Description

Recommending Constellium (CSTM $6.45)

5/16/2017

Quick Summary

Constellium, an aluminum manufacturer, has been written up twice on VIC, and each time has declined substantially post write-up. This is a name that IPO’d in 2013 with inflated expectations, and followed up in late 2014 with an egregiously overpriced acquisition financed with debt. The post IPO management team has been replaced, and the stock offers inexpensive exposure to four relatively attractive aluminum manufacturing lines – packaging sheet, automotive sheet, automotive structures, and aerospace sheet. The key risks are leverage and exposure to auto cyclicality. Leveraged at slightly over five times EBITDA, a pronounced auto downturn could have an outsized impact on the stock. However the company would likely earn through a more garden variety low single decline in auto units, as industry unit declines would likely be offset by growing aluminum content on certain cars, supplied by the company’s new auto sheet lines which are currently ramping production.

More detailed review of history

In the months following its 2013 IPO by Apollo group, Constellium’s EBITDA forecasts fell substantially. This was partly a function of too optimistic expectation, and partly the result of operational setbacks. As of early 2014 street consensus saw Constellium’s EBITDA ramping from 300 mil EURO in 2014 to 465 mil Euro in 2016. The ramp reflected a fairly optimistic outlook for sales growth, as well as expectations of substantial margin expansion as higher margin automotive sheet and structures increased as a percent of overall product mix. In late 2014 the company had a furnace failure at its Ravenswood, West Virginia plant, requiring a $35 million installation of a replacement furnace, and forcing the company to source materials during the rebuild at higher costs. In addition, the overall pace of aerospace deliveries slowed moderately. In addition, the mix shift which investors had expected to boost margins went slower than hoped.

In addition, in 2015 the company acquired Wise Metals for $1.4 billion US dollar, roughly 17x Wise’s 2015 EBITDA, well above the original deal price expectations. Wise’s earlier year EBITDA had been inflated by the pass through of metal prices, a fact management failed to account for.  The company had planned an equity offering to follow the acquisition, but a precipitous fall in the stock price made that option less palatable. As a result the acquisition was financed entirely with debt, resulting in the high current leverage of 5.3x EBITDA, and forcing the company to substantially curtail its earlier capital expansion program.

In response to these missteps, in July of 2016 the company hired Jean-Marc Germain as CEO, and Mr. Germain subsequently hired Peter Matt as CFO. Mr. Germain comes out of the aluminum industry, with past experience at Pechiney, Alcan, and Novelis, while Mr. Matt comes from investment banking with a focus on the metals industry. In addition, new divisional heads were appointed to the packaging and aerospace segments with solid industry experience. There appears to be far more urgency to set realistic operating goals, reduce leverage, and maximize investment ROIs.  

Constellium’s current goal is to reach 500 miillion Euro EBITDA by 2020, inclusive of roughly 100 million Euro from the acquisition of Wise Metals (ie, roughly what post IPO investors had hoped for in 2015). The current target appears conservative and achievable – it is predicated on high single digit annual EBITDA growth off the current EBITDA base of roughly 400 million Euro.

The company has also significantly improved the Wise operations, achieving $26 million in cost reductions as of year-end 2016, putting Wise EBITDA in the mid to high 80 million Euro range, or mid to high $90 million range US.

The rationale for Wise was that it would provide a foundation for investments in lightweight automotive sheet at costs substantially below a greenfield operation. That logic still appears to hold, as the cost of a competitive facility is likely north of $1 billion, several times the cost of adding a second line at Wise. That said, management has backed off committing to substantial future capital expenditures until it has pre-booked significant automotive orders. This again is a more conservative approach than that of prior Constellium management, who had more of a ‘build it and they will come’ strategy.

Related to this, Braidy Industries has announced a plan to begin construction on a one billion dollar light-weight aluminum project in 2018. The earliest this project could plausibly supply at scale to commercial customers is 2020, at which point it would presumably have to scale up its commercial relationships taking several more years to reach profitability. It is not clear if committed financing exists for this project and it is difficult to see how the economics could make sense given the incumbent lead and brownfield cost advantage. New entrants, as well as incumbent expansion, are longer term risks that bear monitoring, but for the moment the industry supply / demand balance appears stable and incumbents appear disciplined on expansion.

