Universal Stainless: Aerospace Market Growth Remains Strong

seekingalpha09-12

Universal Stainless has seen a 400% share price increase since December 2023, mainly driven by strong aerospace market growth.USAP's backlog has declined 16% YoY, potentially indicating future sales ...

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(NASDAQ:USAP) has experienced a 400% increase in its share price since December last year, mainly driven by strong growth in its aerospace market. In this article, I will deep dive into the recent performance of the company, with an emphasis on the current headwinds that they are facing, including a decline in sales in non-aerospace markets and a backlog decline over the past few quarters. In the Outlook section, I will provide the rationale behind my Buy rating, including a brief overview of their financials and demand in the aerospace market. For now, I will begin with a company overview section for those readers new to this stock. Company Overview USAP is a US-based manufacturer of stainless steel, nickel alloys, tool steel, and other alloyed steels. They also offer conversion services, where they process materials supplied by their customers, although this is a small part of their business. They operate in one business segment and they categorize revenue according to product lines and sales channels. I considered including a table below to show the breakdown of their revenue using figures from their latest 10-K.   Year Specialty Alloys Premium Alloys Conversion Services & Others   2023 ($ million) 213.08 68.10 4.76   2022 ($ million) 160.35 39.23 2.54   Click to enlarge Also, I've considered including a breakdown of their revenue per market to understand which market contributes the most to their revenue.   Year Aerospace Power Generation Oil & Gas Heavy Equipment General Industrial & Others   2023 ($ million) 216.09 4.21 13.98 31.21 20.45   2022 ($ million) 137.49 6.12 17.98 27.14 13.39   Click to enlarge In my view, management has a good stake in the company, with an aggregate ownership of common stock of 9.9% across all 10 directors and executive officers. The chairman of the board, Dennis Oates, owns 2.7% which, I believe, is a decent amount of skin in the game. Other significant positions include Udi Toledano (director) with 1.4% and Christopher Zimmer (CEO) with 1.7%. Strong Performance In Q2, But There Are Some Headwinds To Consider As always, I like to start with the headwinds and pressures that the company is currently facing.  One of the biggest challenges I see is a decline in backlog, which fell to $297 million by the end of Q2 2024 from $355 million in Q2 2023. I am sweating about this decline because the backlog tends to be a good indicator of future sales and production for a manufacturing company. One of the factors that contributed to this decline was a more efficient production lead time for premium alloys, which decreased to 45-50 weeks from 70-80 weeks last year. Cutting lead times is a good sign of production efficiency for a manufacturing company, but if there are few to no new orders in the backlog, there is a risk that the company could run out of orders if the demand doesn't increase, or at least stabilize. This leads us to the next challenge: softer demand in non-aerospace markets. As mentioned in the section above, aerospace is the key driver for revenue growth for USAP. In Q2 alone, 83% of the total revenue came from the aerospace market. However, I believe that this creates a high dependency on this sector, which is good when demand in aerospace is high, but when this demand drops, the lack of revenue diversification could significantly impact the growth of the company. Sales in the energy market fell by 15% quarter-over-quarter, totaling $5.1 million in Q2 2024. The capacity shift toward aerospace production limited growth in the energy markets. Additionally, the general industrial market, which includes semiconductor manufacturing, also experienced a decline in sales by 22% QoQ. A similar situation happened in the heavy equipment market, with sales falling by 11% QoQ. However, in this last case, the key driver for the decline was customer hesitation in building up their inventories due to uncertainty over demand for EVs and Hybrids. If you haven't read my article on Hertz, you can find it here. There, I explain in more detail the plans of the company to sell more than 30,000 EVs during this year. Needless to say, I am not convinced by EVs in the short to midterm as depreciation costs are very high, so I am not surprised by the revenue decline in the heavy equipment market. Another headwind comes from production bottlenecks in premium alloy production, specifically in the vacuum induction melting (VIM) process. Although USAP ramped up melt production in Q2, VIM remains a bottleneck, particularly for small products that are labor-intensive to produce. In this case, I’m not overly concerned about this bottleneck since lead times have improved compared to last year (from 70-80 weeks in 2023 to 45-50 weeks in 2024), and the backlog experienced a significant decline in the meantime. The faster it depletes, the sooner the company reaches a point where revenue may dry up, so I am not worried about a slowdown in lead times. Finally, I see a significant amount of cash tied up in inventories. Actually, total inventories increased to $149 million from $142.4 million in Q1 2024. Management expressed their goals to reduce inventory levels back to Q1 levels by the end of Q3, but I believe that any failure to achieve this could negatively impact cashflows. Outlook A quick look at the weekly chart below shows the cyclical nature of this business.   