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Stock Strategist Industry Reports

Allegheny and Carpenter Are Undervalued

Near-term headwinds hide attractive aerospace growth prospects.

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We contend that the near-term headwinds facing  Allegheny Technologies (ATI) and  Carpenter Technology (CRS) obscure the attractive long-term growth prospects associated with the companies' exposure to the aerospace end market.

Allegheny and Carpenter are currently in 5-star territory, trading at a steep discount to our fair value estimates on an uncertainty-adjusted basis. We assign a $27 fair value estimate to Allegheny and a $55 fair value estimate to Carpenter, as we expect that the challenges currently facing each company will gradually dissipate, clearing the way for profitable long-term growth.

A key factor driving Allegheny's and Carpenter's share prices lower has been the steady decline of oil and gas prices. In recent years, both companies had enjoyed profitable growth by manufacturing high-value alloys for a wide variety of applications in oil and gas drilling projects. Low energy prices inspired a massive drawdown in the global rig count, weighing on each company's shipment volumes across key, high-margin product lines.

Perhaps even more important, low oil and gas prices have also weighed on investor sentiment regarding the companies' shipment volumes to the aerospace end market. Aerospace is the single-largest end market by revenue for Allegheny and Carpenter, accounting for 41% and 46% of sales, respectively, in their most recent fiscal year. Both companies manufacture high-value specialty metals and alloys that have a high degree of content on next-generation commercial aircraft. These next-generation aircraft are 20%-30% more fuel-efficient than their legacy counterparts, but with oil prices falling by such a large magnitude, investors have become concerned that deliveries and therefore volumes for Allegheny and Carpenter will disappoint.

But our research indicates that low oil prices generally do not lead to lower delivery rates. Annual decreases in futures prices for West Texas Intermediate were followed by lower combined commercial aircraft deliveries by Boeing and Airbus only twice in the past 20 years (2002 and 2010). In both of these cases, weak aircraft delivery volumes were probably caused by weak economic growth rather than cheap oil. Other than these two years, each year in which oil prices declined (1997, 1998, and 2012) was followed by a year of robust aircraft delivery growth (42%, 15%, and 7% year over year, respectively).

This of course doesn't address the magnitude of the current decline in oil prices. In 1998 and 2009, WTI prices fell 30% and 38%, respectively, the two largest single-year declines over the past 20 years. However, aircraft deliveries rose 42% in 1998 and 15% in 1999. In 2009, deliveries rose 14% before falling only 1% in 2010. For combined deliveries from Boeing and Airbus, we forecast low-single-digit growth in 2016 and high-single-digit growth through 2020 despite low oil prices. These delivery rates should support steady volume growth for Allegheny and Carpenter.

We also expect both companies to deliver significant margin expansion through 2020 as a result of an improving product mix and the benefits of operating leverage. The companies' aerospace shipments encompass high-value products that generally command attractive margins. Allegheny and Carpenter are just now emerging from major reinvestment cycles in which they significantly increased their production capacities for manufacturing high-value materials. For Allegheny, this involved the construction and qualification of its new hot-rolling and processing facility ($1.2 billion) and titanium sponge facility ($500 million). For Carpenter, this involved building a state-of-the-art production facility in Athens, Alabama ($500 million). These assets continue to operate far below full capacity, although utilization should steadily improve as aerospace demand picks up over time.

As this plays out, operating leverage should drive margin expansion. We expect Allegheny to deliver a midcycle operating margin just shy of 14% and Carpenter to deliver a midcycle operating margin of 14% by the end of the decade. These levels sit well below operating margins above 20% achieved before the onset of the financial crisis.

For Allegheny, near-term headwinds are significant. Its flat-rolled products segment has become unprofitable on an EBITDA basis, as the company is dealing with low stainless steel prices, weak demand from the energy end market, and an ongoing lockout of union employees. However, with the ramp-up of the new hot-rolling and processing facility, the eventual signing of a new contract with the United Steelworkers union that is likely to save costs for Allegheny relative to the expired agreement, and operational rightsizing, we expect the flat-rolled products segment to restore profitability in 2016. In the company's recent fourth-quarter earnings call, management echoed this view, asserting that the segment would be profitable again by the second half of the year. Meanwhile, we expect operating margins associated with the high-performance materials and components segment to reach 8% in 2016 and improve thereafter. We expect companywide EBITDA to rise from an estimated $259 million in 2016 to $788 million by the end of the decade.

Carpenter has also struggled to generate profitable growth more recently, logging only a 6% operating margin in fiscal 2015, well below the 9% average from fiscal 2010 to 2014. Although low oil prices have weighed on shipment volumes and margins, the company has effectively no exposure to commodity-grade stainless and grain-oriented electrical steel products (unlike Allegheny). Therefore, we expect Carpenter to generate consistent earnings growth as volumes rise and its product mix improves. We expect companywide EBITDA to rise from $266 million in fiscal 2016 to $584 million by the end of the decade.

Although our investment theses for Allegheny and Carpenter are long term in nature, we contend that misplaced concern about low oil prices and excessive focus on other near-term headwinds provide a very attractive entry point in either stock. Although Allegheny trades at a larger discount to our fair value estimate than Carpenter, it is also subject to more pressing headwinds and could require more time before our thesis gains traction. Carpenter represents a lower degree of uncertainty than Allegheny about earnings volatility, but potential returns are more limited, in our view. We assign each company a narrow economic moat rating, as we believe they benefit from intangible assets and switching costs. Each stock represents an attractive long-term holding for the patient investor, in our opinion.

Andrew Lane does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.