Analysis

Today’s company is an essential business for both Boeing (BA) and Airbus (EADSY), and that has credit markets wrongly spooked

September 9, 2020

Demand for industrial metals is heavily dependent on the demand for their end-markets. If demand increases for products like cars, planes, or homes, the metals used to produce them will also see huge benefits.

Today’s company is an aluminum fabricator with customers that are household names in the automobile and flying industries. Understanding its outlook, and that of its end markets, can directly impact how we think about its credit risk.

Below, we show how Uniform Accounting restates financials for a clear credit profile. We also provide the equity tearsheet showing Uniform Accounting-based Performance and Valuation analysis of the company.

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As we highlighted last week when talking about General Motors (GM) and yesterday when discussing Brown-Forman (BF.B), many investing trends have been bucked this recession. Once universal adages about credit markets, including how past recessions have been driven by credit crises, have not applied.

One trend that has not changed is the cyclicality of industrial metals such as copper and aluminium.

While this recession has not translated to reduced home building, it has meant aggregate demand has dropped significantly elsewhere. With these industrial metals, it is important to look at their end markets to determine demand trends.

With talks about an infrastructure stimulus and increased home building, two areas copper is exposed to, copper is back above its 2019 levels.

Aluminum on the other hand has seen more prolonged struggles. It is used most commonly to produce cars and airplanes, two products that have seen huge declines in demand due to the pandemic. Boeing and Airbus have cut production on many different airplane models, leaving aluminum producers with below historical volumes.

Therefore it is no surprise that Moody’s rates Constellium (CSTM), a big aluminum fabricator, as a high yield B2 credit. However, Moody’s may be painting Constellium with too broad a brush.

A deeper look at Constellium, whose stock we talked about previously, shows a company with healthy operating flexibility. Cash flows and cash on hand is enough to easily exceed operating obligations until 2025.

Additionally, Constellium has refinanced and pushed all its debt out to 2024-2026, giving the firm additional runway to improve operations. Despite the current industry headwinds to aluminum, Constellium has four years to right the ship before these obligations are due.

As consumer demand for travel and cars eventually picks up in the wake of coronavirus, these companies will increase aluminum usage. Constellium stands to benefit from this, which should further strengthen its credit profile.

As such, rating it similarly to other commodity based names as a B2 credit shows Moody’s once again is not looking at the full picture. At Valens, Constellium is rated as a cross-over name (XO, equivalent to Baa3), much safer than Moody’s ratings.

Any credit analyst worth their salt could see that the combination of the company’s operational model and debt maturity schedule outweighs near-term end market headwinds to warrant a much safer credit rating.

A Widening of Credit Spreads and Ratings Improvement Are Likely Going Forward Due to CSTM’s Material Debt Headwalls and Healthy Expected Cast Build

Cash bond markets are understating CSTM’s credit risk, with a CDS of 332bps and a cash bond YTW of 0.883% relative to an Intrinsic CDS of 460bps and an intrinsic YTW of 2.363%. Meanwhile, Moody’s is materially overstating CSTM’s fundamental credit risk, with its high-yield B2 credit rating five notches lower than Valens’ XO (Baa3) credit rating.

Fundamental analysis highlights that CSTM’s cash flows should consistently exceed operating obligations in each year after 2020. Meanwhile, its combined cash flows and expected cash build would be sufficient to service all obligations until 2025, when the firm faces a material $778mn debt headwall.

As a result, the firm has several years to improve operations before this debt headwall, and it also has ample capex flexibility to cover potential cash shortfalls in the near-term. This is critical, as the firm’s neutral 50% recovery rate on unsecured debt and minimal market capitalization may inhibit its ability to refinance on favorable terms, if necessary.

Incentives Dictate Behavior™ analysis highlights mixed signals for creditors. CSTM’s compensation framework should incentivize management to focus on all three value drivers: top-line growth, margin expansion, and asset efficiency, which should lead to Uniform ROA expansion and increased cash flows available for servicing debt obligations. Additionally, management does not have change-in-control compensation, indicating they are not incentivized to seek a buyout or sale of the firm, reducing event risk.

However, the compensation framework does not punish management for overleveraging the balance sheet to drive growth. Moreover, management members are not material owners of CSTM equity relative to their annual compensation, indicating they may not be well-aligned with shareholders for long-term value creation.

Earnings Call Forensics™ of the firm’s Q2 2020 earnings call (7/22) highlights that management is confident in their ability to enforce certain contracts.

However, they may be downplaying concerns about free cash flow potential and may lack confidence in their ability to operate plants given coronavirus disruptions. Moreover, they may be concerned about the sustainability of energy efficiency improvements and government programs.

Furthermore, management may be concerned about continued increases in Holding and Corporate costs and may be concerned about supply chain headwinds and its impact on utilization. Finally, management may be concerned about their ability to continue flexing costs and may lack confidence in their ability to discover new ways to do business in the market.

CSTM’s material debt headwalls indicate that credit markets are understating the firm’s credit risk, while operational sustainability, healthy expected cash build, and capex flexibility indicate that Moody’s is overstating credit risk. As such, both a widening of credit spreads and a ratings improvement are likely going forward.

SUMMARY and Constellium SE Tearsheet

As the Uniform Accounting tearsheet for Constellium SE (CSTM:USA) highlights, the company trades at a 41.2x Uniform P/E, which is above global corporate average valuation levels, but below historical average valuations.

High P/Es require high EPS growth to sustain them. That said, in the case of Constellium, the company has recently shown a 59% Uniform EPS decline.

Wall Street analysts provide stock and valuation recommendations that in general provide very poor guidance or insight. However, Wall Street analysts’ near-term earnings forecasts tend to have relevant information.

We take Wall Street forecasts for GAAP earnings and convert them to Uniform earnings forecasts. When we do this, Constellium’s Wall Street analyst-driven forecast projects a 585% and 136% EPS contraction in 2020 and 2021, respectively.

Based on current stock market valuations, we can use earnings growth valuation metrics to back into the required growth rate to justify Constellium’ $8.13 stock price. These are often referred to as market embedded expectations.

The company needs Uniform earnings to grow by 5% each year over the next three years to justify current prices. What Wall Street analysts expect for Constellium’s earnings growth is well below what the current stock market valuation requires.

Furthermore, total obligations—including debt maturities, maintenance capex, and dividends —are above total cash flows, and intrinsic credit risk is 440bps above the risk-free rate, signaling average risk to its dividend and operations.

To conclude, Constellium’s Uniform earnings growth is well below peer averages but the company is trading well above average peer valuations.

Best regards,

Joel Litman & Rob Spivey

Chief Investment Strategist &
Director of Research
at Valens Research