Friday, November 18, 2016

A past AIM Fund holding: Kaiser Aluminum (KALU) by Andy Krueger: "Let's See What Happens to KALU Whenl the Dust Settles from the US Elections”

Kaiser Aluminum Corporation (KALU, $72.12) “Caution: Turbulence Ahead”
 By: Andy Krueger, AIM Student at Marquette University

Disclosure: The AIM Equity Fund currently holds this position. This article was written by myself, and it expresses my own opinions. I am not receiving compensation for it and I have no business relationship with any company whose stock is mentioned in this article. 
Note: This report was prepared prior to the US elections on November 8, 2016


Kaiser Aluminum (NASDAQ:KALU) produces semi-fabricated specialty aluminum goods including aluminum plate and sheet, extruded and drawn goods for the aerospace and high strength automotive markets, as well as other products for general engineering and industrial end markets.  The company earns all of its revenue in North America.
• An abnormally high amount ($8 million) of value added revenue (VAR) remained classified as in-transit goods at the end of the third quarter.
• The third quarter results for KALU reflect roughly $3 million in additional, unexpected maintenance expense compared to the first half run rate.
• VAR from the General Engineering segment the only product line in Q3 with a positive surprise for KALU.
• Negative news for KALU continues to pile up as destocking among aerospace customers is expected, automotive facilities are shutting down and the ramp-up in new bumper programs is slower than initially modelled.
• KALU is hovering near the 52-week low of $72.12 and it may not even be the bottom as 2017 guidance was lowered.  Investor confidence is waning as the best news management can offer is their commitment to following through on long-term capital investments in KALU’s facilities to expand capacity.

Key points: KALU found itself with $8 million worth of inventory stuck in shipment, without the ability to recognize revenue.  Management guided that this $8 million resulted in $3-4 million of lost EBITDA in the third quarter.  Although these sales will be shipped in the fourth quarter, typical seasonality is expected to offset any benefit KALU would receive from these extra shipments.

KALU experienced a significant maintenance expense associated with the furnaces in four of their manufacturing plants nationwide.  This $3 million expense, in-transit inventory, and typical third quarter seasonality contributed to a 350bps decline in EBITDA margin for KALU.

Aerospace and high strength VAR was down 4% compared to the prior year third quarter, automotive extrusion VAR declined 3%, but general engineering posted a VAR increase of 6%. General engineering took advantage of the capacity growth out of the Trentwood facility to grow VAR for the quarter.  Unfortunately for KALU, this beat is one of the few positive takeaways from the reporting period.

Management guided toward destocking of aerospace plate products by KALU’s customers in 2017.  The destocking caused management to make general comments about 2017 demand being lower with a specific estimate to be provided on the 4Q16 earnings call.  For now, investors should prepare for the worst.  The generous incentives utilized by automakers failed to spur additional sales, and production plant shutdowns have begun as a result.  KALU is also exposed to delays in bumper programs that are not seeing the demand initially modelled.  Finally, price pressures in the non-contract aerospace and general engineering plate end markets are lowering demand for KALU products and forcing KALU to make price concessions to customers as they work to maintain their market share.

What has the stock done lately?

Over the last week, KALU is down over 8%.  Significant near-term headwinds were identified on the third quarter earnings call causing investors to question any industry drivers they once believed in.  The company is now trading significantly below the 50-day and 200-day moving averages.  Investors can only hope the stock has reached a trough and the fourth quarter estimates regarding the effects of destocking on KALU’s sales will be minimal.  Additionally, KALU is trading at a blended forward EV/EBITDA of 6.7x, the lowest multiple since the beginning of the fiscal year.  A lack of near-term upside potential is concerning for investors, even if a long-term thesis remains intact.

Past Year Performance: Six months ago, KALU rode a stream of positive news and above average demand estimates to the top and was trading at $94.83.  Now, a share price in the $90 range seems far-fetched compared to the $72.45 the stock currently trades at.  Admittedly, when I pitched KALU, I believed the stock had bottomed out when it was trading near $82.  Clearly I was mistaken as the firm has since experienced a fair amount of negative press since my pitch, most of which is summed up in the above points.  Kaiser is trading at its lowest share price since the late January-early February time period when investors had concerns regarding the amount of imports to the US.  The near future remains unclear for KALU, but management has shown the ability to take KALU shares from near $70 to over $90 per share (although they have now shown the ability to do just the opposite as well).

Source: FactSet 

My Takeaway

The lack of any near-term investment thesis is discouraging as an investor.  The investment thesis I presented in my pitch has turned out to be a longer-term thesis than originally anticipated.  This significant dip in KALU share price with management leaving the door open for additional negative news in the fourth quarter does not make me hopeful for a strong recovery out of KALU.  

The long-term thesis presented in my pitch will not take shape until 2018 or 2019, and I believe KALU shares will fall further on negative news out of the fourth quarter earnings call.  As a result, I recommend selling the AIM Equity Fund’s position in KALU to wait for the stock to reach an even deeper discount before looking at another possible investment.

Note: The AIM Fund recently sold its position in KALU.