Description

Investment Thesis

Despite recent appreciation and a price near a 52-week high, Kaiser Aluminum (“Kaiser”) remains an attractive stock and under-followed situation. The aerospace heat treat plate and automotive extrusion markets exhibit solid growth trajectories, yet the shares trade at a multiple more reminiscent of peak earnings.

At current prices, Kaiser trades at 6.7x and 8.9x 2013E EBIT and EPS, net of excess cash and NOLs. Using a more reasonable 10x EBIT multiple or 13-14x EPS, the shares are worth ~40%+ above current levels.

Company Overview

In a former life, Kaiser was involved in all aspects (upstream and downstream) of the aluminum industry as a fully integrated player. In 2002, as a result of the economic downturn and legacy liabilities (pension, OPEB and asbestos), the company filed for bankruptcy. Upon emergence, legacy liabilities were largely jettisoned and Kaiser became a more focused producer of semi-fabricated specialty aluminum products. Through 11 facilities in the US and one in Canada, Kaiser manufactures highly-engineered rolled, extruded and drawn aluminum products for use in aerospace and high strength products, automotive applications, general engineering (“GE”) and other industrial end markets.

The crown jewel is the aerospace and heat treat plate segment which accounts for 37% of shipments (ytd), but 60% of value-added revenue (i.e. net sales less hedged cost of alloyed metal). These products consist of heat treat plate and sheet, as well as cold finish bar, seamless drawn tube, hard alloy extrusions and billet which are manufactured to demanding specifications. These applications require high tensile strength, fatigue resistance and durability due to extreme variations in temperature and altitude.

The other businesses consist of GE products (41% volumes / 27% valued-added revenue), automotive extrusions (11% / 8%) and other (12% / 5%). GE products have a wide range of applications including transportation and other industrial end markets whereas automotive extrusions are used for bumpers, anti-lock braking systems, vacuum chambers, tooling plate and drive shafts, among other things. Other products are used in industrial applications, including consumer durables, electrical/electronic, machinery and equipment, and light and heavy truck applications.

To produce semi-fabricated products, Kaiser procures primary aluminum ingot typically based on the Average Midwest Transaction Price and scrap aluminum at a discount. Changes in price are passed through to customers when contracts are based on spot or index pricing. For firm price contracts (28% of shipments), the company hedges metal prices with financial derivatives as the goal is to be metal neutral. The focus is on conversion margin.

Competitors in global heat treated flat-rolled products include Alcoa, Alcan, Aleris and Constellium, and in extrusions SAPA, Norsk Hydro and Alcoa, among others. There is customer concentration as the five largest customers account for 42% of net sales.

Over the past five years, the company has invested $400 MM in organic growth opportunities with the bulk dedicated to the Trentwood and Kalamazoo facilities. For Trentwood, the capital went to expand capacity and increase thickness capability for aluminum heat treat plate for aerospace and high strength applications. The Kalamazoo plant served to improve rod and bar efficiencies for GE and to provide capacity for future growth.

Business Dynamics

The heat treat plate and sheet product market is an oligopoly with strong barriers to entry, particularly in the aerospace market. New competition is limited by technological expertise, investment in specialized equipment and a rigorous, multi-year qualification process. It is difficult to displace an incumbent supplier and Kaiser serves as a valuable alterative to Alcoa and Alcan.

The GE, automotive and other markets are more commoditized, and as such more competitive and fragmented, but limited new capacity additions and expected efficiency improvements bode well for the company.

In general, aluminum exhibits low density, high corrosion resistance and an almost infinite recyclability. The metal is ideal for low weight and high strength applications. 

Aerospace and defense consumption of fabricated aluminum products is driven by overall levels of airframe build rates, defense spending and growth in monolithic* construction. Replacement demand, along with longer routes, larger payloads and a focus on fuel efficiency should drive continued demand. As such, annual growth from 2013-2017 is expected to exceed 5% - air frame orders booked by Boeing and Airbus equate to a backlog in excess of eight years**. On the defense side, production of the F-35 (Joint Strike Fighter) will drive demand and limit the impact of reduced defense spending.

*Monolithic = heavily machined aluminum plate produced using a single piece of metal as opposed to various parts affixed to one another.

**Management anticipates steadily increasing build rates throughout the remainder of the decade.

The GE and other segments are correlated to broad economic patterns and industrial activity in North America, including light and heavy truck and trailer applications.

The automotive extrusion segment is driven by automotive build rates in North America and increased aluminum usage by OEMs due to the focus on reducing vehicle weight and improved fuel efficiency. CAFÉ* standards mandate average fuel efficiency of 35 mpg by 2020.

*See WSJ article “Detroit Sheds Pounds for Gas-Mileage Gains” from 1/13/13.

Over the past decade, automotive aluminum extrusion content grew at a CAGR of 3.6% (Kaiser’s growth >2x). Foreign manufacturers in Japan and Europe have been far advanced over the US in converting steel and iron to aluminum applications, so going forward the US should see (catch up) content growth.

The convertible bonds have a conversion price of $48.31, but dilution is offset by call options the company purchased concurrent with the issuance. At this time, Kaiser also sold net-share-settled warrants for 3.6 MM shares at $61.32. These warrants cannot be exercised prior to the expiration on July 1, 2015.

