business

Carpenter Technology: Sturdy Steel Stock

S&P likes the specialty metals outfit's solid growth prospects and attractive valuation, and ranks the shares strong buy

Based on our view of Carpenter Technology's (CRS; recent price, $48) solid long-term earnings growth prospects, low debt levels, and sizable free-cash-flow generation, we believe the stock is undervalued compared with most of the metals companies we follow, and we think it has compelling capital appreciation potential.

We believe the company's sales of specialty metals to the aerospace and energy markets will boost its long-term growth. In our view, these two markets are in a secular uptrend and we think increased demand from these industries will benefit Carpenter's long-term sales and earnings per share (EPS).

The stock carries Standard & Poor's highest investment recommendation of 5 STARS, or strong buy.

COMPANY PROFILE

Based in Reading, Pa., Carpenter Technology produces a wide variety of specialty steel, high-performance alloys, and other metal products that improve performance and safety in cars, airplanes, and bicycles; are used in steel implants for medical rehabilitation; and become part of gas turbine units and nuclear reactors. Carpenter products can be found in automobile airbag switches and antilock brakes, airplane landing gear and engine blades, golf clubs and boat shafting, home thermostats and popcorn poppers, and medical tools and pacemakers.

Products are processed from raw materials such as chromium, nickel, titanium, iron scrap, and other metal alloying elements at plants in Pennsylvania, California, and South Carolina. They are divided into five categories, with stainless steel accounting for 36% of sales in fiscal 2007; special alloys, 46%; tool and other steel, 3%; ceramics and other materials, 5%; and titanium products, 10%.

Sales by end market in fiscal 2007 were: aerospace, 37%; industrial, 23%; consumer, 11%; automotive, 12%; medical products, 7%; and energy, 10%.

Stainless steels include a broad range of corrosion-resistant alloys, including conventional stainless steels and many proprietary grades for special applications.

Special purpose alloys are used in critical components such as bearings and fasteners. This product line includes heat resistant alloys that range from slight modifications of the stainless steels to complex nickel and cobalt base alloys; alloys for electronic, magnetic, and electrical applications with controlled thermal expansion characteristics, or high electrical resistivity or special magnetic characteristics; and fabrication of special stainless steels and zirconium base alloys into tubular products for the aircraft industry and nuclear reactors.

Tool and die steels are extremely hard metal alloys, used for tooling and other wear-resisting components in metalworking operations such as stamping, extrusion, and machining. Other steels include carbon and alloy steels purchased for distribution and other miscellaneous products.

Ceramics and other materials include certain engineered products, including ceramic cores for investment castings ranging from small simple configurations to large complex shapes and structural ceramic components, precision welded tubular products, as well as drawn solid tubular shapes. The ceramics unit was sold in March, 2008, for $144.5 million.

Titanium is a corrosion-resistant, highly specialized metal with a combination of high strength and low density. Most common uses are in aircraft, medical devices, sporting equipment, and chemical and petroleum processing. Foreign sales accounted for 30% of the total in fiscal 2007.

Carpenter estimates there are about 10 domestic companies producing one or more similar products that it views as major competitors to its sales in one or more end-use markets. The company also believes there are several dozen smaller domestic producing and converting companies that compete against it in specialty metals. Carpenter's distribution network competes directly with several hundred independent distributors of similar products. Finally, numerous foreign producers export into the U.S. various specialty metal products similar to those produced by Carpenter.

COMPANY AND INDUSTRY OUTLOOK

Based on our expectations for a rebound in demand from aerospace, continued increases in demand from the energy market, and stable sales in the company's other four segments, we look for a 4.7% sales gain in fiscal 2009.

Given the S&P forecast for gross domestic product growth of 1.3% in calendar 2009, even with the 1.3% GDP growth projected for calendar 2008, we estimate sales in the company's auto, industrial, consumer, and medical products segments will come close to fiscal 2008's projected levels.

Excluding the impact of surcharges, revenues in the aerospace segment decreased 1% through the first three quarters of fiscal 2008 due to a decline in demand for fasteners and reduced shipments to a customer that is increasing its internal production of aerospace products. Also, it appears to us that delays in production of the Boeing 787 airplane and the Airbus A380 airplane may have hurt volume. Assuming there are no further delays in aircraft deliveries, we look for a rebound in aerospace sales in fiscal 2009. Beyond fiscal 2009, aircraft deliveries should rise through calendar 2010, according to the Airline Monitor Forecast. In our view, this should keep demand buoyant for such products as titanium coil used to make fasteners.

