EUR 850.00 For Business Accounts Only

Morningstar | Allegheny Technologies' Profits Nearly Double in 2Q; Free Cash Flow Generation Kicking Into Gear. See Updated Analyst Note from 24 Jul 2018

Thanks to significant margin expansion across both of its reporting segments, Allegheny Technologies' operating income nearly doubled to $111 million in the second quarter. Due to the company's strong performance year to date as well as management's more optimistic guidance, we've increased our near-term profit forecast. Having reassessed our terminal EV/EBITDA multiple, we've modestly increased our expectations for the company's free cash flow conversion from EBITDA and long-term growth profile. Accordingly, we've raised our assumed multiple to 9.5 times from 8.5 times.

Taking all of these adjustments into consideration, we're raising our fair value estimate to $35 per share from $31, with half of the increase coming from higher near-term profits and the other half from the terminal multiple update. Our narrow moat rating is unchanged. Although our long-term outlook that operating margins will reach 15% by 2021 might have looked lofty just a few quarters ago, the company appears well on track to achieve this trajectory.

The commercial aerospace end market remains the key driver of profitable growth. For the high performance materials and components, or HPMC, segment in the second quarter, jet engine and airframe sales rose 16% and 7%, respectively. We expect these two categories to account for nearly all incremental HPMC sales in 2018 from the prior year. HPMC operating margins reached 16.5% in the quarter, up from 12.9% year on year. Regardless, wee see more opportunity ahead, as we believe margins will exceed 20% as soon as 2020. For reference, HPMC operating margins were just shy of 40% in 2007 before the onset of the financial crisis.

We were also pleased to see a nice recovery from the flat-rolled products, or FRP, segment. FRP segment operating income reached $26 million in the quarter, up from only $3 million in the same period last year (and a $32 million loss in the second quarter of 2016).

After enduring multiple years of cash burn, the company restored positive free cash flow last year to the tune of $38 million. Management is now guiding to over $150 million of free cash flow in 2018 (excluding pension contributions). At the the company's current market cap of $3.6 billion, this implies a 4% free cash flow yield, although we expect free cash flow to rise a great deal further through the end of the decade. This would reward longtime shareholders who weathered the company's pricey reinvestment cycle from 2011-2014, during which time the company booked $1.5 billion of capital expenditures. Although the company's capital expenditures during the reinvestment period were 8.5% of sales, capital expenditures should represent only about 3% of sales over the next five years.