The Allegheny Technologies (NYSE:ATI) that existed three years ago was bloated with debt, overly dependent on low-efficiency commodity-driven business, and not taking full advantage of the opportunities within its industry or the expertise on its payroll. The Allegheny Technologies that exists today is none of those things -- and all for the better.
Now three years deep into its turnaround, the specialty metals company has rediscovered an innovative ethos and started to deliver value to shareholders once again. The valuable niche held by Allegheny Technologies within the aerospace and defense industries and the specific catalysts on the horizon suggest that the best is yet to come for the business and why it's the one stock I'd buy right now.
An avalanche of catalysts in the next year
Allegheny Technologies designs, engineers, and manufactures high-performance specialty metal alloys for a wide range of applications. It reports two business segments: high performance materials and components (HPMC) and flat rolled products (FRP).
In the first half of 2018 over 80% of HPMC revenue was derived from high-margin aerospace and defense product sales, with another 8% sourced from medical applications. That helped the segment contribute $183 million, or 83%, of the company's total operating profit in the first six months of the year. However, the ramp-up of a new joint venture will add a considerable amount of high-margin, next-generation product sales to the FRP product mix, too. The JV is expected to boost full-year 2019 operating profit by at least $20 million.
The strength of operations is being driven by several sources of momentum:
- Next-generation engine sales: As fellow The Motley Fool contributor Lou Whiteman recently described, Allegheny Technologies is taking full advantage of its role as leading supplier of the next-generation LEAP engine -- even outperforming its own contracts. The company expects next-generation engine products to comprise nearly 100% of total jet engine sales by 2020.
- High-margin stainless steel JV: The FRP segment will soon get a boost from a new 50-50 joint venture between Allegheny Technologies, contributing next-generation process know-how, and Tsingshan, the world's largest stainless steel producer. The JV is expected to add $20 million to $35 million in operating profit and $30 million in cash flow generation per year.
- New CEO in 2019: Allegheny Technologies announced that Robert Wetherbee will become president and CEO on the first day of next year. He was recruited in 2014 to lead the (now successful) turnaround of the FRP segment.
- Continued investment in metal 3D printing: Allegheny Technologies is a leader in manufacturing powder metal products for use in additive manufacturing. In July it announced the acquisition of Addaero -- a start-up leveraging metal 3D printing to design and build high-precision components for aerospace and defense customers -- to bolster its position in the new industry.
Despite the swift progress, Allegheny Technologies stock is still well below the heights it fell from in 2014. Shares have also lagged the total return of the S&P 500 in the last three years with a gain of 54%, compared with 64% for the index. Why the gap?
Well, analysts aren't entirely wrong to tread carefully. The specialty metals manufacturer dug a big hole for itself years ago, and today Allegheny Technologies is still chasing an investment-grade credit rating. But reduced capital spending and improved profitability are expected to deliver at least $150 million in free cash flow in 2018 -- a swing of $409 million from 2014.
There's also ongoing uncertainty related to the implementation of tariffs. While the company's FRP segment delivered strong year-over-year growth in the first half of the year even with increased trade uncertainty, management expects trade restrictions to hamper the business from reaching optimal performance. Allegheny Technologies is awaiting a decision, expected to be handed down in the third quarter of 2018, on exclusion requests for products purchased by its stainless steel JV and elsewhere in its FRP segment. The issue is the purchase of cast slabs of steel from a Tsingshan facility in Indonesia, which are then processed and finished at a facility outside of Pittsburgh. The facility was formerly idled in 2016 and is now the only one of its kind in North America.
Here's the thing: Allegheny Technologies has already stated that its long-term goal includes positioning its FRP segment to be profitable "regardless of raw materials volatility or trade policy." The new JV may find it difficult to execute its business model with tariffs in place, but that alone wouldn't jeopardize the company's future. After all, the JV hasn't begun contributing its full amount of operating profit yet, and only 17% of operating profit in the first half of 2018 came from the FRP segment as a whole.
Plus, considering the new CEO has hands-on experience with the FRP segment, he'd be perhaps the perfect individual to navigate any prolonged uncertainty in that area of the business. In a worst-case scenario, Allegheny Technologies may have to shift more capital to its HPMC segment, but those markets have above-average growth prospects in aerospace and, perhaps a little further away, along the technology vertical of metal 3D printing. In other words, the largest source of uncertainty facing the business is relatively insignificant in the grand scheme of things. Wall Street certainly hasn't knocked the stock because of it.
There's more in the tank for Allegheny Technologies stock
By now I think investors can consider the turnaround of Allegheny Technologies a success. Offloading unprofitable businesses and reducing capital expenditures to focus on only the products with the highest margins (new alloys in HPMC, innovative steels in FRP) or best growth potential (metal 3D printing processes) have positioned the company to exploit upcoming opportunities in core markets. The newly strong cash flow should also help the business to earn an investment-grade rating in the near future.
Considering the stock performance is lagging the business performance -- the stock is trading at less than 0.9 times sales and just 12 times forward earnings -- and that the incoming CEO led a key part of the turnaround, there's a lot for long-term investors to look forward to in the next five or 10 years. That's why Allegheny Technologies stock is one I'd buy right now.