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Morningstar | Allegheny Technologies Issues Mixed 3Q Results, but Profitable Growth Should Persist Beyond 2018

Allegheny Technologies' third-quarter earnings were highlighted by solid results for the flat-rolled products segment but somewhat disappointing results for the high-performance materials and components segment. We've reduced our full-year profit outlook in light of this performance, but our long-term forecasts are unchanged. Our $35 fair value estimate and narrow moat rating are intact.

Although our quarterly updates typically focus on the HPMC segment, which we expect to provide effectively all incremental profits over the coming decade, we'd be remiss if we didn't highlight the company's impressive turnaround of the FRP operations.

After suffering heavy losses from 2013 to 2016, the FRP business has now delivered four straight profitable quarters. Although we view management's 2019 segment operating profit guidance of $100 million as lofty, we're still encouraged that the segment is once again a material positive contributor to companywide profits. While recent profitability has been boosted by rising nickel prices (a trend that has reversed thus far into the fourth quarter), we are optimistic about the prospects of rising capacity utilization at the company's state-of-the-art hot-rolling and processing facility. Although the facility has operated at very low utilization rates since construction was completed in 2014, management has pursued a joint venture and third-party conversion agreement to boost the asset's production. We expect higher HRPF operating rates and a lower overall exposure to prevailing stainless steel prices to sustain profitability for the FRP business in the years to come.

Results from the HPMC operations were less encouraging, although this was still the ninth straight quarter of at least 100-basis-point year-on-year operating margin expansion. A number of headwinds drove segment operating margins sequentially lower to 13% in the third quarter from 16.5% in the second quarter. However, these headwinds appear to be fleeting, one-off items, and therefore, we still expect management to hit its unchanged full-year guidance for a 300-basis-point year-on-year segment operating margin increase. We expect significant margin expansion to continue in the years ahead as production run rates for next-generation commercial aerospace products rise, the product mix improves, and the benefits of operating leverage take hold.

For Allegheny as a whole, we are starting to see the company's recent reinvestment cycle bear fruit. Capital expenditures should remain constrained in the coming years, and the company's free cash flow will rise materially. Allegheny is already on pace to exceed its 2018 free cash flow guidance of $150 million. Cash that the company generates in the near term will be used for pension funding, as management still aims to reduce its onerous net pension liability. Over a longer time horizon, once the pension's funded status has been addressed, we view a dividend increase and share repurchases as a logical next step rather than the pursuit of M&A.