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A Deep Discount on This Narrow-Moat Metals Stock

Andrew Lane

Andrew Lane: For Carpenter Technology (CRS), we think concern about the impact of low oil prices provides an attractive entry point to a compelling secular-growth story. Carpenter is a manufacturer of specialty metals with considerable exposure to the commercial aerospace end market. Its portfolio of high-value alloys, stainless steels, and titanium products provides the benefits of lightweighting and strength as well as resistance to heat and corrosion.

As the composition of the commercial-aircraft fleet moves toward a higher proportion of very large, next-generation models, the average shipset content of Carpenter's high-value materials will increase. This should allow the company's sales growth to far outpace the 3% to 4% annual commercial-aircraft delivery growth that we forecast through the end of the decade. Due to a more favorable product mix and the benefits of operating leverage as production volumes rise, we expect operating margins to expand from 8% to roughly 14% in a midcycle environment.

We ascribe a narrow economic moat rating to Carpenter Technology due to the presence of intangible assets and switching costs. Given the highly specialized nature of its product lines, Carpenter engages in lengthy qualification cycles with the customers and end users of its products. When these qualifications are achieved, they effectively establish intangible assets and typically lead to profitable long-term supply agreements.

Switching costs stem from the fact that, although Carpenter's specialty metals account for a very small proportion of the total cost of manufacturing a commercial aircraft or constructing an oil rig, they have a very high cost of failure or, in other words, have "can't-fail applications." Because of this dynamic, customers are generally unwilling to switch suppliers on the basis of cost alone.

Although low oil prices will continue to weigh on shipment volumes to customers in the energy end market, we think cheap fuel prices are unlikely to disrupt commercial-aircraft delivery rates. This is the primary basis upon which our outlook diverges from the expectations baked into share prices, as the stock is currently trading at a 30% discount to our $55 per share fair value estimate. We added Carpenter Technology to the Morningstar Best Ideas list at the beginning of July, and we see considerable upside from here for Carpenter shares.