Following a substantial gain forecasted for fiscal 2008 energy segment sales, we look for another large increase in fiscal 2009. In our opinion, growing demand from the oil and gas industry will continue to lift the call for the company's high-strength and corrosion-resistant products in both the near and long term.

We look for margin improvement and increased operating income, reflecting our expectation for higher aerospace volume and less rapidly rising costs for raw materials. We project EPS of $5.13 in fiscal 2009, vs. estimated EPS of $4.39 for fiscal 2008, as results further benefit from lower interest expense and a flat tax rate.

Predicated on our forecast for higher net income, unchanged depreciation, and capital spending of $125 million vs. capital spending of $125 million in fiscal 2008, we project Carpenter will generate free cash flow per share of $2.65 in fiscal 2009, vs. our estimate of free cash flow per share of $1.79 for fiscal 2008.

In our view, Carpenter's free-cash-flow generation will enable it to grow via acquisitions and plant upgrades, and we also think the company will be able to repurchase shares and increase the dividend. From fiscal 2005 through the first nine months of fiscal 2008, the company increased the annual dividend from 26¢ a share to 72¢ a share and spent $279.7 million to repurchase over four million shares of its common stock. For the same period, it increased capital spending from $13.8 million, to $72.7 million, to upgrade its finishing plants and expand its premium melt capacity.

VALUATION

With the shares recently trading at 9.4 times our fiscal 2009 estimate and 2.3 times our cash and marketable securities per share projection of $20.71 at June 30, 2009, we think Carpenter is attractively valued on both an absolute and a relative basis. For example, most of the carbon steel companies we follow currently trade at price-earnings multiples of 12 times and higher vs. a p-e of under 10 times for Carpenter, despite what we see as the company's stronger balance sheet and greater free-cash-flow generation compared to these peers.

Our 12-month target price of $78 reflects our view that Carpenter should trade at a p-e of 15.2 times our fiscal 2009 estimate, just below the midpoint of its historical range of the last 10 years and at a premium to its two main peers, Allegheny Technologies (ATI) and Titanium Metals (TIE), and 3.8 times our estimate for cash and marketable securities per share at June 30, 2009. In our view, Carpenter's stock warrants a premium p-e given its superior free-cash-flow generation, greater dividend growth, and relatively stable earnings vs. its main peers.

Compared with its main peers, the company's products are less commodity price-sensitive, by our analysis. Consequently, its sales and EPS tend to be less volatile. We believe a company with less volatile and more consistent EPS should command a higher p-e. Based on a ratio of stock price to tangible book value, Carpenter currently trades at 2.5 times its fiscal 2007 yearend tangible book value, at a discount to its main peers.

CORPORATE GOVERNANCE

On balance, we have a neutral view of Carpenter's corporate governance practices. We view favorably that over 75% of the board of directors is independent of the company, that the nominating and compensation committees are composed solely of outside directors, and that there are no former company chief executive officers on the board. Other positive factors include the absence of a poison pill, the establishment of a board-approved CEO succession plan, and the fact that the company has only one class of stock.

Several negative factors, in our view, include the fact that the board is classified, the combined positions of chairman and CEO, that shareholders do not have cumulative voting rights in director elections, that directors can change the size of the board and amend the bylaws without shareholder approval, and that shareholders can not call special meetings.

INVESTMENT RISKS

Risks to our recommendation and target price include the possibility that further unanticipated delays in aircraft deliveries may occur in fiscal 2009, preventing a recovery in aerospace demand. Another risk is that GDP growth in calendar 2009 could fail to match forecasted GDP growth in calendar 2008.

With our estimate for higher EPS in fiscal 2009 resting on our expectation for higher sales in aerospace and essentially flat sales in the auto, consumer, industrial, and medical segments, the absence of a recovery in aerospace and lower-than-expected GDP growth could result in flat-to-lower EPS in fiscal 2009 instead of the higher EPS we forecast. Flat-to-lower EPS would adversely affect our valuation analysis.

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