I think there are a number of positives for Constellium which support a buy recommendation:

1)      The high cost of greenfield development in aluminum is a barrier to entry. Constellium estimates total company replacement plant cost of ten billion, versus the company’s current enterprise value of just under $3 billion US. In the higher growth businesses, new capacity may be added in future years, but the three existing players, Constellium, Arconic, and Novelis have a significant head start.

2)      Constellium’s current EBITDA run rate of $400 million Euro contains roughly 20 million Euro of EBITDA losses related to the ramp up of the continuous annealing lines (CALPs) in the Bowling Green, KY factory (50% JV with UACJ) and Neuf-Brisach France factory. At full capacity in 2019 those plants will add 165k tons of capacity from France and 100k from Kentucky (50k tons for CSTM’s 50% share). That represents more than 200k tons at an estimated EBITDA margin per ton of $500, for total incremental EBITDA of roughly $100 million, or $120 million above current start up losses. In addition, Wise will provide substrate to the Bowling Green JV at roughly $350/ton EBITDA, adding an additional $35 million in potential profit, taking total incremental profit above $150 million. Even assuming those pricing assumptions prove optimistic, the incremental profit should exceed $100 million, providing excellent visibility on EBITDA rising above $500 million Euro after 2019 (25% growth), even without any organic growth in the core businesses.

3)      Limited cyclicality - the company’s aerospace and auto contracts have long lead times and long term visibility. These contracts also involve customized work, raising competitive barriers. The company’s packaging business faces limited competition and demand tends to be largely non-cyclical.

4)      Although the company is in the last eighteen months of a significant capital expenditure effort, the business at its core is cash generative. Fixed costs (in Euro) include roughly $150 million of maintenance capital, $160 million of annual interest, and $20 million of taxes, for total annual fixed costs of roughly $330 million. Those fixed costs should not change materially over the next few years, as the company has significant tax shields from high depreciation, and as debt should not rise materially with the company inflecting to positive free cash flow in about one year (second half 2018). Excluding growth cap ex, the company is on track to generate free cash flow of roughly $70 million this year. This should rise to more than $150 million over the next three years, as EBITDA grows to $500 million, driven by the aforementioned growth projects. That implies a free cash flow yield of more than twenty percent looking out a few years.

5)      CSTM is cheaper than peers, despite a comparable or better growth outlook over the next few years. Constellium trades at just under 7x times estimated 2017 EBITDA, versus Arconic at 10x and Kaiser at 8x.

Valuation/Price Target

I estimate 2019 free cash flow per share for Constellium at US $1/share, based on (in mil Euro) EBITDA of $470, maintenance capital of $170, cash interest of $165, and cash taxes of $41, netting to $100 million free Euro, $110 million US (assuming 1.1 exchange rate), or $1/share US assuming 110 shares OS at YE 2019. At a target 12x free cash flow multiple that implies a two year target value of $12 per share, more than 80% above the current share price.  

In reality, the company will likely spend additional funds on growth capital, but one of the appealing aspects of the story is the company has attractive opportunities for capital deployment. Importantly, the company has now said repeatedly it will not invest in a new body in white automotive line until it has firm commitments for a substantial portion of production – a more conservative stance than prior management, who had more of a ‘build it and they will come’ mentality.

Quick notes on operating segments: Constellium’s key end markets are packaging (aluminum cans), aerospace, auto aluminum sheet, and extrusion molds for automotive. Packaging is mature but relatively non-cyclical, and has modest growth in Europe, driven by a move towards aluminum from glass for beer. The same trend is afoot in the US, but on a smaller scale. Aerospace involves multi year contracts with good long term visibility. Auto also has longish contracts, and is in a growth phase as manufacturers reduce vehicle weights. That transition could support unit growth even as total industry units decline. Clearly the last point depends on how much industry units fall, but mid-single digit unit declines likely would be absorbed by increasing representation on the vehicle.

Constellium’s segment breakdown at present is: Packaging/Automotive Rolled (52% revenue, 53% EBITDA), Aerospace/Transportation (27% revenues, 27% EBITDA), Automotive Structures & Industry (21% revenues, 27% EBITDA), all before corporate EBITDA costs.

For a more detailed overview of the business lines, the company published an extensive slide deck to accompany its March, 2017 analyst day. The webcast is also available at the company website.

Risks

Overbuilding by incumbents

Net entrants after 2020

Automotive SAAR

Aerospace pushouts

Catalyst

Inflection to free cash flow positive in one year, deleveraging, more consistent performance against management targets.