MTRN - Margin Challenges And End-Market Worries Overshadowing Good Growth At Materion

Summary

• Materion has seen healthy revenue growth on the back of demand from semiconductor, heavy machinery, aerospace, and energy customers, but margins have become a point of concern.
• Most of the margin headwinds seem resolvable in the near future, but this is a "show me" story now.
• Materion continues to evolve toward more specialty applications, including new opportunities in battery technologies.
• Long-term revenue and FCF growth, driven by leading-edge semiconductor volume growth, electrification, and aerospace, can support a higher share price.

This has been a tougher-than-expected year for Materion ( MTRN ). While the company has seen strong demand in key core markets like semiconductors, industrial, aerospace, and energy, multiple margin headwinds have worked against the company, depressing reported profits and cash flows and leading to negative estimate revisions. The third quarter in particular was rough for sentiment, with a sharp drop pushing the shares down almost 10% since my last update – underperforming Johnson Matthey ( JMPLY ), but outperforming the semiconductor market that drives a substantial part of the business.

The margin challenges are disappointing, but not unsurmountable, and I think the share price has already paid the price for the reset of expectations. I do have some concerns about weaker semiconductor volumes in 2023, but I believe heavy industry, oil/gas, and aerospace should remain healthy. I’ve decided to take a more conservative “show me” stance on longer-term margin improvement, but even with those revisions, high single-digit growth can support a higher price for the shares.

Underwhelming Third Quarter Results Undermine The Bull Story

The news coming out of third quarter earnings wasn’t universally bad, but there were certainly disappointments in Materion’s results.

Revenue rose 10% as reported, with underlying organic value-added revenue growth of 15%. Performance Material growth was quite healthy at 29%, but Electronic Materials was softer at 10% organic growth, while the Precision Optics business saw a 10% erosion, due in part to exiting some business lines.

Benchmarking Materion’s performance is never easy, as there really aren’t any good publicly-traded comps. Johnson Matthey has some similarities, but hasn’t yet reported its most recent half-year results. Likewise there are some parts of the Advanced Materials business at Honeywell ( HON ) that are partly comparable, and that business grew 33%, but comparing those businesses is still a stretch.

I can say, though, that 7% growth in the semiconductor business was ahead of the 3% growth in wafer starts in Q3. Industrial growth of 11% looked to be roughly on par with volume growth in heavy machinery (Caterpillar ( CAT ) et al), but did lag relative to the organic growth posted by many companies (suggesting some combination of below-market volumes and more limited pricing leverage). The 18% growth from aerospace/defense customers looked fairly solid, but it’s hard to say for sure given the big difference in aerospace and defense mix across companies.

Gross margin was worse than lackluster, falling about six points year over year (to 28.5%) to 300bp sequentially. Margins were down yoy in all businesses. Management called out a weaker semiconductor mix (lower demand for precious metal sputtering targets), yield issues at a Performance Materials plant, and difficulties recouping higher tantalum costs. Management didn’t go into much detail on pricing, other than to point to positive price/cost leverage, with more opportunities to benefit in 2023.

Adjusted EBITDA rose 29% in the quarter, with underlying margin down 230bp to 16.8%. Performance Materials saw a 280bp yoy decline to 22.2%, Electronic Materials saw a 110bp decline to 15.1%, and Precision Optics saw a 590bp decline to 14.5%.

The End-Market Outlooks Are Mixed

Materion does have a diverse collection of end-markets, but the semiconductor market accounts for about a third of sales, while industrial (mostly heavy machinery) accounts for about 20%, and aero/defense for about 10%.

I’m not particularly bullish on semiconductors for next year. Given improving inventory positions and weakening end-market demand, I expect an ongoing slowdown in wafer starts. Materion has diverse exposure in areas like deposition targets, wires, lids, and so on, but at the base level the business is driven by chip volumes. I do see some opportunities for new content/wallet share wins (more advanced nodes require more of what Materion supplies), and semiconductor volumes are not likely to shrink, but this segment isn’t likely to be as strong in 2023.

Industrial demand is more nuanced. Orders for heavy trucks remain strong, and likewise there is still healthy demand for agriculture, construction, and mining equipment. I do expect orders to slow next year, but production (which drives Materion’s business) should remain healthy, as backlogs are still inflated.

Aerospace/defense should continue to recover on the back of improving build-rates and increased content in new platforms. Likewise, I expect ongoing growth in oil/gas demand given supporting energy prices. Auto production volumes are likely to be softer, though Materion could benefit from recapturing some pushed-out business.

Still Investing In Future Growth Opportunities

Materion has executed well on a multiyear strategy to move away from a reliance on more commoditized products and toward more specialized materials that enable leading-edge semiconductor production, high-performance connectors, batteries, and so on.

While the auto business is still relatively small, the company continues to invest in capabilities for materials used in applications like thermal substrates (needed for battery enclosures), connectors, and sensing components. The company is also expanding into areas like new battery chemistry, battery cell interconnects and other battery components, and charger connectors.

In addition to a next-generation battery tech project (that is being partially funded by a battery manufacturer partner, the company is investing in a new precision clad strip expansion, added tantalum capacity, and new clean energy technologies (molten salt purification for nuclear energy applications).

The Outlook

Materion has actually performed reasonably well on revenue this year, and so my 2022 revenue estimate is higher now, but that’s moderated some by a weaker outlook for 2023. Long term, I’m still looking for close to 7% revenue growth, with Materion leveraged to ongoing growth in leading-edge semiconductor production, vehicle and industrial electrification, and aerospace.

Margins have clearly been a point of pain this year, and while management believes some of the headwinds will abate in 2023, I’m taking a more conservative stance with my margin assumptions now. I’m still looking for free cash flow margins to reach the mid-single-digits in the next three years, and then improve into the high single-digits over time, driving high single-digit to low double-digit long-term FCF growth.

The Bottom Line

Even with lowered margin assumptions, Materion shares look priced to generate a long-term annualized return in the high single-digits. Likewise, an 11x multiple on my lowered ’23 EBITDA estimate still supports a fair value in high-$80’s (with the multiple supported by what the market has paid for similar margins, returns, and growth from specialty material companies in the past).

Disappointing margins and concerns about weaker semiconductor demand will likely dog Materion a little while longer, and it doesn’t help that there aren’t many analysts following this stock and beating the drum on its virtues. I’d prefer to wait to see more margin improvement before getting more bullish, but the long-term opportunity is still credible enough to merit a spot on a watch list.

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