It took a little while, and there were definitely bumps along the way, but the suppliers of critical nickel and titanium alloys to the aerospace industry (among other end-markets) have been enjoying strong stock market performance as Airbus (OTCPK:EADSY) and Boeing (BA), as well as engine manufacturers like General Electric (GE) and RTX (RTX) and their suppliers, have worked out the kinks in their supply and manufacturing chains and ramped up production in 2023.
ATI Inc. (NYSE:ATI) shares are up about 40% since my last update on the company, which isn’t bad, but Carpenter Technology (CRS) and Universal Stainless & Alloy (USAP) have done even better (up about 75% and 70%, respectively). While I don’t think we’ll see the peak of the aerospace cycle until the end of the decade, a lot of this recovery is in the valuation now and there are nearer-term concerns about other markets, as recessionary headwinds have weighed on some businesses outside of aerospace.
I don’t rule out the possibility of more upside from the aerospace cycle (not to mention eventual recoveries in some of the weaker consumer and industrial markets today). Likewise, I don’t ignore the capacity expansion plans on the books for ATI, nor the possibility that margins could exceed my expectations. Still, these aren’t stocks where you want to overstay your welcome, so I’d be careful about hanging on to squeeze every last penny of upside.
The Aerospace Recovery Looks Clear To Accelerate Further
There have certainly been some fits and starts in this recovery phase of the aerospace cycle, including recent concerns about whether issues with a supplier (Spirit AeroSystems (SPR)) might impact Boeing’s near-term 737 production schedule and challenges working through manufacturing bottlenecks on the engine side.
Those issues seem largely resolved now, and with that the outlook for a meaningful ramp in the aerospace business at ATI is quite good. Aerospace revenue rose 39% year-over-year in the second quarter against overall growth of 9% for the company, with even stronger growth airframes (up 55%) and engines (up 37%). Aerospace and defense revenue has expanded back to 58% of total revenue, and management is still looking to drive this number to 65% as the recovery/growth phase continues.
And continue it should. Boeing will likely end the year having produced around 400 to 430 737s and should exit the year around 38/month (annualizing to over 450). In a couple of years, that should accelerate further to 50/month (600/year) before peaking around 60/month, or around 60% above current production rates. Production of 787s will likewise accelerate from here, with Boeing targeting 5/month exiting the year, accelerating to 10/month in ‘25/’26, and then holding that level for several years. At the same time, other producers like Airbus and Embraer (ERJ) will be stepping up their production schedules.
ATI is well-placed in the aerospace food chain, as it is a key provider of nickel and titanium alloy forgings used in engines (including the more lucrative hot-side components). The company is also more meaningfully leveraged to widebody airframes, so as the production of larger planes steps up in the next three years, ATI should see a disproportionate benefit to both revenue and margins.
Other Markets Matter, Though, And Aren’t Looking As Strong
For better or worse, ATI is not a pure-play aerospace story. While close to 60% of revenue comes from aerospace and defense, the 40% that doesn’t still matters. The company saw meaningful declines in the energy (down 10% yoy), electronics (down 27%), auto (down 30%), and food equipment/appliance (down 67%) markets in the second quarter, and those pressures may hang around.
Between weakening consumer confidence, the UAW strike, and trouble in China’s EV market, the auto market outlook isn’t particularly robust now. The weakness in energy seems more idiosyncratic and product/customer-driven, as the energy market is still healthy on balance and I expect it to remain so through 2024. With electronics and appliances, I’m comparatively more comfortable that the former has bottomed, but there’s still a lot of uncertainty across multiple industrial and consumer end-markets heading into 2024.
I don’t think these headwinds will last much beyond 2024, but I do think weakening and uncertain industrial end-markets have played into the shares coming off their highs. I’m skeptical that the inventory destocking process in the industrial sector is over just yet, and I do see this as a possible source of near-term margin weakness for ATI – the extent to which the market will look past this and focus on improving aerospace results is impossible to predict; on good days it probably will, but in periods of market weakness/worry, it’ll likely matter more.
The Outlook
The good news/bad news here is that ATI has done about as well as I expected, and the aerospace build-rate improvements have likewise come along as I modeled. As things haven’t really gotten notably better, my modeling revisions are relatively limited – a small upward tweak to 2023 and a small downward tweak to 2024. I’m incrementally more bullish on the possibility of a slightly longer up-cycle for aerospace, as well as the contributions from the two-stage capacity expansion project that ATI has underway, but my out-year revenue estimate is only about 7% higher than before.
Likewise, not much has happened to lead me to reconsider my margin assumptions to any great extent. Results over the last three quarters have led me to modestly reduce my 2023 margin estimates and modestly increase my 2024 estimates, but I’m still looking for margins to scale up into the high teens over the next two to three years, lifting free cash flow (“FCF”) margins into the low-to-mid-teens. Given the plans to boost capacity, I have reduced my near-term FCF margin estimates (to account for the larger capex), but I still believe mid-teens FCF margins are possible in the best years.
All of that means relatively modest changes to valuation relative to the movement in the share price. My discounted cash flow-based fair value moves up to $44 (helped in large part by moving out to the right one year), and my EBITDA-based estimates move from around $37.50 to $44.50. With the later, I’m now using a 9.5x multiple (versus 9x previously) – that is about 15% above the historical full-cycle average to account for what I expect to be a stronger-than-normal aerospace cycle and changes made to the business that should make it more profitable. I could see an argument for going as high as 10x, maybe even 11x at peak, but that’s stretching it (and would get me to around $53/share).
The Bottom Line
The only thing worse than selling early and leaving money on the table is staying too long and seeing paper gains evaporate or transform into losses. I’m not suggesting that the music is about to stop for ATI, and it well may be the case that this roughly 15% pullback is an opportunity to reload ahead of improving build-rates at the airplane and engine OEMs. Still, I’d be cautious about overstaying my welcome here unless you have a strong thesis that the aerospace cycle will be even better than expected.
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