quarterly volatility is not new or rare in these markets, I wonder if this is a byproduct of companies becoming more cautious on building inventories on concerns of slowing demand. I’m not sure, but it’s worth watching as a possible leading indicator.

With a capacity-constrained industry, pricing should also be healthy. Most of USAP’s second quarter pricing leverage came from material pass-throughs (nickel and so on), but base prices were still 6% higher than in the year-ago period, and I would expect further pricing moves as the backlog fills.

Self-Help Could Make A Difference

As I’ve written in prior pieces, USAP’s buy-and-hold credentials are poor. This is a company that generated zero net free cash flow from 2006 to 2021 (the best year was +$25M, the worst was -$29M), and they’re not especially well-placed on the spectrum of specialty materials companies. As I mentioned above, the company is only just now offering products that could be used in the hot side of engines, and their products have generally skewed to lower-spec, lower-margin categories.

Management is working on this. The company now has products for engine hot-side use, though it will take time to get those qualified in by customers. In the most recent update, the company noted 9 net new customer approvals since Q2’20 (54 since 2016), 2 new product introductions (from 17 in Q2’20 to 19), and 19 products under development exiting the quarter. At the same time, the company has been selectively pruning away lower-value commodity products and continuing to reinvest in production capacity for premium alloys (including new vacuum melt furnaces).

The Outlook

Based on healthy trends year-to-date, as well as that swelling backlog, I’ve increased my modeling estimates. I was a bit below $200M for ’22 revenue, but I’ve moved up to over $220M, with better than 20% growth on top of that in ’23 and high single-digit growth in ’24. I’m a little concerned that I’ve gone too far too fast for ’23 (management has guided to “$200M-plus revenue), particularly if the price of commodities like nickel back off, but I also think I may be too low for ’25 revenue.

Given under-absorption of overhead, a sharp upturn in revenue will drive a strong improvement in gross margin. That’s already in process, as adjusted gross margin more than doubled in Q2 to 12.6%, and I expect full-year gross margin above 12% with improvement over the next four years.

My EBITDA estimates have moved from a little over $22M to $24M for FY’22 and to over $35M for FY’23. For free cash flow, working capital needs and capex have led me to reverse expected positive free cash flow to a smallish deficit in FY’22 (around $7M), but flip an expected deficit in FY’23 to over $20M in positive free cash flow.

Valuation remains challenging. Discounted cash flow certainly produces a number, but the challenges of modeling the next two or three years correctly, let alone 10 years or more, leads me to regard DCF-based fair values more as guideposts. Still, the shares do look undervalued on this metric.

More useful, I think, is an EV/EBITDA-based approach. As in the past, I use a multiple of 6.5x on my ’23 EBITDA estimate, discounted back a year at a double-digit discount rate. That gives me a fair value above $14/share, and while that 6.5x multiple is well below what I use for ATI or Carpenter, I think that’s fair given the company’s financial track record, portfolio mix, and what specialty metals companies have traded for in M&A (including Acerinox’s (OTCPK:ANIOY) buy of VDM back in late 2019).

The Bottom Line

To reiterate, I don’t think Universal Stainless is a good candidate for long-term “buy and forget” investors. This is, instead, a trade on recovering aerospace demand for specialty materials and the margin leverage that such demand can drive at USAP. Low liquidity and Street familiarity are concerns, and the aerospace cycle could disappoint, but I still believe these shares are undervalued ahead of a coming ramp in revenue, margins, profits, and cash flow.