EADSY - ATI Inc.: Shift Toward Aerospace And Defense Supports More Upside

2023-09-26 12:09:38 ET

Summary

• ATI is reporting strong growth and climbing profitability for its high performance materials and components segment.
• The company's shift toward opportunities in the aerospace and defense industry supports a positive long-term outlook.
• We are bullish on ATI with the stock appearing undervalued relative to aerospace and defense industry peers.

ATI Inc (ATI) has been a surprising winner this year, with shares rallying more than 40% and currently trading near a decade high. The company previously known as "Allegheny Technologies" is benefiting from a resurgence of demand for its specialty materials including stainless steel, titanium, and high-performance alloys across several end markets.

Beyond the top-line momentum, the story has been firming margins and higher earnings amid ongoing efficiency gains. An ongoing shift in the company to focus more on high-value aerospace and defense industry opportunities supports a positive outlook. We are bullish on the stock and expect more upside going forward.

ATI Financials Recap

ATI last reported its Q2 results in early August with EPS of $0.59 which came in $0.04 ahead of estimates. Revenue of $171 million was up by 9% year over year. The strongest metric was likely adjusted EBITDA margin that reached 14.3%, re-accelerating compared to 12.8% in Q1.

What we find is that there is a divide between the company's stronger High Performance Materials & Components (HPMC) segment against the weaker Advanced Alloys & Solutions (AA&S) side of the business. This reflects the strategic direction of ATI to focus more on the aerospace and defense business.

HPMC group drove growth with sales up 33% y/y and even 12% from Q1 capturing a jump in shipments of jet engines as commercial manufacturers ramp up narrow-body and wide-body aircraft production. Increased defense industry activity has also been robust. HPMC's segment adjusted EBITDA margin came in at 20.5% compared to 15.2% in Q2 2022, highlighting the importance of this dynamic.

Comments during the earnings conference call suggested good visibility of further gains into the second half of the year. On this point, aerospace and defense now contribute 58% of total sales, up from 46% in the period last year. Management sees that level climbing towards 65% over the next several years.

On the other hand, AA&S sales fell by -8% y/y and sequentially from Q1. Here the theme has been a slowdown in more general industrial verticals including automotive, electronics manufacturing, and even energy in terms of major orders.

Nevertheless, the understanding is that the near-term outlook for most end markets is trending stronger. Even Energy sector applications are likely to get a boost amid the recent rally in oil prices.

The Q2 results were good enough for management to raise the full-year EPS target to a midpoint estimate of $2.20 compared to $2.15 previously. This would mark a major turnaround compared to $0.96 in 2022 which was defined by supply chain shortages and inflationary cost pressures.

The company is also guiding for free cash flow between $125-$175 million. We view the net leverage ratio of 2.7x as stable with room for debt reduction going forward.

What's Next For ATI?

The way we're looking at ATI is that the company is finally hitting its stride in terms of operational and financial execution. The corporate name change in 2022 marked several years of internal restructuring, and our take is that the outlook right now is stronger than ever.

A consolidation of the company's leadership position in aerospace by capturing market share in next-gen opportunities is a trend we expect to continue over the next decade. Announced targets to generate 12% average annual growth through 2025 compared to 2021 levels is a good backdrop for the stock. We believe the path to reach an adjusted EBITDA margin between 18% and 20% by 2025 is well within reach.

A big reason we like ATI Is our sense that even with the stock rally this year, shares are still attractive relative to category peers. ATI trading at a forward P/E multiple of 19x is well below a group average closer to 25x between names like Howmet Aerospace Inc ( HWM ), TransDigm Group Inc ( TDG ), Carpenter Technology Corp ( CRS ), and even Honeywell International Inc ( HON ).

That forward P/E multiple for ATI drops to 15x based on the 2024 consensus EPS estimate, which widens the spread even further. It appears that the market is still pricing ATI as more of an "industrial" metal fabrication name rather than an aerospace and defense supplier.

ATI Stock Price Forecast

We rate ATI as a buy with a price target of $50.00 for the year ahead, representing a P/E multiple of 22x based on the 2023 consensus EPS estimates.

A bullish investment thesis, considering there is room for some valuation multiples expansion as the company continues to shift its profile toward the aerospace industry through more high-performance and value-added components.

Strong demand for commercial widebody aircraft from major manufacturers like The Boeing Company (BA), and Airbus SE (EADSF) support a growth runway we expect to continue over the next decade.

In terms of risks, the elephant in the room is the volatile macro environment. A deterioration in the global growth outlook would undermine the earnings outlook and likely open the door for a leg lower in the stock. Monitoring points for the company over the next few quarters include the adjusted EBITDA margin as well as jet engine market performance.

For further details see: