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Carpenter Set to Build Free Cash Flow

Fear of energy end-market weakness provides an attractive entry point for long-term investors.

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The SAO division delivered $41 million of operating income, a 67% increase relative to the same period last year even though sales fell 15%. The negative impact of lower volumes was more than offset by lower operating costs and a more favorable product mix. We expect the division to carry this momentum forward, and we've increased our near-term operating margin forecasts accordingly.

The PEP segment generated a slight operating loss of $0.4 million. Although we expected a weak quarter, given the segment's high exposure to the energy end market, the result was lower than we anticipated. The PEP segment had generated operating income of $8 million-$15 million each quarter since the beginning of 2012. We have materially lowered our near-term operating margin forecasts for the PEP segment, as we now expect only a 2% operating margin in fiscal 2016.

A key driver of long-term earnings growth will be the ramp-up of the company's state-of-the-art facility in Athens, Alabama. CEO Tony Thene indicated that the facility is operating at only a 15%-20% utilization rate and this figure is unlikely to rise materially in fiscal 2016. Over time, however, as aerospace-related volumes rise and energy-related volumes recover, an improving utilization rate should drive significant margin expansion thanks to the benefits of operating leverage.

Concern about weakness in the energy end market provides an attractive entry point for long-term investors, in our opinion. After updating our valuation model, we are keeping our fair value estimate unchanged at $55 per share for narrow-moat Carpenter Technology.

With respect to some of Carpenter's key end markets, aerospace sales increased a modest 3% relative to the same period last year, but we expect accelerating growth over the course of the year and into fiscal 2017. We were pleasantly surprised by 19% year-on-year sales growth to the transportation end market, which has surpassed the energy end market in terms of its contribution to companywide sales. This changing of the guard, however, was also driven by ongoing weakness in oil and gas. Sales to the energy end market declined 53% versus the first quarter of 2015, in line with a 51% decrease in the directional and horizontal rig count over the same period.

Amid significant weakness in the energy end market and the negative impact of typical seasonality on a companywide basis, we were pleased to see that Carpenter still generated $7 million of free cash flow in the quarter. This was particularly impressive given a $33 million inventory build, slightly higher than the $31 million inventory build in the first quarter last year.

Carpenter continued to make slow but steady progress on its share-repurchase plan, which was approved in October 2014. It has bought back $170.4 million of shares, amounting to 34% of the $500 million authorized. The firm spent $45.9 million in the first quarter.

Being a Niche Operator Pays Off Carpenter uses a variety of raw materials, including nickel, cobalt, titanium, and ferrous scrap, to produce high-value specialty alloys and metals. The company's key products must meet complex customer specifications and are designed to withstand environments of extreme heat, pressure, and corrosion. To manufacture these specialized product offerings, Carpenter employs production methods that are difficult to replicate. As a result, the market composition for specialty alloy and high-performance metal production is very different than that associated with the production of commodity-grade metal products such as flat-rolled steel. Carpenter operates in a small, well-defined niche and participates in the highest-value decile of specialty steel production.

Carpenter is highly leveraged to the rapidly growing aerospace end market and invested further via its February 2012 acquisition of Latrobe Specialty Metals, a leading producer of alloys used in aircraft landing gear. We expect demand from aerospace customers to grow materially over our explicit forecast period as production of next-generation aircraft ramps up. Not only will Carpenter benefit from increasing build rates, but its shipment volume growth will be supported by the fact that the amount of lightweight metals per plane will increase as aerospace companies look to increase fuel efficiency. The energy industry constitutes Carpenter's second-largest end market, as the company manufactures metals and components for exploration and production customers. To better service growing demand for its aerospace and energy product lines, the company has invested $500 million to construct a state-of-the-art manufacturing facility in Alabama.

To manage the volatility associated with its raw material costs, Carpenter uses pricing surcharges, indexing mechanisms, and base price adjustments. This effectively allows the company to pass on raw material price fluctuations to its customers at the point of sale. For the 25% of its sales that are consummated via fixed pricing arrangements, the company uses material forward contracts to mitigate the impact of changing raw material prices.

Technical Expertise Sets Carpenter Apart We believe Carpenter Technology operates with a narrow economic moat. In our view, the most appropriate lens by which to analyze the company's competitive advantages is our moat framework for commodity processors. Moaty businesses that operate in this space tend to benefit from intangible assets and switching costs, and we believe Carpenter exhibits both of these moat sources. Carpenter largely purchases commodity-grade metals at market prices for further processing. This prevents it from establishing a material cost advantage relative to its peers.

Carpenter has a wealth of technical expertise that allows it to produce high-value, specialized steel products. The company employed production processes that require advanced metallurgical expertise in order to manufacture alloys that are resistant to corrosion as well as extreme heat and pressure. It is one of only a handful of companies that make such products, as the industry exhibits significant barriers to entry.

The process of mixing and melting specialty metals and alloys requires highly specialized furnaces that are very capital-intensive and require a great deal of time to construct and ramp up. These include vacuum induction melt furnaces, vacuum arc remelts, and sophisticated presses and forges. Carpenter's alloys are required to undergo commissioning and qualification cycles that generally take one to three years because the materials must be approved by not only the company's customers, but also the end users. For example, a new alloy that jet engine component manufacturer and Carpenter customer Firth Rixson might purchase has to be qualified by Firth Rixson and also by the aircraft manufacturer that ultimately purchases the component from Firth Rixson.

Although the qualification process is lengthy and capital-intensive, a successful product qualification effectively establishes an intangible asset that allows for long-lasting business relationships as customers are compelled to enter into long-term supply contracts with qualified suppliers. Although Carpenter is on the cutting edge in developing specialty alloys, patents are less of a barrier to entry than one might expect. Mainly, this stems from the fact that Carpenter's customers prefer to enter into supply relationships with a number of different companies and therefore prefer that the production of mission-critical materials not be patent-protected.

Customers Stick Around Switching costs ultimately stem from the fact that, whether considering an oil well or commercial aircraft, Carpenter's specialty alloys constitute a small portion of the construction cost but have a very high cost of failure. As Carpenter puts it, the company produces materials with "can't-fail applications." For this reason, its business relationships are very sticky and customers are reluctant to switch to unproven suppliers on solely a cost basis. Therefore, we expect that the industry will remain largely limited to existing players, allowing each market participant to generate sustainable economic profit.

Wide moats are hard to come by for commodity processors, as cost advantages tend to be fleeting and other moat sources generally aren't influential enough to stave off product replication for much longer than a 10-year period. Additionally, roughly one third of Carpenter's revenue is derived from the sale of stainless steel, a market that is much more competitive and requires little metallurgical expertise. Stainless steel production weighs on Carpenter's returns on invested capital and partially dilutes the moatiness of the company as a whole. For these reasons, it is unlikely that Carpenter will be able to establish a wide moat in the years to come.

From a quantitative perspective, Carpenter generated an average return on invested capital of 12% over the past decade. This period spans a full business cycle, as returns exceeded 23% before the onset of the global financial crisis but remained below 10% in each of the past three years. In a midcycle environment, we expect the company to generate ROICs just above 12%. Given our assumption that the firm's weighted average cost of capital sits just below 10%, we are confident that Carpenter will be able to generate economic profit by the end of our explicit forecast period.

Revenue Is Cyclical Relative to our broad coverage universe, Carpenter is subject to high revenue cyclicality, as evidenced by the fact that revenue has fluctuated by 10% or more in either direction over 7 of the past 10 years. In our view, the company is also subject to medium operating leverage and medium financial leverage. Per our forecasts, Carpenter is capable of generating a 14% operating margin in a midcycle environment. Although this level of profitability modestly exceeds the company's trailing 10-year average, we believe the company should deliver much improved profitability as improving commercial aircraft build rates drive an upcycle across the broader aerospace industry.

Carpenter exhibits a healthy balance sheet and, although its net debt/EBITDA ratio was 2.0 times at the conclusion of fiscal 2015, it has historically remained below 1.0 times. In 2015, Carpenter's EBITDA covered its interest expense 9.5 times. The company has no maturities until calendar 2018 and appears positioned to work down its total leverage between now and then as capital expenditures associated with its new Alabama facility have come to an end and positive free cash flow has been restored. Carpenter has only modestly underfunded pension and OPEB plans.

In our view, Carpenter's board and management team have generally been shareholder-friendly. Our only concern is that management has occasionally raised capital via equity issuance even though the balance sheet could have supported materially higher debt commitments before leverage ratios became stretched. Although free cash flow has been disappointing in recent years, Carpenter has been profitable every year over the trailing 10 years and we anticipate that the management team will drive material earnings growth through our explicit forecast period.

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