CRS - Universal Stainless & Alloy Products Still Highly Leveraged To The Aero Recovery

Summary

• USAP's fourth quarter results were only slightly below my expectations, but misalignment between surcharges and material costs undermined gross profits.
• The backlog continues to grow, more than doubling from the prior year, as aerospace demand continues to recover.
• Aerospace should remain strong for several years, with widebody production only just getting back on the recovery track later this year, and oil/gas could also be a source of strength.
• USAP isn't a high-quality play on the aerospace market's demand for specialty alloys (that would be ATI or CRS), but the shares should perform better as operations normalize.

Universal Stainless & Alloy Products (USAP) has been a frustrating way to play the recovery in aerospace (a key customer for specialty metal alloys), as multiple operational challenges have limited the company's revenue and profit leverage to this recovery. This is part of the reason I consistently refer to this as a "risky" play on these trends. Even so, while the company incurred additional setbacks in the fourth quarter, there is still evidence of progress and meaningful leverage to further recovery in aerospace demand, as well as in markets like oil and gas.

These shares have lost a bit of ground since my last update , while others like Haynes ( HAYN ), Carpenter ( CRS ), and ATI ( ATI ) have continued to head higher (by about 5%, 12%, and 18%, respectively). I do see a potential "catch up" trade here, and I think fair value is above $10, but I again remain investors that this is a company where execution has been an issue and it's also an illiquid stock with no institutional following.

Fourth Quarter Results Show An Ongoing Demand Recovery, Marred By Operational Issues

In discussing USAP's fourth quarter results I will compare results to my own estimates, as there is no sell-side coverage against which to benchmark results.

Revenue rose 30% year over year and almost 22% quarter over quarter, coming in $1.4M, or about 2.4%, short of my expectation. Growth was driven by roughly 10% sequential growth in both realized prices and volumes and the small shortfall was spread across both drivers. Specialty alloy revenue rose 18% yoy and almost 13% qoq, while higher-margin premium alloy revenue rose 92% yoy and 69% qoq (to 24% of the total).

Carpenter has also reported earnings for the quarter, and saw 46% yoy and 11% qoq revenue growth (34% yoy and 12% qoq ex-surcharge).

Gross margin was weaker than I expected, with margin down 440bp yoy and 210bp to 4.3% versus my estimate of 13%. Of the $3.2M shortfall in gross profits, almost all of that can be explained by a "misalignment" in the timing of surcharges and raw material costs (a known risk, and one that took $2.4M out of gross profits) and an unplanned weather-related outage that cost another $0.7M. There was also a $0.3M impact from an earlier accident (a metal spill) and I'd incorporated that in my model.

SG&A spending was more or less as I expected, but the gross margin challenges pushed the company to a $3.2M operating loss (versus my estimate of $0.3M). Adjusted EBITDA fell about 46% yoy and 50% qoq.

Underlying Trends Still Positive

There's not much going on in the broader markets that USAP addresses that concerns me much at this point, and I believe 2023 will be a stronger year for the company, albeit perhaps with a modestly different revenue mix.

Aerospace revenue rose 56% yoy and 27% qoq, making up 71% of revenue and aerospace demand was largely responsible for the 114% yoy and 17% qoq increase in the backlog (Carpenter's backlog was up 107% yoy). Airbus ( OTCPK:EADSY ) and Boeing ( BA ) are both solidly on recovery trajectories, and while some may be disappointed with Boeing's recent guidance that it will look to "stabilize" 737 production at 31/month before expanding to 50/month in 2025/26, I don't think that's a problem.

Boeing also disclosed that it plans to ramp to five 787s a month by later in 2023 and ramp to 10/month in 2025/26. This confirmation of an emerging recovery in widebody jets is in line with my expectations, but nevertheless a positive for suppliers like USAP.

Revenue from heavy machinery customers declined 28% yoy and 10% qoq this quarter, as auto and commercial vehicle producers (among others) worked down inventories. Management sounded relatively bullish on this market for 2023, but I'm a little more cautious here, mostly on the commercial vehicle side.

Oil and gas revenue rose 30% yoy and 43% qoq, and I'm bullish on this market for USAP in 2023 given where energy prices are now. I'd expect general industrial demand (about 7% of revenue) to be softer in FY'23, while power generation is really too small to matter.

Ramping capacity to meet emerging demand has been a challenge for USAP in 2022, and management is stepping up its capacity in anticipation of enduring demand from the aerospace end-market. Management announced that it was adding two more vacuum-arc furnaces, with the units scheduled to be operational a year from now (in the first quarter of 2024).

The Outlook

Given USAP's performance this quarter, I'm not making too many core changes to my model. While misalignment of surcharges and raw material costs is always going to be a risk, nickel prices have been moving higher lately (driving surcharges up as much as 20%), while realized material costs have been lower. I've shifted a bit of mix between specialty and premium, as premium has been outperforming my expectations, and I've trimmed my gross margin target for FY'23 (to 13% from 14%) mostly out of caution.

I expect close to 30% revenue growth for USAP in 2023 and double-digit growth again in 2024, as I expect a multi-year run of better results on strong aerospace demand. This is still a cyclical business, and I expect a downturn further down the line and low-to-mid single-digit longer-term growth. I'm expecting low double-digit EBITDA margins next year, improving to mid-teens over the following two years, as well as meaningful positive free cash flow.

Using the 6.5x EBITDA multiple that I've been using for some time, I get a fair value a little above $13 based on my '23 EBITDA estimate.

The Bottom Line

ATI and Carpenter have been the better plays on the aerospace recovery, and that honestly doesn't surprise me. That doesn't mean that USAP can't yet participate, and for investors willing to take on greater risk in the pursuit of greater returns as execution and profits improve, USAP is still a name worth considering.

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