CONSTELLIUM NV CSTM
March 12, 2014 - 4:03pm EST by
gosens
2014 2015
Price: 27.23 EPS $1.75 $2.31
Shares Out. (in M): 105 P/E 15.6x 11.8x
Market Cap (in $M): 2,859 P/FCF 10.0x 11.6x
Net Debt (in $M): 241 EBIT 375 434
TEV ($): 3,099 TEV/EBIT 8.3x 7.1x

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  • Aluminum
  • loser

Description

SUMMARY:

We believe that Constellium NV (“CSTM” or “the Company”) represents a compelling long investment with ~54% upside to current intrinsic value and >100% upside as we look out 2 to 3 years.  Constellium represents the best pure play exposure to the global theme of light-weighting via the use of Aluminum (Al) in aerospace and automotive applications.  Despite the recent run post-IPO, the stock is still cheap on a relative and absolute basis, trading below peers on near-term multiples despite the earnings ramp that will occur from 2015 onwards. 

Constellium is a downstream producer of aluminum products and is paid a conversion fee for processing raw aluminum into various end products while taking little to no commodity price exposure.  While the majority of CSTM volumes are represented by the less profitable packaging business (Al beverage cans, etc.), the more profitable aerospace and automotive businesses are experiencing structural growth and will become a more significant part of the business over time.   We believe that the market is not fully discounting the positive mix effects associated with the growth in aerospace/automotive volumes and the resultant increase in company profitability over the next 5 years.  We expect EBITDA to double by 2018, driven by end market growth, recently announced capacity expansions, and the effects of operating leverage. 

KEY POINTS OF THESIS: 

1.  Demand for Aluminum in Automotive/Aerospace Applications is Accelerating 

CSTM is poised to benefit from secular growth of aluminum content in two main end markets: 

i.  Autos:  Higher emissions standards for global auto OEMS.   Higher fuel economy standards translate to a need for reduced weight while maintaining strength/stiffness.  Aluminum is the most cost effective material to meet weight reduction targets, with the highest growth categories expected to be aluminum sheet for body/structural applications and aluminum extrusions for bodies and bumpers.  CSTM has significant exposure to both of these product categories. 

ii.  Aerospace:  The use of aluminum in commercial airplanes has been growing for years, but newer models contain more aluminum than previous models.  The use of proprietary/highly profitable alloys such as Aluminum-Lithium (Al-Li) is set to grow significantly with the ramp up of the A350 and 787 derivatives. 

2.  High-ROIC Brownfield Expansions and Mix Shifts to More Profitable Product will Drive Substantial Improvement in Profitability Over the Next 5 Years: 

We have used primary research to break out the unit-economics of this business by product and the implications for future profitability (impossible to do this from Company/Competitor disclosures).  The implications of our bottoms-up analysis is that CSTM will experience a substantial increase in profitability over the next 5 years and beyond, driven by a mix-shift to higher value-added/proprietary products and two recently announced capacity expansions.

 

HISTORY AND IPO PROCESS: 

Constellium was originally part of Alcan’s downstream aluminum business before Alcan was acquired by Rio Tinto for US$38B in 2007 at the peak of the cycle.  As part of the US$11B divestment of Alcan’s downstream operations, Rio Tinto eventually sold 61% of this business to Apollo in 2011 for limited proceeds but with Rio Tinto maintaining an interest to share in upside.  At the time of the sale, the majority of Alcan Engineered Products’ operations were loss-making, sub-optimally structured, and there were ongoing labor issues.  The business was renamed Constellium and underwent a reorganization under Apollo.  Profitability improved substantially and the business completed its IPO in May of 2013 at US$15 per share. 

We believe the IPO was “priced to sell” because:   Apollo had locked in substantial gains regardless of the IPO price; investor appetite for commodity-related stocks was limited at the time; there was substantial market volatility during the IPO time frame. 

