An Abrupt Shift In Business Will Challenge Carpenter’s Self-Improvement Story (NYSE:CRS)

The outbreak of Covid-19 has dramatically shifted the outlooks and operating environments for many businesses, and in the case of Carpenter Technology (CRS), it’s going to seriously challenge the company’s recent self-improvement efforts, efforts that had seen notable product mix and margin improvements in the Specialty Alloys business. With aerospace making up about 60% of Carpenter’s revenue mix and the likelihood of a multiyear recovery path given the hit to the airline sector, Carpenter is going to have its work cut out for it.

I still see opportunities for Carpenter to drive better results through self-improvement, but the next few quarters will give investors good insight into how much the company’s efforts over the past few years matter in real-world downturns. Past downturns have pushed operating margins down to the low single digits, and the company will need to do better than that to support an “it’s different this time” argument for a stock and a sector where it’s long been difficult to earn sustained market-beating returns.

Weaker Results Ahead Of The Aerospace Downturn

There were some good parts to Carpenter’s fiscal third quarter (calendar first quarter) earnings report, but it’s hard to feel great about the results overall when margins declined significantly while the aerospace business was still growing. With aerospace tipping over into what I believe will be a multiyear downturn, Carpenter’s ability to mitigate decremental margin pressure will become critical to the story.

Revenue declined about 2% year over year in the quarter on a nearly 9% decline in sales volume. The Specialty Alloy business (or SAO) saw 1% revenue growth on a 10% volume decline, as the company continues to benefit from a mix shift toward premium alloys and products like soft magnetics. Performance Engineered Products (or PEP) revenue declined 15% on a 10% volume decline.

Gross margin declined 240bp (using ex-surcharge revenue as the denominator), doing most of the damage to profits this quarter. Adjusted operating income declined 20%, with operating margin contracting 270bp. At the segment level, PEP went back into the red, while SAO produced 4% growth and 50bp of year-over-year margin expansion.

Carpenter did better than most aerospace suppliers this quarter, with revenue up 7% as reported and up 4% ex-surcharge on 4% volume growth, helped by 11% growth in engines. That’s not bad relative to the expected impact of the 737 MAX production issues, but with aerospace production likely to fall sharply across the board, I don’t believe this relatively better performance means that Carpenter is going to avoid a major hit to revenue and earnings.

Looking Ahead Into A Severe Decline

Maybe it goes without saying, but there’s practically no meaningful visibility into the outlook for aerospace production. Several airlines have already declared bankruptcy, with Avianca (AVH) and LATAM (LTM) arguably the most significant to date, and I expect many more before this cycle is over. Even those that survive the crisis will do so with strained balance sheets, and major non-airline aircraft purchasers like AerCap (AER) are working with suppliers to delay future deliveries and preserve cash flow. Put it all together, and I think the sector is going to see pressure through 2021, at least, and then need time beyond that to recover.

Carpenter is likewise looking at what I believe will be a multiyear downturn in the oil/gas market, but with the company’s decision to exit the Amega West business, its exposure to oil/gas will be less than 5% going forward.

On the positive side, Carpenter has been doing relatively well with medical customers in the orthopedic and dental space, and medical is around 10% of the business now. Carpenter could see some destocking pressure over the next quarter or two as elective procedures resume, but I’m not worried about the growth outlook for this business over the next few years. Transportation should start to recover later this year, and Carpenter has some leverage to EVs through its soft magnetics portfolio. Last is the hodgepodge that is “Industrial”, in which Carpenter has been seeing some improving trends in electronics recently.

There’s really nothing Carpenter can do about the macro issues it and its customers are facing. Carpenter has managed to improve its mix in aerospace, and opportunities like electrification (through auxiliary power units) are meaningful, but the company still needs Boeing (BA), Airbus (OTCPK:EADSY), and others up and running with airline production.

What management can do is look to control costs, and that’s where we’ll see how much recent efforts to restructure the business really matter. These efforts have included more efficient manufacturing systems and a shift toward a higher-value mix, but management will also have to effectively re-scale the business for the significantly lower volumes that will be coming without overly compromising the company’s leverage to the eventual recovery. Getting out of the Amega West business is a good move, even if this is likely exiting at the bottom, as is temporarily shuttering two domestic powder metal facilities.

The Outlook

I believe this peak-to-trough move could drive a 20% or worse decline in revenue and a roughly 40% decline in EBITDA, but I do still believe that Carpenter can generate low-single-digit revenue over the long term and low-mid single-digit revenue on a normalized basis. Trough margins are a big concern to me. Carpenter has hit the low single digits before (though still staying positive), but I’m looking for a higher trough in the mid single digits this time around. The impact to free cash flow will be lumpy in the near term due to working capital moves, but I expect mid-single-digit FCF margins over the longer term as the company reaps the benefits of its self-improvement efforts.

The Bottom Line

Between discounted cash flow and EV/EBITDA (based upon a through-cycle multiple), I believe fair value for Carpenter is in the mid-to-high $20s (DCF supports the higher end). At the higher end, that suggests worthwhile upside, but I want to reiterate the huge modeling uncertainties in place right now. I also want to point out that the long-term performance of specialty alloy companies like Allegheny (ATI), Carpenter, Haynes (HAYN), and Universal Stainless (USAP) just isn’t that good. You can definitely make money if you time your entries and exits right, but these are generally stocks you want to hold for a year or two in a recovery cycle and not look at as long-term holdings.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

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