Materion’s Transformation To A Diverse, Growth-Leveraged Company Continues (NYSE:MTRN)

Barely covered by the Street and not widely followed by Seeking Alpha readers, Materion (MTRN) is nevertheless a company worth paying more attention to these days. Management’s efforts to diversify the company beyond its historical core in beryllium-based products are already paying off, and Materion is transforming into a diversified supplier of advanced materials for critical applications in diverse (and growing) end-markets like semiconductors and advanced autos, and recovering markets like aerospace.

The shares are up close to 20% since my last update, with a big post-earnings spike generating that upside. There are risk factors to consider, including its exposures to cyclical markets and a higher debt load, but I believe mid-to-high single-digit revenue growth and improving margins still support a bullish stance on this largely unknown specialty materials producer.

Further Progress In The Fourth Quarter

Although Materion’s fourth quarter results weren’t substantially better than expected, the company did exit the year with momentum and with momentum in its end-markets.

Revenue rose 17% as reported, while value-added revenue grew at a reported 27%. Materion passes along the changes in prices for metals like gold, silver, platinum, copper, and so on, and that creates the difference between reported revenue and “value-added” revenue.

While reported revenue was about 7% short of sell-side expectations, value-added revenue was basically inline. While growth in VA revenue was a reported 27%, actual organic growth was closer to 13% excluding contributions from the HCS acquisition. By segment, Performance Alloys and Composites VA revenue grew by about 23% in organic terms, Advanced Materials grew by 16%, and Precision Coatings grew 5% (adjusted for year-ago sales in an exited business and sales tied to COVID-19 PCR testing).

Gross margin declined two points (to 18.4%) on reported revenue and rose about one point (to 30.8%) on a VA basis, with significant improvement in the PAC segment (up more than five points to 28.5%). Overall gross margin was a little light, impacted by Omicron, some start-up costs for a new strip clad facility, and mix (a defense customer in particular).

Adjusted EBITDA and adjusted operating income were both basically in line, with the latter rising 52% and VA-based margin improving almost two points to 11.3%. Both PAC and AM grew (up 51% and 74%, respectively), with margins improving 230bp and 180bp to 15.4% and 14.0%.

Strong Guidance On Strong Markets

The big takeaway for me was strong guidance from Materion management on the basis of strength almost across the board for its major end-markets. Management offered two EPS guidance ranges, one with acquisition amortization excluded (up 35% year over year at the midpoint), and one with it; the latter still offers 31% YoY growth and about 5% upside to prior sell-side expectations, and I don’t really agree with ignoring the cost of acquisitions (even if that is becoming more common).

Materion’s two largest end-markets, semiconductors and industrial, are strong and getting stronger. The company has made a major push to broaden its exposure to the semiconductor market (including the HCS acquisition), and the company is well-placed in critical component areas like lids and frames (used in semiconductor packaging), sputtering targets (used in physical vapor deposition), and specialty materials like tantalum used to create barrier layers to protect copper interconnects in multi-layer chips.

Although I do have some concerns that the semiconductor sector will see shrinking lead-times and rising inventories lead to a correction in the 2023-24 timeframe, it’s important to note that the cyclicality of the chip sector doesn’t lead to meaningful year-over-year declines in chip volumes, and Materion is well-leveraged to ongoing growth in advanced packaging and increasing complex architectures at advanced nodes that consume more engineered materials; all of which means I expect that Materion’s content growth opportunities will mitigate any volume risk.

On the industrial side, Materion is leveraged to recovery growth in areas like molding/tooling, improving process control (optical filters), and heavy machinery, where the company’s alloys are used in bearings and bushings for equipment used in construction, mining, and so on. Given my general bullishness on these markets (you can read my recent articles on CNH Industrial (CNHI) and Komatsu (OTCPK:KMTUY) here and here), I expect healthy trends here through 2023.

Materion also still has notable leverage to future growth in vehicle electrification. Materion alloys are used in connectors for batteries and other electrical components, within batteries themselves, and in growing optical markets like LiDAR.

The Outlook

One item of note from the fourth quarter results is that the company’s R&D spending has exceeded 3% for the first time ever. Materion doesn’t have a straightforward peer group, but for specialty alloy companies, that’s a fairly high level of spending, and it’s consistent with management’s ongoing efforts to develop new, higher value-added materials for customers in attractive end-markets like semiconductors, aerospace, autos, and so on.

Given strength in important markets like semiconductors and industrial, and recoveries in aero, autos, and energy, I think Materion is set up for good results in 2022-2023 and beyond. I’m looking for around 16% reported revenue growth in ’22, and I think there could be upside, and I’m looking for long-term annualized revenue growth in the mid-to-high single-digits (whatever you would call “around 7%”).

With management actively acquiring and investing in higher value-added products, as well as some past restructuring efforts, I expect ongoing improvement in margins, with EBITDA margins improving from the 8% range across most of the past decade into the low double-digits over the next few years and mid-teens in around four to six years. Over time, I expect FCF margins to improve into the high single-digits, and I do have some concerns that that could be too bullish given the long-term track record of low single-digit FCF margins (though that was with a more commoditized business mix).

The Bottom Line

On a macro level, the bull argument for Materion is that the company has shifted over time from a more commoditized supplier of beryllium-based alloys to a diversified developer of advanced alloys targeting faster-growing markets like semiconductors. Based on discounted cash flow and margin/return-driven EV/EBITDA, I believe these shares are more than 10% undervalued today and priced for a longer-term total annualized return in the double-digits. That makes this a name still well worth considering even with growing Street nervousness about the chip sector.