Specialty Metals, Vertical Business, and Diversity for Your Portfolio

Damian is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.

Back in the 90’s, visiting farms during harvest season was an everyday activity. Dad owned a few Senor B6 models that had many issues with metal parts. Ironically, it remains branded as ‘The Big One by Senor.’ A distinguished characteristic is the complex system of levers and pulleys that give way to a new task and a new breakage. Some were due to design defects, many others a consequence of bad steel.

However, there are three companies that are pushing the envelope in the metal industry in order to make harvesting easier, and frying safe: Allegheny Technologies (NYSE: ATI)Precision Castparts (NYSE: PCP), and Carpenter Technology (NYSE: CRS).

Ride the lightning

To value a company, one must look beyond the stock price. In case of Allegheny, the task is somewhat complicated by its long-term revamping plans, and analysts constantly search for signs. The company has seen its stock price take a beating during the last two years. For the same reason, the stock will be looked upon to show its hidden potential.

First, Allegheny has embarked on a deep reform of its business model. The flat-roll steel model is yet to expire, but the company is moving ahead to higher-margin alloy products. At the same time, the firm has progressively cut costs through an internal initiative. Last, acquisitions and investment on capital have reduced its exposure to foreign markets and to the industry’s cyclicality. The scheme has paid-off since the economic slowdown has not dented its balance sheet or leading market position.

Second, restructuring implies widening its specialty alloys offering, which has seen a rise in demand. Hence, Allegheny has gained an edge over competitors attached to the lower-margin steel business model. The specialty alloys segment accounts for 40% of sales and generates most of the company´s profit. Demand for specialty alloys is expected to increase, as new commercial airliners require stronger and lighter metals for their engines. Also, the defense sector is putting a great emphasis on UAV (unmanned aerial vehicles), additionally increasing the demand for the same product.

Third, Allegheny has completed acquisitions and capital investments in order to meet the increasing demand and assure the necessary backlog to maintain sane finances. Vertical integration has been the guiding vector for acquisition and capital investment. The company's building of a new titanium sponge facility and acquisition of Ladish go in line with this business integration and should help meet incremental demand.

In all, Allegheny is financially sane even with a rising debt-to-cash ratio. Most importantly, the company’s tight restructuring towards specialty metals is already providing incremental earnings. Also, expansion of the aerospace industry will provide new sources of revenue. Trading at 28 times its earnings, it is recommended to buy this firm’s stock before price scales back up.

Master of puppets

In comparison with Allegheny, Precision has been able to steadily climb up the Fortune 500 list. The company’s wide portfolio and global reach make it a unique contender. Since the beginning of time, the firm has focused plenty of efforts on diversifying, and acquisitions gave way to a vertical business model, whose height and width created an economic moat for the corporation.

Size matters, and Precision’s dimensions made it possible to benefit from the rising demand for cars and commercial airliners. In the case of airplanes, the company is generating more revenue per flying plane, because more parts per engine will be provided and at a higher retail price. Moreover, high switching costs for customers make its moat even wider. Some have been clients for over 40 years now, proving client loyalty and stickiness. Hence, it is expected for revenue to sustain current levels even if no new planes roll out of the factory.

The company made eight acquisitions during 2012, and all helped to further develop and integrate the vertical business model. This scheme has helped sustain revenue growth, and a 10-year rising operating margin and earnings per share. Such characteristics have shielded the firm from cyclical effects, evidencing the existence of an economic moat and financial strength.

Currently trading at 22 times its earnings, slightly above the industry average valuation, and given the expected dividends and potential for growth, added to a cyclical shield and economic moat, it is recommended as a buy.

Diversification counts

If Allegheny made a difference through specialty alloys, Carpenter is the one who lost on the bargain. But, the company’s strength lies elsewhere: diversity. Its business is spread across the globe, with foreign markets, especially Europe, contributing almost half of its revenue. Holding leading market shares in various segments, this company deserves a closer look.

No new structure has been developed. Carpenter has, however, turned its attention to higher-margins and specialty metals. Latrobe and Amega West’s acquisitions, along with the building of a new metal facility in Huntsville, Alabama, are evidence of the attention the firm is giving to the segment. Latrobe is an important landing gear provider, while Amega’s importance is related to drilling and oil extraction. Nevertheless, both require specialty metals that will be provided in part by the new facilities.

Carpenter’s attention to specialty metals corresponds with the increasing revenue share they represent. Faced with growing competition, management chose to raise the bet through acquisitions. The added business were skilfully selected to contribute to the firm’s vertical structure. So, a slight cash reduction should not be alarming.

Having felt the competition’s strength, Carpenter responded with acquisitions. There is no new business model here; acquisitions mean the company will catch a bigger share of the aerospace and oil industries’ expansion. Stock price remains reasonable at 17 times its earnings, but I would still recommend holding until the cycle restarts after the summer.

Bottom line

Any investor looking to buy stock of a metal company should better buy into a firm with a particular talent. Metal-roll producers do not make the cut. Companies that strive to have the technological edge will be rewarded with more clients.

The argument is simple, demand is changing and suppliers have to adapt. Carpenter has taken more time to adapt and revenue suffered, while Allegheny runs ahead of time and positive results have come its way. Precision, however, has already established itself in the market and is less exposed to market swings. So, I recommend buying Precision stock if money is not an issue; otherwise, satisfy your appetite with Allegheny.

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Damian Illia has no position in any stocks mentioned. The Motley Fool recommends Precision Castparts. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. Is this post wrong? Click here. Think you can do better? Join us and write your own!

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