Description

Key Metrics Summary

Recommendation: Long Common Stock

Company: Constellium N.V.

Ticker: CSTM

Price: $11.80

Market Cap: EUR 1.1bn

Enterprise Value: EUR 2.9bn

Daily volume: ~ $11mm

Short Interest: 1%

Price Target: $34

% Gain to Target = 154%

Thesis Summary

CSTM benefits from (1) the secular growth in automotive aluminum usage, due to tightening environmental standards, and (2) capacity constraints at its position in the value chain due to the high costs and long lead times for greenfield capacity and an oligopolistic competitive structure.  This results in a long-term period (5 years +) of double-digit EBITDA growth, with upside optionality over the next few years from pricing increases across all products as capacity utilization increases in the entire system.

• Aluminum flat rolled content per vehicle is expected to increase from 34lbs in ’12 to 170lbs in ’25 according to an often cited industry consulting report (Ducker).  We believe this demand could understate the degree to which aluminum demand could increase.  Increased automotive aluminum demand drives CSTM’s EBITDA from ~375 million euros in ’15 to ~ 580 million euros in ’18.

• The potential for price increases is not well understood by the market, and is not included in our above EBITDA estimates.

Disrupted valuation, relative to (1) CSTM’s historical valuation, (2) peer valuation, relative to growth, and (3) standalone growth prospects, due to (a) temporary missteps in its acquisition of Wise Metals in Q1 ’15 and (b) weakness in its Aerospace segment (~20% of PF EBITDA) that started in 2H14 and (c) Greece related European overhangs combined with a lack of natural investor base given the company is European domiciled but trades in the US.  Given these issues are due to temporary factors, I believe this valuation discount presents an extremely compelling risk/reward and opportune entry point.

• The stock price has declined from ~$32 in mid ‘14 to $11.80 currently (down ~-63%), due largely to these temporary issues and whose financial impact should reverse.

• The company’s relative illiquidity and high leverage (Net Debt/EBITDA = 5x) has led to an exaggerated stock price reaction from these fundamental factors.

The company has strong normalized EBITDA-to-FCF conversion, relative to peers, due to CSTM having (1) a lower structural tax rate and (2) a higher depreciation expense/tax shield created by its asset write-ups of Wise Metals.  Given industry valuations are largely driven by EV/EBITDA, this creates a greater margin of safety for CSTM’s valuation given stronger underlying FCF once capex returns to normalized levels.

Assuming an 8.5x EV/Forward EBITDA exit on 12/31/17 (higher multiple to give credit to continued long-term double digit EBITDA growth runway), and giving CSTM credit for its lower tax rate, I get to a $34 price target or ~50% IRR.

Business Description

CSTM produces rolled, finished aluminum sheet and extrusions.  Finished aluminum is made by (1) inserting primary aluminum/ingot into a hot mill, which rolls the aluminum flat at high temperatures, and (2) taking this hot mill product and rolling it at colder temperatures in a cold mill, creating an even thinner rolled sheet.  This rolled aluminum can be used for can or industrial end markets, or processed even further in a heat treatment facility to create higher quality aluminum for use in automotive and aerospace end markets.

The North American rolled aluminum producer market is an oligopoly, and includes Novelis (45% market share), Alcoa (30%), Constellium/Wise (15%) and Other (10%).

Aluminum is sold to customers in can, automotive and aerospace end markets in typically multi-year (5 to 10 years) contracts, with varying degrees of volume commitments (minimum commitments are common for Aerospace).  Pricing is quoted as a spread to the underlying commodity price (i.e., LME aluminum price), and so CSTM and its rolled-aluminum peers take no aluminum commodity risk (there is some risk in local premiums that represent freight/warehousing costs, but this can be hedged with customer contract pass-throughs). When I refer to “aluminum” in this write-up, I am referring to finished/rolled aluminum, as opposed to the primary material.

CSTM purchased Wise Metals on 1/5/15 (close date), which represented a major strategic push for CSTM into the North American can and automotive aluminum markets.  Pro forma for the acquisition, Constellium’s approximate EBITDA breakout by end-market is packaging (41% of total), aerospace (19%), automotive (11%), transport (14%) and industrial (15%).  The company’s sales breakout by region, PF for Wise, is Europe (61%), North America (30%), Asia (3%) and Other (6%).

