2023-07-26 07:08:25 ET
Summary
- Despite the global pandemic's negative impact on Commercial orders, Howmet Aerospace has significantly outperformed the Defense & Aerospace sector and the S&P 500 over the past five years.
- Increased NATO and U.S. military spending is a positive catalyst. In addition, Howmet has pricing power on its metal castings and forgings for new aircraft builds.
- Howmet's Q1 revenue was $1.6 billion, up 21.2% year-on-year, driven by a 29% increase in Commercial Aerospace Segment sales; the company also reduced debt by $176 million.
- FY23 guidance was raised with the midpoint of FCF generation at $635 million. This bodes well for shareholders considering Howmet has a robust $922 million share buyback authorization in place.
Over the past 5 years, and despite a global pandemic that hammered commercial aerospace orders, Howmet Aerospace ( HWM ) has not only vastly outperformed the Defense & Aerospace sector, it has run rings around the S&P 500 as well (see chart below). Today I'll take a look at Howmet to see if I can determine what the company's "secret sauce" is and whether or not it's too late for investors to climb on board.
As you can see in the above graphic, the 5-year total returns of Howmet have blown away the total returns of the SPDR S&P Aerospace & Defense ETF ( XAR ), the iShares U.S. Aerospace & Defense ETF ( ITA ), and even the Vanguard S&P 500 ETF ( VOO ).
Investment Thesis
As I pointed out in my recent article on the XAR ETF, increased NATO and U.S. military spending as a result of Russia's invasion of Ukraine is a very positive tailwind for the Aerospace & Defense Sector (see XAR: An Excellent Defense ETF To Benefit From A Rejuvenated NATO ) as a whole. Howmet should certainly be a beneficiary. And, given the modified equal-weight management investment strategy of the XAR ETF, the fact that Howmet - rising to the #3 holding - means it has been one of the best performing companies since the last re-constitution of the equal weight fund (only TransDigm ( TDG ) and Curtiss-Wright ( CW ) have performed better).
As also pointed out in that piece, last month Morgan Stanley identified Howmet as a top-pick , saying:
It (Howmet...) is a strong operator with upside from continued aerospace end market recovery and market share gains from VSMPO-AVISMA. Aerospace grade castings and forgings remain a bottleneck for new airplane production, providing Howmet with pricing power and market share wins from underperforming peers.
That being the case, let's take a closer look at this company.
Earnings
Howmet specializes in making lightweight metal components (aerospace grade casting forgings) for the commercial and military aerospace markets. These are commonly used in jet engines, fastening systems, forged wheels, and as structural metal components.
The slide below from the Q1 presentation sums up Howmet's first quarter financial results :
As you can see from the graphic, Q1 revenue of $1.6 billion (+21.2% yoy) beat estimates by $110 million . Net income was $148 million - $0.35/share, which was up 13% yoy. Adjusted EBITDA grew 20% yoy and 7% on a sequential basis. Those results were driven by a 29% increase in Commercial Aerospace Segment sales. However, free-cash-flow was a negative $41 million (see more commentary on FCF below).
In addition, HWM reduced debt (2024 Notes @ 5.125%) by $176 million during the quarter and ended Q1 with $538 million in cash and a net-debt to LTM EBITDA ratio of 2.6x. That led S&P Global Ratings to revise their outlook on HWM from "stable" to "positive" and affirm their 'BB+' issuer credit rating on the company.
The strong Q1 performance enabled Howmet to repurchase $25 million in stock during the quarter for an average price of ~$43/share. Since Howmet separated from Arconic ( ARNC ) in 2020, the company has repurchased ~$928 million of common stock at an average price of $31.79/share. The stock is currently trading at $50 and change.
Total Q1 quarterly dividends totaled $17 million ($0.04/share).
As you can see in the Q1 presentation slide below, HWM has a nicely diversified product offering across all segments, led by Engine Products, which were responsible for 48% of Q1 sales:
Defense Aerospace was up 11% yoy and was driven by the F-35 program and growth in legacy spares. Yet on a sequential basis, Defense Aerospace revenue was flat due to typically strong year-end seasonality.
Howmet CEO John Plant commented on the quarter:
The demand picture continues to be strong for commercial aerospace, with higher aircraft production rates underpinned by continued growth in air traffic. We are encouraged by progress of aircraft OEM customers to meet their higher build rate targets. Given our strong first quarter and improving aerospace backlog, we are increasing full year 2023 guidance for revenue, Adjusted EBITDA*, Adjusted Earnings Per Share*, and Free Cash Flow.
The updated (raised) Q2 and FY23 guidance is shown below:
The midpoint of FY23 FCF guidance (i.e. $635 million) would be an obvious acceleration of FCF generation in the 2H of the year as compared to the $41 million of negative FCF in Q1. If the company were to hit that FCF guidance mid-point, it would equate to FCF of an estimated $1.54/share based on the 411.81 million shares outstanding at the end of the quarter.
The negative FCF result in Q1 was explained away by CEO Plant on the Q1 conference call:
Free cash flow was negative $41 million, driven by the higher revenues and will now be followed by three successive quarters of substantial cash inflow.
In addition, $635 million in FCF bodes well for shareholders considering that we also learned on the Q1 conference call that Howmet still has $922 million left on the board of directors' existing share buyback authority. CEO Plant said:
Continuing share repurchases can be expected as cash is generated and the current authority is sufficient to continue this program.
Risks
As a supplier to the commercial aerospace market, HWM is exposed to global economic conditions (not to mention global pandemics ...) that could negatively impact consumer commercial travel and, as a result, new commercial aircraft builds. Higher inflation and higher interest rates are part of that risk.
Meanwhile, much of new commercial aircraft orders come out of Asia. That being the case, order flow will pick up if the Chinese economy picks up.
Upside risks include a continued recovery in supply chains and a continuing recovery in the commercial travel. Order flow and revenue continue to grow but have yet to reach pre-pandemic levels across Howmet's entire product line. Howmet could easily grow revenue and earnings in the double-digits over the next 3-4 years.
Seeking Alpha's "Factor Grades" currently rate Howmet Aerospace as follows:
As you can see, the company gets strong marks except for "Valuation". The TTM P/E according to Yahoo Finance is 43.7x , a significant premium to the S&P 500. The forward PE, according to Seeking Alpha, is 29.3x, demonstrating accelerating growth that should enable HWM to eat into its current premium valuation. Still, Howmet is relatively richly valued as compared to the S&P 500 (TTM P/E= 26.4x ). That said, revenue is growing at a 20%+ clip and the company will be generating very strong FCF in Q2 and the 2H of the year.
Summary & Conclusions
Howmet is scheduled to report Q2 Earnings on August 1st (next Tuesday). I'm expecting another strong report but the stock has been trading very strong going into that report and is already +28.3% YTD (see below). That being the case, I wouldn't chase the stock here and it is possible that the report could be a "sell on the news event". However, longer-term I am bullish on Howmet and would BUY the stock given an opportunity at $45. That's because the company has a strong FCF profile and a significant share repurchase authorization already in place.
For further details see:
Howmet Aerospace: Flying High Above The Returns Of The S&P 500