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Morningstar | Carpenter Technology Unjustly Punished For Soft 1Q Results; Runway Still Clear For Profit Growth

Carpenter Technology shares moved sharply lower after the company's fiscal first-quarter earnings release. We view the sell-off as overdone. First, although profits fell short of management's guidance, the company's performance in a vacuum was still encouraging. Second, end market demand trends remain favorable, supporting our expectations for attractive long-term profitable growth. Finally, the operational headwinds driving the soft quarterly results will prove temporary. We've modestly reduced our fiscal 2019 profit outlook and our fair value estimate falls to $58 per share from $60. Our narrow moat rating remains, as the company's ROIC profile will improve materially going forward.

A key concern behind today's sell-off was Carpenter's guidance shortfall. The specialty alloys operations, or SAO, generated $53 million of operating income, below the low end of guidance to $59 million. The performance engineered products, or PEP, segment reported $7 million of operating income, shy of guidance to $9 million. On one hand, this is concerning due to the fact that management has historically exceeded its profit guidance on a consistent basis. However, we buy into management's contention that the disappointing results are reflective of fleeting headwinds rather than an impairment of the company's long-term earnings power. The three main factors that contributed to lower profitability were longer-than-expected maintenance outages, ongoing cost headwinds from the Dynamet fire recovery, and modestly higher input costs than previously anticipated.

On the bright side, demand trends remain encouraging. Sales grew year on year across Carpenter's five main end markets. Most importantly, sales to the aerospace and defense customers, far and away the company's most important end market, grew 11% and should continue to grow rapidly over the foreseeable future. As production volumes rise, margins will expand via the benefits of operating leverage and an improving product mix.

The sell-off leaves Carpenter Technology in 4-star territory, given a 23% discount to our fair value estimate and the company's high uncertainty rating. Thanks to the sell-off, the stock now offers attractive risk-adjusted return potential. Until today, shares had traded in 3-star territory since early 2018. Carpenter remains well-positioned to bear the fruit of its major reinvestment cycle from 2012-2015 and end market demand should continue to cooperate. Thanks to this dynamic, we expect significant free cash flow growth in the years to come.

For fiscal 2019, we forecast EBITDA of $373 million and adjusted earnings of $3.56 per share on $2.52 billion of revenue. All three estimates represent significant growth from the prior year (EBITDA of $306 million and adjusted earnings of $2.50 per share on $2.16 billion). Additionally, even though first-quarter results were soft, we still expect adjusted operating margins (excluding surcharge) will expand meaningfully to 12.5% from 10.6% this year. Five years forward, we forecast that margins will peak just above 20% before settling at roughly 15% midcycle. Accordingly, the market's overreaction to disappointing first-quarter earnings is only a bump on the road given our outlook for substantial profitable growth going forward.