Thesis

Secular growth in automotive aluminum usage, due to increasingly stringent environmental regulatory standards

• Aluminum usage in autos is expected to accelerate due to stricter CAFE regulations in the US, and generally stricter regulations internationally that mandate fleet-wide miles-per-gallon (mpg)  targets, that can only be met through implementing a number of changes amongst which making the car lighter/more fuel efficient through increased aluminum usage is a critical component.  There are major components of the car that have yet to be converted from steel to aluminum, in particular the car’s basic frame (called “Body-in-White” (BiW)).

• Aluminum volume used in autos is projected by industry forecasters (e.g., Ducker, a report by the steel industry association, etc.) to increase dramatically over the next ten years. We have conducted calls with senior executives at OEMs who are in charge of meeting these environmental standards, and they agree that automotive aluminum usage will accelerate in the next few years.  These experts confirm that aluminum usage is necessary to meet the standards, and that there are no major potential substitutes that could cost-effectively replace aluminum’s role in light-weighting the vehicle. In addition, due to the long planning cycle around automotive platforms, most of these decisions have already been made and cannot easily be changed.  These experts stated that upcoming auto platforms will see substantially increasing aluminum content.

• The Ford F-150’s success speaks to the ability to use aluminum effectively in cars, without there being any major image problem amongst consumers.  The F-150 also demonstrates how few car conversions (to increased aluminum usage) are needed to support growth: at full production in ’16, the F-150 will use 350k tons of aluminum, compared to total US automotive aluminum demand of only 220k tons in ’14, an increase of 160% on overall demand.

• The cost of failing to meet these standards is extremely onerous for OEMs, as a result they have consistently met environmental regulatory standards over the last few decades.

Capacity constraints in rolled aluminum at current prices, and an oligopolistic competitive structure, should lead to higher rolled aluminum prices in the future.  This is not incorporated in our estimates.

• Despite the anticipated meaningful increase in aluminum demand driven by autos, automotive aluminum capacity is constrained due to the high cost of greenfield capacity that cannot be justified at current auto aluminum prices.  The ramp in auto aluminum demand is instead being met by conversion of existing aluminum can capacity (e.g., can packaging used for carbonated soft drinks and beer) to automotive capacity, which is economic.  However, this conversion is happening at a measured pace given the industry is an oligopoly, and the largest players have committed to only converting capacity to automotive on a contracted basis by end customers.  This conversion is resulting in higher capacity utilization in aluminum can as it reduces capacity in these lower profitability segments leading to higher aluminum can prices, which benefits CSTM.

• At current automotive aluminum prices, the after-tax ROIC for converting existing capacity to automotive is ~23%, compared to ~6% for greenfield capacity.  “Converting” capacity simply means adding a heat treatment facility to an existing plant, and feeding rolled aluminum that previously would have been sold to can customers through this new facility.

• All of the automotive aluminum demand to date has been met from converting existing can capacity

• Assuming all the demand for automotive capacity is met by converting can capacity, North America will run out of this can capacity over the next few years.  This will likely require greenfield capacity additions to meet continued growth in automotive aluminum demand, which should lead to increased prices to induce this higher cost supply.

• Automotive aluminum EBITDA per ton would have to go up to near $1,400 from current levels at around $900 to justify greenfield expansion according to the company.

• Even without increases in automotive aluminum prices, the increased utilization of can capacity due to its conversion to automotive should result in increased pricing for these segments.  CSTM’s EBITDA is ~40% can, PF for the Wise acquisition, and so CSTM will benefit from these can price increases.

• Price increases in automotive and can aluminum are not incorporated into my base case model/price target.

• Aluminum can sheet capacity is held by Novelis (45% market share), Alcoa (30%), Wise (15%) and Other (10%), so the finished aluminum market is a relatively concentrated and rational market

• Alcoa and Novelis have both committed to not convert over can/industrial capacity into automotive, unless they receive firm commitments/contracts from the auto OEMs.

Company valuation is disrupted due to (1) missteps of CSTM’s recent acquisition of Wise Metals and (2) weakness in aerospace aluminum and (3) Greece related European overhangs combined with a lack of natural investor base given the company is European domiciled but trades in the US. Valuation should recover from these levels given these issues should be temporary.

