USAP - Universal Stainless & Alloy Products: Strong Upside Lying Ahead

2023-06-16 10:51:06 ET

Summary

• Universal Stainless & Alloy Products, Inc. is benefiting from strong demand in the aerospace industry, with sales growth and improved profitability expected.
• The company's stock has upside potential, but the uncertain environment due to a potential recession may weigh on its market value.
• It is advised to hold the stock for now, as a more attractive price may be offered in the near future.

This analysis supports a Hold rating on Universal Stainless & Alloy Products, Inc. (USAP).

Universal Stainless & Alloy Products, Inc. is based in Bridgeville, Pennsylvania. It manufactures and markets premium (vacuum induction melted products) and specialty alloy products in the United States and abroad.

The company currently sells its products to service centers, forgers, re-rollers, and original equipment manufacturers [OEM].

The Growth Driver of the Premium Alloy Segment: An Outlook

The premium alloy products segment (over 25% of total sales of Universal Stainless & Alloy Products) has promising growth prospects based on robust current and expected demand from the aerospace industry.

The boost comes mainly from the recovery of air transport for both civil and commercial services following the reopening of all human activities after the Covid-19 virus pandemic. But the military sector will also be a very important contributor to the growth of the Universal Stainless & Alloy Products, Inc. segment. It is no longer a secret that governments have significantly increased spending on armaments, including the construction of military aircraft, helicopters, and satellites. This is largely due to an increased perception of security needs by countries due to tensions between the Western world and Russia/China. These tensions have recently increased over the conflict in Ukraine and the issue of Taiwan's independence.

The premium alloy products segment also serves markets other than Aerospace such as Power Generation, Oil & Gas, Heavy Equipment, and General and Industrial markets.

Thanks to its superior properties that enable very high performance under demanding/specific conditions of pressure and temperature, the premium alloy product is increasingly being used in other industrial sectors, for example in capital-intensive industries such as the mining industry or the oil & gas industry.

Plus, if the product can withstand certain thermal conditions, it will also find a large application in the electrical and electronic sector, which is growing rapidly in a technology-oriented society that can no longer do without communication devices, appliances, and various technologies including the Internet.

Based on the growth trends highlighted in this Global Industry Analysts, Inc.'s report published in late May 2022, the global market size for this product is set to grow at a CAGR of 4.5% over the next three years, reaching $9.6 billion in 2026. The market size was estimated at $8 billion in 2022.

And it is also important to emphasize that Universal Stainless & Alloy Products, Inc. is among the major players in the global market of high-performance alloy products, according to analysts at Global Industry Analysts, Inc.

So the prospects for the premium alloy segment of USAP appear very bright, although its main engine of growth remains the aerospace industry, which the company also serves with its other assortment of specialty alloy products.

How the Company's Revenue Reflects Strong Momentum in Aerospace Demand for High-Performance Alloys

And it was thanks to tremendous sales growth in premium alloy products -- nearly 98% year-over-year and nearly 31% sequentially -- that Universal Stainless & Alloy Products Inc. reported record sales in the first quarter. The company earned $65.9 million from sales of its stainless steel, nickel alloys, tool steel, and various other alloyed steel products in the United States and abroad. Total revenue increased 38.5% year over year and 17.2% sequentially.

Premium alloy products accounted for 26.8% of total sales in the first quarter of 2023, while sales of specialty alloy products accounted for the remainder of total sales.

The significant increase in sales of premium alloy products to aerospace customers -- an increase of nearly 63% year-on-year and a 22.2% increase sequentially to $49 million in Q1 2023 -- demonstrates the company's strategy to leverage the strengths of demand dynamics in the aerospace market. Aerospace accounted for 74.3% of total revenue in Q1 2023 versus 63.3% of total revenue in Q1 2022 and 71.3% of total revenue in Q4 2022.

Oil & gas accounted for 9.7% of total sales in the first quarter of 2023, versus 9.2% in Q1 2022 and 9.4% in Q4 2022. Heavy equipment accounted for 10.5% of total sales in the first quarter of 2023, versus 17% in Q1 2022 and 10% in Q4 2022. General industry, transformation services and others accounted for 6.3% of total sales in the first quarter of 2023, versus 7.9% in Q1 2022 and 7.5% in Q4 2022. Power generation accounted for 1.6% of total sales in the first quarter of 2023, versus 2.7% in Q1 2022 and 1.9% in Q4 2022.

The company got off to a great start in 2023 by laying a very solid foundation. The impressive sales growth is expected to continue due to the excellent momentum of the aerospace industry's demand for its alloy products. In addition, looking ahead, the company now has a record order backlog of $366 million and record bookings of $117 million, both accumulated at the end of the first quarter of 2023.

The company is poised for continued revenue growth and profitability improvement. The latter aspect is analyzed in the next section.

How the Profitability of the Company's Operations is Developing

From a profitability perspective, the Universal Stainless & Alloy Products' business is performing very well, reflected in a double-digit gross profit margin, which was not the case for the last few quarters according to the chart below.