Since the IPO there have been multiple secondary offerings with Rio Tinto exiting its remaining stake and Apollo continuing to reduce its interest.  Nearly every broker on the street has had some involvement in the IPO/secondaries, leading to ongoing restrictions by sell side analysts and some stale estimates.  

 All Figures in USD IPO Current     IPO Current
Share Price 15.00 27.22   EBITDA:    
Shares O/S 105 105   2014E 427 450
Equity Value 1,575 2,859   2015E 502 530
        2016E 626 660
Total Debt 482 509   EV/EBITDA:    
Cash 215 268   2014E 4.32x 6.89x
Net Debt 268 241   2015E 3.67x 5.85x
TEV 1,843 3,099   2016E 2.94x 4.69x

                               

CURRENT VALUATION: 

CSTM trades at a discount to its peers and to its replacement cost.  Under IFRS purchase accounting, CSTM’s recorded PP&E value is reflective of Apollo’s purchase price (balance of EUR302M as at 12/31/2012).   CSTM estimates (via a third party) the true replacement cost of its production facilities at ~EUR 6.5B.  The current market valuation of CSTM implies a ~62% discount to replacement value.  We do not believe that the market would ever need to replicate all of CSTM’s capacity (can stock in Europe is over-supplied), but this level of discount does provide us some comfort in terms of a margin of safety.  

CSTM’s closest public comp, Kaiser Aluminum (“Kaiser” or “KALU”) does not disclose its total operating capacity.  However, if we assume that Kaiser is currently running at ~90% utilization, then KALU would be trading at US$4,829/t of capacity vs. US$3,114/t for CSTM (does not include additional capacity from announced expansions).  Applying KALU’s TEV/t to CSTM’s current and future capacity implies upside of 57% and 91%, respectively.    On a multiples basis, CSTM trades at a discount to all of its peers (and this is on near-term earnings that do not reflect the steep EBITDA ramp we expect in outer years).  Note that the table below differs slightly from the one above as we are adjusting for pension.

 

  Equity Pension Adj.  Adj. TEV/EBITDA
Company Value TEV LTM 2014E 2015E 2016E
  US$M US$M x x x x
Kaiser 1,242 1,343 6.78x 7.55x 6.74x 6.62x
             
Alcoa 12,641 24,539 7.79x 7.95x 6.68x 6.76x
Hindalco 3,011 10,675 8.56x 7.98x 6.45x 5.48x
Average     8.17x 7.97x 6.57x 6.12x
             
Carpenter 3,125 3,789 9.94x 8.90x 7.13x 6.17x
Allegheny 3,412 5,412 18.03x 10.36x 6.95x 5.43x
Average     13.99x 9.63x 7.04x 5.80x
             
Rolled Products     6.78x 7.55x 6.74x 6.62x
Integrated     8.17x 7.97x 6.57x 6.12x
Specialty     13.99x 9.63x 7.04x 5.80x
CSTM 2,859 3,331 8.18x 7.14x 6.10x 4.92x  

 

COMPANY OVERVIEW: 

CSTM is a downstream producer of specialty aluminum products.  While the cost of the metal appears in both revenue and COGS , CSTM takes little to no commodity price exposure.  The Company is paid a conversion fee for processing raw Al into various products, and this fee differs by the level of complexity of the product as well as supply/demand dynamics.  Note that CSTM reports all of its financials in Euro, while its shares trade in USD.  

CSTM has 3 main divisions: 

1. Aerospace and Transportation:  24% of volumes but 44% of EBITDA.  Produces aluminum plate products for aerospace, transportation, and general industrial end uses.  Aerospace applications are the highest margin/technologically differentiated product group. 

2. Packaging and Automotive:  58% of volumes but 37% of EBITDA.  Produces aluminum sheet products.  Can stock (for use in aluminum cans) is the highest volume product but is facing over-supply in Europe and has lower than average profitability.  That being said, packaging is a stable source of cash flow and low single digit volume growth. Packaging volumes also provide significant fixed cost absorption across the division.  This segment also includes automotive sheet (“Body in White” or “BiW”) which is a high-growth and high margin product experiencing significant growth. 