• Valuation is disrupted/cheap relative to history and relative to peers, when taking into consideration CSTM’s greater growth prospects

• CSTM traded at 9.0x EV/Forward EBITDA in mid ’14, before the Wise Metals and aerospace issues began

• CSTM currently trades at 7.2x EV/Forward EBITDA vs its closest peer KALU at 7.8x, despite having much faster EBITDA growth and greater EBITDA-to-FCF conversion.

• EBITDA growth for CSTM is ~15% to 18% over the immediate term, vs KALU at 5%

• CSTM’s tax rate is 30%, vs KALU at 38%.  CSTM also has a higher relative depreciation expense/tax shield than KALU, due to writing up the asset value of Wise Metals

• The appropriate multiple for CSTM on FY ’18 EBITDA is 8.5x EV/ EBITDA, given CSTM will continue to grow faster than KALU even after ’18.  Additionally, CSTM deserves value for its higher FCF-to-EBITDA conversion (once capex reaches normalized levels).

• CSTM’s acquisition of Wise suffered a few setbacks, including (1) a higher working capital balance than originally expected, which led to a higher purchase price (due to the working capital target in the purchase agreement being exceeded), and (2) lower EBITDA than expected in H1 ’15 due to Wise not having properly hedged (through customer contracts) its metal premiums inventory exposure.  Both of these issues are temporary.

• Working capital

• Wise mismanaged working capital, and CSTM believes that it can reverse much of the increase.  Wise’s working capital balance is much larger than CSTM’s working capital, relative to sales/cost of goods, and so improving on Wise’s working capital does not seem like a heroic assumption.

• Our diligence calls with Wise Metals’ ex-managers suggest that Wise simply did not focus on working capital as a non-public company, and that there are real areas for improvement.

• Wise’s metal premiums

• When CSTM or Wise purchase its aluminum raw material as an input, they pay (1) an aluminum commodity price, which is listed on the LME aluminum exchange and (2) a metal premium, which theoretically represents transportation/warehouse storage costs between an LME warehouse and the point of receipt of the metal.

• Metal premiums temporarily increased in ’14, and then declined back to historical levels by mid ‘15.   Metal premiums increased due to warehouses effectively cornering the market (leading to higher warehousing costs), and then reversed this increase once new regulation was put into place that effectively changed these warehouse costs back to historical levels.  As a result, the metal premium increase was temporary.

• Wise did not hedge its inventory exposure to metal premiums, causing EBITDA to be negatively impacted as metal premiums declined to normalized levels in ’15.  Essentially, Wise’s cost of goods was being booked at the higher metal premium cost (as Wise worked its way through 2 months of high cost metal inventory), while Wise’s revenue was booked at the lower metal premium price (as metal premium prices were immediately passed through to customers).  This resulted in a temporary squeeze to Wise’s margins for H1 ’15, but this is only temporary, as margins will return to normalized levels once Wise works through its higher cost inventory.

• Based on our analysis, CSTM’s aerospace issues are largely temporary, and do not reflect any structural issues with CSTM or demand.

• Aerospace issues in mid/late ’14 include:

• Lack of capacity due to underinvestment in the last few years

• Supplier change caused a 15mm EUR reduction to ’15 EBITDA

• A large customer deferred orders from ’15 to ’16, causing a 10mm EUR reduction to ’15 EBITDA

• The reason why these issues are temporary are:

• Lack of capacity

• Management is restructuring the plants with capacity constraints, including (1) changing plant management and (2) investing 40mm EUR in debottlenecking

• Company expects results to show in ‘16

• Supplier change

• Supplier contract that CSTM lost was supposedly favorable to CSTM (relative to a market contract), and so this does not represent a risk that more and more CSTM suppliers come back to renegotiate

• Customer deferral

• The issue is supposedly that the customer has too much inventory, and so impact on ’15 is expected to be 10mm EUR, but expect no impact on ‘16

• Company guidance is that Aerospace’s EBITDA per ton is expected to return to its historical levels in the next few years, after declining in ’15.

• Sell-side estimates for aerospace expect weakness to continue going forwards, and so estimates have already been de-risked

Risks

• Execution risks on completing conversions at Wise on time and on budget

• Execution of turnaround in aerospace

Catalyst

• Execution of EBITDA growth
• Announcements by OEMs of greater aluminum usage on upcoming auto platforms