TradingView Since December 2023, the share price increased by over 400%, which was mainly driven by the high demand in the aerospace market. Additionally, in the last month, there has been a small pullback (17% decline) which I believe could be an interesting opportunity to start a long position in this stock. Let me explain why I think this is the case, and also why I haven't bought any shares yet. First, I believe that there are no clear signs of a major slowdown in demand in the aerospace market. Yes, the backlog has been decreasing significantly, however, I believe this is due to the decrease in lead times and the decline in other markets due to the prioritization of aerospace premium alloys. However, I have to admit that the growth rate of sales in the aerospace market of 34% YoY might not be sustainable over time, and I believe it could fluctuate in the next quarters. However, I do not foresee any decline in revenue growth for the moment. Simply, the demand for new fuel-efficient aircraft is way too high from the two main aircraft manufacturers, Boeing and Airbus. Also, I am not concerned about delays in the 737 MAX program, as they haven't led to order cancelations for USAP's products. Additionally, a quick look at their income statement shows that operating income, EBITDA, and net income have been increasing consistently over the past year.   TradingView In regards to their balance sheet, I like the fact that total debt has been decreasing since Q1 2023, while current assets have been quite stable.   TradingView Free cash flows have also been positive over the past year, even though they decreased in Q2 2024 due to the build-up in inventory levels that I discussed in the previous section. For these reasons, I believe that, despite the heavy reliance on the aerospace sector, USAP's share price could continue to rise, potentially reaching the $50 price level, which, I believe, could be a resistance level considering the peaks from 2007 and 2011. If you are wondering why I haven't bought any shares yet is due to the low cash position that I currently have in my portfolio, and also due to the lack of insider buying activity this year. If I see insiders buying, especially during this pullback, I will reconsider closing some of my current positions to free up some cash to start a long position in USAP. Conclusion To conclude, I believe that the strong growth in the aerospace sector could continue in the following quarters, as there are no clear indications to suggest otherwise. However, there are some risks and challenges that the company is currently facing that could break my bull thesis. One of them is the over-reliance on the aerospace sector, which has driven down sales in the other markets. Also, the backlog decline, which is mostly attributed to lower lead times, could be something to keep an eye on in the next earnings release, as a further decline without an improvement in lead times could indicate that orders are slowing down.  Despite these headwinds, I believe the consistent revenue growth, positive cash flows, and decreasing debt back up the increase in the share price since December 2023. Therefore, I maintain a Buy rating for this stock, and I will keep an eye on insider buying transactions during this pullback.","kind":null,"is_publish_news":true,"is_publish_highlight":false,"is_publish_live":false,"is_publish_wemedia":null,"editions":null,"column":"","sentiment":"0","news_tag":"analysis","news_rank":0,"symbols":[],"gpt_button":1},"commentList":[],"isCommentEnd":true,"newsSizeData":{"likeSize":0,"commentSize":0,"repostSize":0,"favoriteSize":0,"likeStatus":false,"favoriteStatus":false},"APP":{"userAgent":"Mozilla/5.0 AppleWebKit/537.36 (KHTML, like Gecko; compatible; ClaudeBot/1.0; +claudebot@anthropic.com)","isDev":false,"isTTM":true,"deviceId":"web-server-community-laohu8-v3","version":"4.26.4","shortVersion":"4.26.4","platform":"web","vendor":"web","appName":"ttm","isIOS":false,"isAndroid":false,"isTiger":false,"isTHS":false,"isWeiXin":false,"isWeiXinMini":false,"isWeiBo":false,"isQQ":false,"isBaiduSwan":false,"isBaiduBox":false,"isDingTalk":false,"isToutiao":false,"isOnePlus":false,"isHuaWei":false,"isXiaomi":false,"isXiaomiWebView":false,"isOppo":false,"isVivo":false,"isSamsung":false,"isMobile":false},"href":"/m/news/2466270090"}