3. Extrusions:  18% of volumes and 19% of EBITDA.  Includes extruded aluminum products for auto (i.e. bumpers and body) and other applications.  Auto applications are experiencing significant growth.

Within CSTM’s reported divisions are multiple products with different drivers, end-markets, growth rates, and competitive dynamics.  The table below provides an overview.  Note that the key drivers of our thesis are:   Aerospace Plate, Aluminum-Lithium/Proprietary Alloys, and Automotive Sheet (“Body in White” or “BiW”).  

Division:  Aerospace and Transportation                                                                               

i)  Aerospace Plate         

End-Market:  Commercial Aerospace     

Customers:  Boeing; Airbus        

Competitors:  Alcoa; Aleris; Kaiser           

LT Growth Rate:  10+%

Comments:  Significant R&D investment/regulatory barriers to entry; Commercial build rates, higher Al intensity per plane driving growth 

ii) Al-Li and Proprietary Alloys    

End-Market:  Commercial Aerospace     

Customers:  Boeing; Airbus

Competitors:     Alcoa    

LT Growth Rate:  +15% to +20%

Comments:  Significant R&D investment/regulatory barriers to entry; Alcoa and CSTM are only players with patented Al-Li alloys; Highest margin/lowest volume products that will see significant demand growth as A350 and 787 derivatives ramp up in 2015 and beyond 

iii)  Transportation and General Engineering Plate Products         

End-Market:  Transportation; Infrastructure; General Industrial

Customers:  ThyssenKrupp; Ryerson; Others     

Competitors:  Alcoa; Aleris; Kaiser           

LT Growth Rate:  Flat to declining

Comments:  Less profitable business facing reduced capital spending by customers

 

Division:  Packaging; Automotive                                                                            

i) Automotive Sheet (Body in White or BiW)       

End-Market:  European and U.S. auto production            

Customers:  Auto OEMS (current focus on premium Germans) 

Competitors:  Novelis; Hydro; Alcoa       

LT Growth Rate:  >10% 

Comments:  Highest growth product driven by structural growth and low starting point.  CSTM is expanding into U.S. market where growth rate will be highest.  Also expanding European capacity 

ii)  Can Stock           

End-Market:  European food and beverage packaging   

Customers:  Rexam; Crown; Ball; Etc.     

Competitors:  Novelis; Hydro; Alcoa       

LT Growth Rate:  +2% to +3%          

Comments:  Al cans are under-penetrated in Eastern Europe.  Alcoa's Saudi capacity expansion could pressure European exports to Middle East.

 

Division:  Extruded Products                                                                     

i)   Automotive Structures and Extrusions (Body and Bumper)         

End-Market:  European automotive production

Customers:  Peugot; Renault; TRW; Etc.

Competitors:  Benteler; YKK; Hydro; Aleris; SAPA; Eurol; Fuchs; Impol

LT Growth Rate:  +5% to +10%          

Comments:  Growth driven by Al content in bumpers which is still under-penetrated 

ii)  Large Profiles              

End-Market:  Infrastructure and General industrial         

Customers:  Alstom; Siemens; Bombardier

Competitors:   Same as above 

LT Growth Rate:  Flat to declining             

Comments:  Less profitable business facing reduced capital spending by customers  

Discussion of Barriers to Entry: 

As previously mentioned, the key to the CSTM story is the growth of the Aerospace/Automotive markets and the impact on overall profitability.  The production of Aerospace plates, Al-Li compounds, and Automotive Sheet (BiW) is limited to ~3 players (no product group has more than 3 large incumbents) and there are substantial barriers to entry in order to compete in these markets.  These barriers to entry include: 

• Customer relationships:  Constellium, Alcoa, Novelis, Aleris, and Kaiser all have long histories with customers and have established a track record of performance and trust.  Aerospace/Auto OEMs are unlikely to risk production/delivery schedules to new/unproven competitors. 