The gross profit margin was supported by higher shipment volumes and selling prices, as well as supply chain improvements. I am confident that Universal Stainless & Alloy Products, Inc.'s gross profit margin will continue to improve in the coming quarters as monetary policy continues to ease inflationary pressures on raw material procurement. The company may also experience higher labor costs if the company needs to retain employees, adjust wages to reflect the higher cost of living or expand capacity to fulfill existing backlogs. However, the strong demand momentum in the aerospace industry provides room for increasing prices on alloy products, which may instead have a strong positive impact on profitability.

Notable was the improvement in the company's EBITDA, which increased by 71% year over year and by 282.4% sequentially to $6.5 million in the first quarter of 2023.

Net loss also improved, amounting to $0.06 per diluted share for the first quarter of 2023 versus a net loss of $0.41 per diluted share for the fourth quarter of 2022 and versus $0.18 per diluted share in the prior-year quarter.

The Financial Condition

The company ended the first quarter of 2023 with net debt of $97.93 million. Because of the total debt of $99.44 million, the company paid $5.7 million in interest expense for the trailing twelve months ended Q1 2023. Perhaps the company is struggling to pay interest expenses as it suffered a $4.5 million loss instead of generating an income from operations over the trailing 12 months. However, for the first quarter, the operating income returned to green territory as it reported a positive income of $1.4 million versus an operating loss of $3.2 million in Q4 2022 and an operating loss of $1 million in the prior-year quarter. Due to higher borrowing costs, the interest expense increased 185.7% year over year and 25% sequentially to $2 million in Q1 2023. The company is increasingly using debt to fund its operations (up 29.2% year over year and 3.7% sequentially), but it shouldn't be a problem for the company to carry it going forward. The ongoing, albeit slow, decline in core inflation should sooner or later lead to a decline in the cost of borrowing, while operating income now relies on strong demand from the aerospace industry to meet its growth targets.

However, investors would also be better off weighing the above information against the possibility - albeit small - of USAP going out of business within a few years, which is indicated by an Altman Z-score of 1.87 (by scrolling down this page you will find the ratio in the risk section). This indicator must be higher than 3 for the probability of bankruptcy to be zero.

The Stock Valuation

Shares of Universal Stainless & Alloy Products, Inc. were trading at $11.65 as of this writing giving it a market cap of $103.2 million.

In my opinion, shares are not trading expensively, despite trading well above the 200-day simple moving average of $8.38, the 100-day simple moving average of $9.40, and above the 50-day simple moving average of $10.19. Nor are they when compared to their 52-week range of $6.52 to $12.34, as this stock price has tremendous upside potential anchored in the aerospace industry.

In my opinion, two factors are setting the stage for strong demand for USAP's alloy products. The recovery of civil and commercial air travel after the Covid19 pandemic crisis and countries' strategy to also increase the number of military aircraft, helicopters and satellites in response to increased geopolitical tensions globally.

Furthermore, as past interest rate hikes continue to act on the prices of goods and services and the central bank likely eases monetary tightening after 2023, these factors will also help the company improve its operating profitability. This will translate into less pressure that elevated inflation and high borrowing costs have placed on the company so far.

The above factors define the potential for a sharp rise in the share price and I believe there is a good chance of acquiring this potential at a lower price than the market is offering today.

Let's see why.

A significantly lower energy price than a year ago and the impact that robust inflation and the increased cost of money are still having on consumption and investment dampen the growth prospects of the other markets that Universal Stainless & Alloy Products also serves.

These are Power Generation, Heavy Equipment Manufacturing, Oil & Gas, and General Industrials & Conversion Services. These four sectors together make up 20-25% of the company's business, while the Aerospace industry, as illustrated above, accounts for 75%.

But while this stock's business growth is now more dependent on the aerospace industry than all four other industries combined, the last four certainly have a greater impact on stock market performance than the individual aerospace sector due to the presence of a larger number of listed companies.

Then, the market beta coefficient, which links USAP's fluctuations to changes in the overall stock market, could be used to roughly determine what headwinds might arise for USAP's stock price as bearish sentiment affects other USAP markets.

With a significant value of 0.7x for the 24-month beta coefficient, which measures the performance [output] of the USAP stock price as a function of the stock market performance [input], there is a risk that the shares of USAP will be caught up in the downturn of the market despite the growth catalyst of the Aerospace strong demand. (Scroll down this page to the Risk section, which reports the 24M beta).

I predict the market downturn as a result of the following: the Fed's new estimates of a higher interest rate target of 5.6% this year from March's forecast of 5.1% may have already given the market the input to consider the possibility of even a deep recession in late 2023, as the revised estimate implies further rate hikes after the break on June 14, which tends to dampen rather than support the business cycle.

Thus, I anticipate that in the coming weeks, USAP stock could trade at a much more attractive price than it is currently.

As such, I would not add Universal Stainless & Alloy Products, Inc. shares to the position right now, preferring to limit the stance to Hold for the time being.

Conclusion

The Universal Stainless & Alloy Products, Inc. business is benefiting from strong demand dynamics in the Aerospace industry and is poised for continued sales growth and improved profitability. However, it is equally possible that the highly uncertain environment due to the looming recession will weigh on the market value of USAP stock. I think the market will propose a more attractive price in the near future to strengthen the position of this US-based manufacturer of alloy products, which serves global markets and has strong upside potential due to the growing demand from the Aerospace industry.

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