Universal Stainless & Alloy Products Takes A Step Back As The Aerospace Recovery Cycle Lurches Forward In Fits And Starts

The recovery in commercial aerospace is real, but it has proven to be considerably less of a smooth upward ramp and more of a drunken lurch, as major OEMs like Airbus (OTCPK:EADSY) and Boeing (BA) struggle to balance uneven production rates and capabilities among suppliers, and those suppliers (and OEMs) continue to struggle with component/supply availability, input costs, labor availability, and just about anything else you care to name. Add in operational challenges (some self-inflicted, others not), and Universal Stainless & Alloy Products (NASDAQ:USAP) ("Universal Stainless") has struggled to maximize these still-early days of recovery.

Down about 10% since my last update, Universal Stainless has lagged other material and component suppliers to the aerospace industry, but only Carpenter (CRS) has really done well over that time, as ATI (ATI), Hexcel (HXL), and Howmet (HWM) have been more "meh" than magnificent.

I've never thought that Universal Stainless was the best operator of the bunch, but I've seen over many years across many cyclical industries that secular upswings tend to produce more dramatic improvements at the less-capable operators, and I believe that will still be the case here. By no means is this the cream of the crop, nor a long-term holding, but I do believe this unfollowed and thinly-traded supplier of specialty steels can still produce attractive returns for more aggressive investors.

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Universal Stainless & Alloy Products Takes A Step Back As The Aerospace Recovery Cycle Lurches Forward In Fits And Starts

Universal Stainless & Alloy Products Ignored On The Runway As Business Starts To Take Off

The last six months or so have been increasingly frustrating as an observer and analyst of Universal Stainless & Alloy Products (NASDAQ:USAP) (“Universal Stainless”). Other providers of alloys and specialty materials to the aerospace industry have seen their share prices outperform Universal Stainless, ATI (ATI) in particular, but Universal Stainless has been frustratingly weak since my last update despite improving orders, pricing, and margins.

Given aircraft production schedules and guidance from major OEMs like Airbus (OTCPK:EADSY) and Boeing (BA), I believe USAP is about to see a significant ramp in revenue and expansion in margins. On top of that, the company is poised to benefit from recovering oil/gas activity, as well as efforts to upgrade the product portfolio (including participating in “hot side” engine components). Even at a significant multiple discount to ATI or Carpenter (CRS), I see upside into the low-to-mid teens as USAP delivers on the growing demand from aerospace customers.

Readers should note that USAP is very small (less than $100M in market cap), fairly illiquid (fewer than 20K shares traded per day, on average), and not followed by Wall Street analysts. Consequently, it’s fair to assume that this is a riskier stock.

 

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Universal Stainless & Alloy Products Ignored On The Runway As Business Starts To Take Off

With Aerospace Recovering, Universal Stainless & Alloy Products Should See A Meaningful Ramp

 

When the market doesn't act the way you think it should, that's a good time to reassess your basic assumptions. In the case of Universal Stainless & Alloy Products (USAP) ("Universal"), the shares of this steel alloy producer haven't responded to the improving outlook for aerospace or heavy industry (80% of revenue), and the shares are down close to 20% since my last update, lagging the S&P Metals and Mining ETF (XME), other aerospace-leveraged alloy companies like Allegheny Technologies (ATI) and Carpenter Technology (CRS), and Hexcel (HXL), a provider of carbon fiber materials to the aerospace industry.

At the risk of hubris, I think the market is wrong and these shares are being overlooked, perhaps due to the fact that they have next to no coverage. While Universal is definitely not a well-run "buy and hold" type of long-term holding, the company's leverage to the aerospace cycle is significant, and the company should see meaningful revenue growth in 2022, as well as positive operating leverage. With a near-term fair value of around $14, this looks like an interesting, if speculative, trade on improving aerospace demand trends.

 

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With Aerospace Recovering, Universal Stainless & Alloy Products Should See A Meaningful Ramp

Improving Stainless Demand And Bottoming Markets Encouraging For Universal Stainless & Alloy Products

This pandemic-driven downturn has been a brutal one for Universal Stainless & Alloy Products (USAP), and while commodity stainless steel markets have turned up on improving demand from end-markets like autos and appliances, it’s going to take a little longer for markets like aerospace and oil/gas to sort themselves out and drive USAP’s recovery.

When I last wrote about USAP, I thought the shares were undervalued below $8 to $9. Since then, the shares have risen about 25% to a little over $9, as 2020 revenue and EBITDA came in a little lower than I’d expected, FCF outperformed on a greater net working capital release, and commodity markets have rebounded sharply.

I do expect meaningful recovery growth from USAP starting late in 2021 and continuing on through 2024 on recovering aerospace and oil/gas, as well as increased premium offerings in a range of smaller markets including “general industry” categories like medical and semiconductor. With that recovery, I think the near-term fair value improves to $10-12/share, and I do see a possibility of the stock overshooting as the recovery becomes evident.

Still, I would remind investors that this is a stock that should be bought to be sold – holding over a full cycle is painful, and despite three major runs over the last 20 years (2007, 2011-12, and 2018), the annualized return over those 20 years is just 1%.

 

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Improving Stainless Demand And Bottoming Markets Encouraging For Universal Stainless & Alloy Products