• Switching costs:  Products are integrated at the design level so switching is unlikely until new models require new designs and even then switching is infrequent 

• Regulatory:  There are significant certification requirements in order to be authorized to produce and sell aerospace plate and other products.   For example, it can take 3 to 5 years for a mill to qualify as an aerospace products supplier even after the technical capability is in place.  Automotive products also have strict quality requirements 

• Technological:  Constellium and Alcoa spend significant capital on R&D each year and have developed proprietary technologies such as their respective Al Li compounds.  Alcoa and CSTM are the only competitors with proprietary Al Li technology and CSTM believes it has the edge with more patents (and has been winning market share with both Boeing and Airbus) than Alcoa. 

• Capital/Capacity:  All automotive sheet capacity expansions in North America and Europe to date have been Brownfield, consisting primarily of switching rolled products capacity away from can stock and through a new finishing line to produce Body in White.  There is limited Brownfield capacity available in both markets, and a new entrant would face high Greenfield costs.  

MAIN THESIS - PART 1.  DEMAND FOR ALUMINUM IN AEROSPACE AND AUTOMOTIVE APPLICATIONS IS ACCELERATING: 

i. Aerospace Plate:

Aluminum demand for aerospace applications is being driven by increased production rates of Al-intensive planes and an increase in the use of proprietary alloys such as Al-Li.  CSTM has guided to ~10% volume growth for its aerospace plate business and substantially more for its Al-Li volumes.  Alcoa, one of 2 main competitors to CSTM in this product group, expects ~12% end-market growth for Al in aerospace applications through 2015. 

In order to reconcile/gain comfort with these forecasts, we spoke to industry experts in order to estimate the Al content in different commercial airplane models.  We then looked at forecast build rates by model and came up with an estimate of end-market growth.  Note that these numbers are estimates, but the analysis provides a CAGR of 6.0% for the overall market.  We think the main sources of difference between our high-level numbers and commentary from CSTM/Alcoa are as follows: 

• Increased aluminum content in 787 and the A350  derivatives (for which we do not have Al-content data)

• CSTM has higher exposure to the 787, A380, and A350.  These three models are aluminum-heavy and will experience production increases over our forecast period.

• Constellium recently won new contracts with both Boeing and Airbus that provide market share/content increases.  This should lead to above-market growth for CSTM 

In our Base Case, we model a 5 year 7.5% CAGR for CSTM aerospace plate volume growth, which is above our rough estimate of market but below mgmt. guidance.  

ii. Aluminum Lithium: 

Aluminum-Lithium technology was pioneered by Alcoa in the 1980’s but achieved very low levels of penetration due to low toughness, poor corrosion standards, and manufacturing issues.  Alcoa and CSTM have since both developed newer proprietary alloys that can compete directly with composite structures in reducing aircraft weight in certain applications, such as top wing skins.  In fact, Al-Li can provide up to 10% lower weight vs. composites in these types of applications. 

Based on conversations with industry experts as well as with CSTM management, we anticipate that Al-Li will experience higher growth rates than other aerospace products (given that it is starting from a base of essentially zero) but will likely remain a lower volume/higher margin product over the medium term.  Interestingly, the two aircraft that will drive demand for Al-Li are the 787 and A350, two next-generation models that are primarily made of composite structures.  As part of its new contracts with Boeing and Airbus, CSTM will supply Al-Li on both the 787 and A350.  

Based on our discussions with mgmt., we anticipate that Al-Li will represent ~12,100 tons of volume for CSTM by 2017 and this will be driven primarily by the A350.  CSTM is also a supplier to the Bombardier C Series, where 20% of total materials used on the aircraft will be Al-Li.  However, given the delays and uncertainty facing this program we have chosen not to include it in any of our scenarios. 