Pursuant to a (poorly timed) high yield issuance, Kaiser’s reported cash balance is $336 MM, or over $17 per diluted share. As a result of its sizable NOL and VEBA (voluntary employee benefit association) earn out (discussed later), the company is incentivized to acquire US businesses. Therefore, the excess cash will likely fund bolt-on acquisitions and further organic growth in the heat treat plate (phases 5-7 at Trentwood) and automotive segments. In January 2011, the company completed the acquisition (non-auction process) of Alexco, a manufacturer of hard alloy extrusions for the aerospace industry for $83 MM.

As of YE 2011, Kaiser reported NOLs of $875 MM. Partially offsetting the NOL is a form of profit sharing with a union VEBA. This obligation provides for variable contributions based on the company’s cash generation. The contribution is 10% of the first $20 MM of annual cash flow, defined as EBITDA less interest, taxes and capital expenditures (including acquisitions) plus 20% of any additional cash flow subject to a maximum of $20 MM* annually. This arrangement exists through 9/30/17**, but I would not be surprised if it is extended. As part of the collective bargaining agreement entered into in 2010, the VEBA contribution was extended from 2012 to 2017. Besides this agreement, the company does not have any obligations to fund the union VEBA.

*Payments are captured on the statement of cash flows. They do not show up on the income statement, although they are tax deductible.

**85% of payments scheduled to expire in 2017; 15% no expiration.

Operating performance improved in 2012 due to a favorable pricing environment coupled with a 20% increase in aerospace and high strength products, a 7% increase in GE products, 1% growth in automotive extrusions, offset by a 20% decrease in other products. The auto business was impacted by model changeovers and lower exports of anti-lock braking systems for European applications.

On the cost front, the company benefited from fixed cost leveraging and lower contained aluminum costs. 

For 2013, aerospace is expected to remain strong. Management expects full utilization of its Phase 4 heat treat plate capacity expansion (5-10% of total) at the Trentwood facility and this year will see a full year of expanded capacity at the Alexco plant. The outlook for auto is also strong due to build rates and increasing aluminum penetration, and there remains ample open capacity at the new Kalamazoo facility to facilitate growth. GE and other are projected to show limited growth due to concerns around the North American industrial economy and flattish North American truck class 5-8 and trailer demand.

Alcoa recently reported 4Q numbers and guided to global growth in the aerospace (9-10%), automotive (1-4%), commercial transportation (2-7%), building and construction (4-5%) and industrial gas turbine markets (3-5%).

Management believes margins can be enhanced through continued operational efficiencies. In 2013, the company should also see a reduction in its natural gas costs as higher cost hedges roll off. Every $1 change in natural gas prices equates to $4 MM of operating costs. I assume a $4 MM benefit in 2013. 

Net, net management’s projection of value-added revenue well beyond $800 MM and EBITDA margins in the high 20%s seems like a reasonable short-to-medium term estimate. For 2013, I assume value-added revenue growth of HSD - led by aerospace, automotive and an improving industrial economy. For EBITDA margins, I use mid-20s as I expect further operating leverage, a larger percentage of higher margin aerospace business and lower natural gas prices and major maintenance expenditures. But I do not think this is the peak. If the industrial economy improves there should be increased utilization at the GE and other plants in addition an automotive tailwind and continued strength expected in aerospace.

I look at valuation on an EBIT and earnings basis, excluding excess cash, NOLs and factoring in the maximum union VEBA liability. Using EBIT, we create the stock for 7.8x and 6.7x 2012E and 2013E, respectively. Similarly, netting out excess cash, NOLs and the VEBA liability of $19/share and fully taxing earnings results in a multiple of 10.8x and 8.9x for 2012E and 2013E, respectively.

At these multiples and in light of the business dynamics and clean post-bankruptcy balance sheet (pension, OPEB and asbestos), a takeout is not out of the question. There would be some impact on the NOL, but the competitive position in aerospace would be attractive to many buyers. Kaiser would be a great fit for Aleris - to build out its aerospace business. Hindalco buying is probably a low likelihood given its weak balance sheet, but it is certainly possible. Additionally, some of the larger aerospace suppliers are potential suitors.

Note that Hindalco acquired Novelis for >9x EBITDA. If you look at the Aleris S-1, the implied EV/EBITDA multiple is in the high 6s, although Kaiser merits a premium due to its higher percentage of specialty products. Carpenter Technology trades at a mid-7s multiple. On an EBITDA basis, Kaiser trades <6x (2013E).

1. Cyclical end markets. Expects difficult 4Q in GE.
2. Composite growth. New airplane designs (787, A380, A350) do replace some aluminum parts, but these planes will continue to utilize many monolithic aluminum parts and these new units will still add to demand. The FAA recently ordered a cease in operations of 787s. Newer versions of 737 and A320 require more aluminum than prior models. Management argues composites will impact competitors more as it subtracts from some of their proprietary alloy business.
3. Higher aluminum prices. Kaiser has held onto some prices in 2012 even though aluminum declined. Inventories are recorded on a LIFO basis. Hence, in a rising aluminum price environment, there is a lag between higher cost of sales is reflected in ASPs. 
4. Imports. Management noted that GE pricing was being held back by import from Europe and South Africa.
5. New capacity. Aleris is building a new facility in China which is expected to serve the aerospace market in 2014. Alcoa is expanding its Davenport facility.
6. Customer concentration (top 5 customers account for 42% of revenue).
7. Defense products are subject to annual funding and congressional appropriations. Strong demand (domestically and internationally) is expected for the F-35 program (healthy Lockheed backlog).
8. Unionized labor force (64%).

Catalyst

Continued strong operating performance

Announcement about Trentwood expansion

Share repurchases ($75 MM remaining) and dividend increases

Takeout