Allegheny Technologies Setting Up For Higher Highs As Aerospace Recovers (NYSE:ATI)

The shares of specialty alloy producer Allegheny Technologies (NYSE:ATI) have already doubled lows in the late fall of 2021, as the market has started pricing in both the recovery in the commercial aerospace market and management’s progress on self-help initiatives. Still, these are the early days of the recovery, and it doesn’t look as though the market is fully pricing in what this newly more efficient company can earn as the cycle ramps further.

To be clear, I do not think that Allegheny is a good buy-and-hold stock for long-term investors. The commercial aerospace cycle should take several years to play out, but even with the improvements made to the business, I think full-cycle returns are unlikely to be all that attractive. In other words, this is a stock to try to own on the way up, but you really don’t want to ride along for the down-cycle. Given low double-digit EBITDA margin in 2022, accelerating into the mid-teens and beyond over the next five years, I think there’s at least 10% to 15% more near-term upside today.

Self-Improvement Matters

I’ll talk more about Allegheny’s cyclical leverage in a moment, but I think there are self-help initiatives underway that also matter.

Most significant is the company’s decision to exit the commodity stainless steel sheet business. While companies like Acerinox (OTCPK:ANIOY) have found paths to profitability in stainless, Allegheny never could, even after the addition of hot-rolling and processing capabilities. The company has already exited three of the five planned facilities and the discontinued businesses were only about 4% of Q4’21 sales, and I expect the process to finish by the end of 1H’22.

The company has also made progress with its pension issues. A combination of contributions, market returns, and rising rates has roughly halved the liability and the company exited 2021 at an 84% funded status. With the pension soon to no longer be a draw on cash, management will be entering this up-cycle with the freedom to reduce debt, pursue selective M&A, and return cash to shareholders.

Finally, and less quantifiable, is a change in management’s overall approach to the business. CEO Bob Wetherbee has been on the job for about three years, and I think there has been a noticeable change in that time. Prior management earned a reputation for making poor capital allocation decisions, but so far this team has done a lot to change that narrative. I would like to hear a little more about positioning for the future (something that’s been a topic at smaller rival Carpenter (CRS)) in terms of new materials/products and new end-markets, but that may be something that the company can achieve through small-scale M&A.

The Cycle Is Beginning…

The biggest driver for Allegheny (as well as Carpenter and even smaller rivals like Haynes (HAYN) and Universal Stainless & Alloy Products (USAP)) is the accelerating/recovering aerospace cycle. Parker Hannifin (PH) management has talked about 18,000 new commercial aircraft being built by 2030, and that is going to require a lot of specialty alloy products for the airframes and engines.

I don’t believe Allegheny has disclosed its content leverage to this newest generation of aircraft (like the Boeing (BA) 737 MAX and the Airbus (OTCPK:EADSY) A320), but commentary from companies like Carpenter and Arconic (ARNC) suggests something on the order of 25% to 40% more content per plane, with Allegheny particularly well-leveraged in engines, as this new generation of engines requires more costly nickel alloys in the turbine and combustion chamber and titanium alloys for the compressor and fan blades.

Acceleration in narrowbody production schedules is already evident, and widebodies should join the party in earnest in 2024. With that, management has talked about $2B in revenue for both of its segments (Advanced Alloys & Solutions and High Performance Materials & Components) in 2025. As utilization scales up, margins should accelerate, with management calling out credible goals (in my view) of 20%-25% segment EBITDA margins in HPMC and mid-to-high-teens margins in AA&S.

While not as big of a driver as aerospace, I’d also note that Allegheny has meaningful leverage to the energy sector as well. How much oil/gas production accelerates in response to higher prices remains to be seen, but this is another potential positive driver beyond the aerospace cycle.

The Outlook

I expect EBITDA margin to improve by about 175bp in FY’22 (to around 12.25%), and I expect further acceleration into the mid-teens thereafter, with a potential blended margin in FY’25 of somewhere around 19%-20%, and possibly higher if management can reach the higher end of their target ranges. I also expect a meaningful acceleration in free cash flow generation, with double-digit FCF margins possible in FY’25/26, depending upon what management decides to do in terms of capex.

In the near term, Allegheny stands to benefit significantly from underutilized capacity. One of the key watch items, though, will be how the industry responds as the cycle matures – in the past, companies have added too much capacity and suffered from under-utilization as the cycle slowed. Long-term contracts should help smooth some of that process and give better visibility, but it remains a risk to the longer-term outlook.

I’m not going to talk too much about long-term discounted free cash flow, as that’s usually only a useful valuation tool when these stocks are near their cyclical lows, and that’s no longer the case for Allegheny. Still, I do see significant improved free cash flow generation over the coming years, and that will help with the pension, net debt, and capital return situations.

I find EV/EBITDA to be more useful for valuation, though it can be difficult to establish a “fair” multiple when you’re looking at accelerating profitability in a cyclical upturn. I’m using a 9.5x multiple on my ’24 EBITDA estimate, discounted back at a double-digit rate, and that gives me a fair value of $31.50. While 9.5x is higher than the company’s historical average forward multiple (8.3x), I believe a higher multiple is warranted given the exit from commodity stainless, the higher leverage to higher-value engine components, and the strength of the upcoming cycle.

The Bottom Line

I believe that as the aerospace cycle really gets going, numbers are going to be heading higher for Allegheny (my ’24 estimate is above the Street) and that will push the stock even further. Clearly there are risks here, as the pandemic amply demonstrated, and I don’t consider this a potential long-term holding. Even so, as a leading player in specialty alloys serving a recovering aerospace market, I think the stock still has room to go higher.