Al-Li is clearly a new product that is gaining significant traction for the aerospace primes as Airbus/Boeing continues to search for new ways to improve reduce weight and improve fuel efficiency.  One industry expert indicated to us that Al Li could represent ~20% of total aluminum demand for aerospace applications over the next 5 to 10 years.  This would represent a >30% CAGR for Al Li volumes through 2020 and would be a significant positive for both CSTM and Alcoa given that this is the highest margin product for both companies.  We do not include this demand growth scenario in in our model but we intend to watch this product segment closely.  

iii. Automotive: 

Regulations in Europe and the United States will require substantial improvements in fuel efficiency by 2020/2025, respectively.  A significant amount of this improvement will have to come from weight reductions as every 10% reduction in weight provides ~3.3% (6.7% in down-sized engines) improvement in fuel economy for passenger vehicles.  Ducker Worldwide expects curb-weight reductions of ~10% to 12% per vehicle, and this will be driven by replacing steel with aluminum for body/structural applications. 

In two recent studies of the North American and European auto markets, Ducker Worldwide indicates that body and closure parts currently represent 1/3 of total vehicle weight and that these parts need to shrink to 25% of total weight.  Aluminum is the only material available that will accomplish this.  Note that Al content in automobiles has been increasing steadily for more than 40 years.  But, nearly 90% of current content is in the engine, wheels, heat exchanger, and transmission.  The next growth driver will be body/structural parts, which are the main applications for Body in White. 

This switching process has already begun, as Ford recently announced that the 2015 F-150 pick-up truck will feature an all-aluminum body.  Other OEMs have followed suit, with GM announcing commitments with Alcoa to produce aluminum-bodied trucks.  We spoke with an engineer at Chrysler who indicated that Chrysler/Fiat is actively designing aluminum body structures into various models and actively seeking to lock up auto sheet capacity.  To quote the Chrysler engineer “Aluminum bodies is [sic] the only way we are going to meet these CAFE (Corporate Average Fuel Economy) standards”.  The outlook for growth in aluminum demand from automotive applications does vary by end market and product type, however: 

• North America:  Overall demand for Al in automotive applications will grow by ~5% through 2025.  The highest growth applications will be aluminum for extrusions (bodies and bumpers) as well as Body in White (auto sheet for body and closure applications) with a forecasted demand CAGR of 14.4% and 34.1%, respectively, through 2017.   Note that CSTM is only exposed to the Body in White segment in North America via a recently announced JV with Sumitomo that will ramp-up to full capacity of 100,000 tons in 2016/2017 (CSTM has a 51% share of the JV).  CSTM is actively looking for additional opportunities to expand capacity in North America and has a target for 20% market share.   With anticipated demand for at least 1 million tons of auto sheet by 2020 in N.A., CSTM’s market share target suggests that CSTM is looking to add an additional 100,000 tons of capacity (150,000 if their market share target is net given the 51% interest in the Sumitomo JV). 

• Europe:  The European market already exhibits a higher level of Al-penetration, higher average fuel economy, and lower average car sizes/weights than North America.  As a result, overall Al content per car is expected to grow at a lower CAGR of ~3.8% through 2020.  However, since EU auto production is starting from trough levels we expect overall Al demand for auto applications to grow at ~5%.  Similar to North America, extrusions and Body in White applications will outgrow the overall market for aluminum in automotive applications by a wide margin. 

•Asia:  China recently announced strict emission/fuel economy regulations (similar to US requirements) which will likely increase Al content per vehicle for that market.  Novelis has already announced expansions into that market, and it is possible that CSTM could do the same.  We do not model this scenario but see it as a source of potential upside down the road.     

iv. European Packaging/Can Stock: 

While not a core part of our thesis, European packaging represents the largest single end market for CSTM.  Can stock provides a more stable volume base than other rolled products such as automotive sheet given that it is tied to consumer staples/non-discretionary spend.  As evidence of this, European can stock volumes declined by <10% during the financial crisis vs. a >20% decline for total flat-rolled product shipments (automotive and general industrial). 

