EUR 850.00 For Business Accounts Only

Morningstar | Carpenter Technology Delivers Operating Margin Above 10% in Fiscal 2018; We Expect Margins To Double

Carpenter Technology reported fourth-quarter results, and we are encouraged that it delivered adjusted operating margins (excluding surcharge) of 10.6% in fiscal 2018. Margins had remained below 10% in each of the three preceding years and had come in at only 8.0% in 2017. Even so, we contend that Carpenter is still in the early stages of its current upcycle from a profitability perspective. We forecast that operating margins will exceed 20% by 2023 before settling at a 14.5% midcycle level, or 12% including surcharges.

Margins above 20% might appear to be a lofty target, and it certainly requires a steep upward trajectory. However, we believe this forecast will prove achievable thanks to the combination of an improving product mix and the benefits of operating leverage as production volumes rise. For example, low utilization at the company's relatively new Athens, Alabama, production facility provided an unabsorbed fixed-cost headwind of roughly $35 million in 2017. In time, as more vendor-approved process approvals are achieved for the Athens facility, operating leverage should become a tailwind for profitability rather than a headwind.

After updating our valuation model, our fair value estimate rises to $60 per share from $58. This mainly stems from a terminal enterprise value/EBITDA multiple increase to 8.5 times from 8.0 due to a modest increase to our long-term growth assumption. Regardless, our updated fair value estimate sits only slightly above the current share price. Price-implied expectations also seem to imply that Carpenter's impressive profitable growth momentum will continue in the coming years. Our narrow moat rating for Carpenter is unchanged. Although we don't expect returns on invested capital to move above our assumed weighted average cost of capital until 2020, we are confident that economic profits will be here to stay thereafter.