Al penetration in food/beverage packaging in Europe has increased from 58% in 2001 to 77% in 2012 (with tinplate losing share), with the majority of under-penetration now in developing economics in Eastern Europe.  Going forward, growth rates in Eastern Europe are expected to outperform Western Europe by ~200 bps 

Overall, we model 2.5% base line growth for the can stock business, although the effective growth is lower due to our assumption that some volumes are diverted away from can stock in order to fill auto sheet capacity (our research indicates a 4-to-1 auto sheet/can stock ratio).  The effective 5 year CAGR for packaging volumes is ~132 bps in our Base Case. 

MAIN THESIS PART 2.  MIX SHIFTS TO DRIVE IMPROVING PROFITABILITY 

As part of our research, we spoke with competitors, consultants/former employees, and customers in order to better understand the economics of this business.  Our goal was to understand the cost structure of the individual business segments and to develop a model that reflected the unit economics of the business by product.  Given the weak disclosure in the public filings and our conversations with sell-side analysts, we are confident that our primary research has given us an analytical edge with respect to understanding the profitability of individual product types and the operating leverage inherent in this business 

The table below is a summary of the economics of the business by division/key product type as outlined above and reconciled to 2013A financials.   Actual profitability levels going forward are dependent on levels of volume/fixed cost inflation.

  Treatment Treatment Cost Fixed/Variable Implied Adj. EBITDA
Division Charges (Variable) Cost Split EBITDA Margin
A&T EUR/t EUR/t % EUR/t % 
Aerospace Plate 3,964 1,070   780 19.7%
Al-Li and Prorpietary Alloys 10,307 4,793   3,400 33.0%
Transportation/Gen. Engineering 2,997 634   249 8.3%
Total Division 3,595 921 60/40 560 15.6%
           
Auto/Packaging          
Automotive Sheet 1,744 575   526 30.2%
Can Stock 1,129 328   168 14.9%
Total Division 1,195 141 50/50 197 16.5%
           
           
Auto. Structures and Extrusions 2,759 1,235 50/50 295 10.7%

 

The combination of a mix shift towards Aerospace/Automotive products and operating leverage will result in substantial improvements to profitability.  We forecast that EBITDA and EBITDA/t will increase at a CAGR of 15% and 9%, respectively, through 2018. 

In terms of allocation of profit improvements, we forecast EBITDA will grow by EUR 278M from EUR281M in 2013 to EUR559M in 2018.  The table below outlines volume/proftiability assumptions and the attribution of EBITDA growth by product type.

  2013   2018
  Volume Mix EBITDA Mix EBITDA/t   Volume Mix EBITDA Mix EBITDA/t
  kt % EUR M % EUR/t   kt % EUR M % EUR/t
Aerospace Plate 109 10.6% 84 30.0% 772   156 11.7% 139 24.9% 892
Al Li 3 0.2% 7 2.3% 2,635   13 1.0% 45 8.1% 3,400
Tranportation/Other 132 12.8% 32 11.3% 241   125 9.3% 45 8.1% 361
Total A&T 243 23.7% 123 43.7% 504   295 22.0% 230 41.1% 780
                       
Packaging 551 53.6% 81 28.7% 146   588 43.9% 120 21.5% 205
Auto Sheet 45 4.4% 23 8.2% 515   248 18.5% 142 25.5% 573
Total P&A 596 57.9% 104 36.9% 174   836 62.4% 263 47.0% 314
                       
Extruded Products 189 18.4% 55 19.4% 289   209 15.6% 67 11.9% 319
                       
TOTAL 1,028 100.0% 281 100.0% 273   1,340 100.0% 559 100.0% 417
                       
          EBITDA Growth Attribution:   EUR M %
          Aerospace Plate - Volume Growth   36 13.0%
          Al Li - Volume Growth     28 10.2%
          Auto Sheet - Volume/Capacity Growth 105 37.7%
          Can Stock - Volume Growth   5 2.0%
          Extruded Products - Volume Growth 6 2.0%
          Tranportation/Other - Volume Declines     (2) -0.6%
          Sub-Total         179 64.4%
          Operating Leverage/Fixed Cost Control 99 35.6%
          Total EBITDA Growth 2013 to 2018   278 100.0%

Sanity Check: 

As a sanity check, we bench-marked both current and forecast CSTM EBITDA/t vs. its peer group.  We believe that Kaiser is the best pure play comp for CSTM.  While Kaiser does not have exposure to can stock, it does have significant exposure to general engineering plate (40% of 2013 volumes and similar in profitability to can stock).   We would also note that CSTM’s product mix is richer than that of KALU given CSTM’s proprietary alloys such as Al-Li and the fact that Kaiser has no exposure to Body in White.  Overall, we estimate that CSTM will close some, but not all, of the gap with between itself and KALU from an EBITDA/t perspective.  

EBITDA/t (USD) by Competitor:

Kaiser: $680

CSTM 2018E: $580

CSTM 2013A:  $363

Novelis:  $345

Alcoa Rolled products:  $308

Aleris Europe Rolled products:  $305 

As an additional check, we applied our cost/profitability model to Kaiser’s current volume mix.  Using our estimates of profitability by product/segment would imply EBITDA/t of US$596 for Kasier aluminum vs. the 2013A figure of US$680 (so we under-estimated by 14%).  This gives us comfort that our estimates are not overly aggressive.  

Economics of Auto Sheet Capacity Expansions:

CSTM recently announced two capacity expansions in its Auto Sheet/Body in White business.  As previously mentioned, the Company will add 100,000t of capacity in North America via its JV with Sumitomo (51% interest).  CSTM will also had 140,000t in Europe over two phases (100% interest). 

Given the significant demand growth being forecast for Body in White in North America, CSTM’s competitors were quick to act (ahead of CSTM) in that market.  Alcoa and Novelis, have announced a combined ~600,000t of auto sheet capacity expansions in the U.S. market (the word expansion is misleading since the starting point was essentially zero) before CSTM announced the JV with Sumitomo.  There are two important things to note here: 

     i. Alcoa and Novelis have already locked in all volumes with customers, meaning that the new capacity is already sold out.   Constellium is in the process of negotiation with            customers to lock-in its volumes.  So, none of this new capacity to date is being built on spec. 

     ii. All of the announced capacity expansions are Brownfield from existing rolled products mills (primarily can stock).  Brownfield conversions will earn higher returns due to lower         capex vs. Greenfield but our research indicates that there is a limited amount of capacity that can be converted and that at some point Greenfield facilities will need to be           built. 

In order to assess the economics of expansions and the potential for new Greenfield capacity being added and pressuring profitability, we looked at the cost of new capacity for both CSTM and the announced expansions by its competitors.  We also spoke with industry experts to estimate the cost of new Greenfield capacity. 

Based on our analysis, the IRR of CSTM’s U.S. and European investments are 26.5% and 21.5%, respectively.  Note that this assumes 100% capacity utilization which is an aggressive assumption and also includes the benefit of spreading fixed costs over additional rolled products volumes (like can stock) which not all competitors would be able to do.  Based on our estimates, EBITDA/t (in EUR) for Auto Sheet/Body in White would have to increase by between 30% and 70% in order to incentivize new Greenfield auto sheet/rolled products capacity (using a hurdle rate of 12.5%).  So, the more likely outcome is continued Brownfield additions until Greenfield capacity is required.  At that point prices are likely to increase in order to incentivize the new capacity.  

Our Bull Case scenario assumes a 10% increase in treatment charges for auto sheet which reflects the level of EBITDA/t required to incentivize new Greenfield capacity. 

PUTTING IT ALL TOGETHER: 

We are cash flow-focused investors and use a DCF as our primary method of valuation (with EV/EBITDA and FCFE yields as sanity checks).  A summary of our scenarios and the implied valuation are as follows: 

Base Case: Volume growth as described above and announced capacity expansions.  Flat pricing in terms of treatment charges by product.  150 bps of fixed cost inflation p.a. (mgmt.. is guiding to complete off-set of inflation with fixed cost reductions).  Share price of US$42.86 or 57% upside.  Implied exit multiple is 6.5x 2018E EBITDA.  

Bear Case:  Lower volume growth and some pricing pressure in European can stock and aerospace plate.  Share price of US$20.53 or ~25% downside.  Implied exit multiple is 5.5x 2018E EBITDA. 

Bull Case:  Additional 100kt of Body in White Brownfield expansion in U.S. market.  Improvement in European can stock profitability driven by market tightness (producers switching away from can stock and into auto sheet).  Share price of US$59.93 for 120% uipside and exit multiple of 6.9x 2018E EBITDA 

We use a 60/20/20 Base/Bear/Bull split to arrive at current fair value of US$42.49 or 54% upside.

Note that these present values reflect intrinsic value today.  Because capex is front-loaded and the EBITDA ramp is back- loaded, simply rolling our Base Case forward by 2 years would give you a fair value of US$57.19, or ~110% upside.  Another way of saying this is that if CSTM trades at ~7x 2018E in 2 to 3 years, it will be a US$50 to US$60 stock.  

The one other comment that we would make is that in only our Bull Case does this company earn a FCF ROIC above its cost of capital (this is somewhat dependent on how you define the capital base, but we use the replacement cost of the assets and then apply a haircut).  This is primarily driven by the exposure to can stock.  We would obviously prefer all of our long positions to be the highest quality businesses as posible, but in our view there is a price to be paid for everything and we think the risk/reward here is too compelling to ignore.  We also think entry/exit EBITDA multiples are reflective of the quality/capital needs of the business.

RISKS:

European Can Stock:  Alcoa has a JV ramping up in Saudi Arabia with capacity of 380kt.  Our checks indicate that only 280kt will be used for can stock and most of this is directed at domestic Saudi Arabia and Asia.  However, it could put pressure on European exports to the Middle East which could soften profitability and/or volume growth in the Packaging/Auto segment.  We have reflected this in our Bear Case, cutting EBITDA/t for can stock by 30%).  

Supply/Demand:  If auto sheet demand is significantly less than currently forecast, there will be over-supply and profitability will be below our forecasts.  We think the risk is to the upside but this is something to watch.  CSTM’s competitors have also warned of high inventory levels in the aerospace supply chain. CSTM has been insulated so far, partly due to the newer nature of its contracts.  However, there could be some short-term noise here.  

Macro:  Highly cyclical and high fixed cost business.  A significant volume decline would pressure profitability and equity would be impaired. 

Near-Term/Long-Term Dynamics:  Given the run in the stock price and a back-end loaded earnings ramp, we could see some softness in the shares if marginal buyers/fast-money are expecting too much too soon.  We would be buyers on the softness, but for those that take a shorter-term view this is something to be aware of.

 

I  do not hold a position with the issuer such as employment, directorship, or consultancy.
Neither I nor others I advise hold a material investment in the issuer's securities.

Catalyst

Investor Day April 2014:  CSTM will hold its first investor day in April.  We expect mgmt. to outline their long-term plans for the business, provide additional disclosure in terms of profitability and growth outlook by product, and frame the potential opportunity in Body in White.   

Additional Capacity Expansion Announcements:  CSTM is actively looking for additional opportunities to add capacity in North America.  Any additional announcements (at economics similar to previously announced expansions) would be positive for the story.

Improved Disclosure and Earnings Trajectory:  This is a long-term earnings growth story vs. a short-term beat and raise story.  2015 and beyond will be the real ramp, but between now and then we expect management to begin to conform its reporting to be more closely in line with KALU.  Currently CSTM does not disclose Value-Added-Revenue, but as we move through 2014 we expect this to change and for investors to be able to better build the margin/profitability bridge between KALU and CSTM to understand the opportunity.

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