Materion Corporation (NYSE:MTRN ) delivered 16% sales growth in 2022, and expects EPS growth in 2023 driven by MTRN's long term agreements and growing backlog. I believe that further R&D efforts, successful integration of HCS-Electronic Materials, and perhaps new acquisitions could push the company's FCF north. Under my cash flow model, even considering potential risks, MTRN appears cheap.

Materion manufactures highly engineered devices for use in a variety of electrical, electronic, thermal, and structural applications. Its clients are often end-market participants such as defense industries and the airline, automotive, energy, telecommunications, and information center industries. Horizontal Post Insulator

Materion reports four operating segments: Electronic materials, performance materials, precision optics, and others. The performance materials segment includes manufacturing engineering systems primarily marketed in Europe and the United States through global sales centers.

The electronic materials segment is intended for the production of advanced chemicals, microelectronics packaging, various types of metallic and non-metallic materials for high-temperature purposes, and specialty products primarily intended for high-tech integrated circuits in addition to systems or memories or solar energy constructions and coating among others. The precision optics segment has operation centers in both Europe and the United States, being the least developed at the productive level by the company, and its sales occur both through these channels and through independent vendors in different regions of use.

According to the last 10-K, with approximately 800 active clients, none of Materion's clients represented more than 10% of the revenue. The company is also geographically diversified. Materion has more than 20 manufacturing centers in Europe, the United States, Asia, Germany, England, China, Thailand, Ohio, and Pennsylvania among others. It also has seven other service, sales, and distribution offices in Korea, China, Germany, Japan, and the United States.

Finally, the company owns mining facilities for the extraction of metals together with other extraction centers for rent with long-term contracts that expire between 2025 and 2046. In my view, these contracts provide a significant amount of visibility about the future revenue. Financial modelers will most likely appreciate the company's long term agreements.

With the exception of precision optics, both the performance materials and electronic materials business segments reported net sales growth in 2022. In sum, total sales growth increased by close to 16% in 2022. Management shared its optimism in the last quarterly press release.

According to management, both organic and inorganic initiatives contributed to the sales growth in 2022. The company believes that sales growth will likely continue in 2023.

The combination of our organic and inorganic initiatives has led to eleven consecutive quarters of top line growth and has positioned us well to continue our growth trajectory in 2023. Source: Quarterly Press Release

Materion expects another year of market outgrowth, and also forecasted 2023 adjusted EPS growth of close to 8%. With these figures in mind, I decided to conduct further due diligence and build a financial model for Materion.

We expect another year of strong end market outgrowth as a direct result of our organic initiatives. With this, we are guiding to the range of $5.50 to $5.90 for full year 2023 adjusted earnings per share, an increase of 8% at the midpoint versus the prior year. Source: Quarterly Press Release

As of December 31, 2022, Materion reported cash of $13.101 million along with accounts receivable of $215 million, inventories of $423 million, and prepaid and other current assets of $39 million. In sum, total current assets were equal to $690 million, more than 2x the total amount of current liabilities.

Net property, plant, and equipment stood at $448 million with operating leases worth $64 million and intangible assets worth $143 million. Finally, total assets stand at $1.69 billion.

Materion reported short term debt of $21 million, accounts payable of $107 million, salaries and wages of $35 million, and other liabilities and accrued items of $54 million. Total current liabilities stand at $238 million.

Operating lease liabilities are worth $59 million with finance lease liabilities of $13 million and retirement and post-employment benefits of $20 million. Unearned income stood at $107 million with long term debt of $410 million.

Let's note that as compared to 2021, long term debt and finance lease liabilities decreased. The company appears to be reducing its debts and increasing its accounts payable, which I believe is great news. It means that the company likely works with providers that are helping finance the company's operations.

I can infer that in the future the objective of the corporation is to maintain its leadership position at an international level with new technological innovations in the specialty materials industry. In this regard, I am quite optimistic because management continues to increase its research and development expenditures.

In 2022, R&D expenditures increased by 9%. I believe that further investments in research and development will likely lead to patents, which may enhance product development, and improve the company's FCF/Sales margins.

It is also worth noting that the backlog increased in 2022 and 2021. Besides, the company expects that most of its orders will be filled over the next 18 months. It means that the current backlog of $576.2 million will likely lead to revenue growth. I included this assumption in my DCF model.

The backlog of unshipped orders as of December 31, 2022, 2021, and 2020 was $576.2 million, $541.1 million, and $279.2 million, respectively. Backlog is generally represented by purchase orders that may be terminated under certain conditions. We expect that substantially all of our backlog of orders at December 31, 2022 will be filled over the next 18 months. Source: 10-k

Finally, under my cash flow model, I also assumed that Materion would successfully integrate HCS-Electronic Materials, which was bought for $395.9 million in cash. I would also assume that new acquisitions could happen if the deal is successful.

On November 1, 2021, the Company acquired HCS-Electronic Materials for a purchase price of approximately $395.9 million in cash, on a cash-free, debt-free basis, subject to a customary purchase price adjustment mechanism. This business operates within the Performance Materials and Electronic Materials segments, and the results of operations are included as of the date of acquisition. Source: 10-k

My results included 2030 net income of $258 million, depreciation, depletion, and amortization of $75 million, and amortization of deferred financing cost in interest expense of around $3.5 million. I also assumed 2030 stock based compensation expense of $14 million, which is a bit more than the figure I saw in 2022.

I also included the following adjustments in the cash flow statement. I included a 2030 decrease in accounts receivable of -$4 million, a decrease in inventory of -$48 million, a decrease in prepaid and other current assets of -$2 million, and increase in accounts payable and accrued expenses of $20 million. Besides, with an increase in unearned income of $24 million, I obtained net cash provided by operating activities of $343 million.

With 2030 CFO of $343 million, I also assumed capex of -$60 million, which would imply 2030 FCF of $282 million. If we also use a terminal EV/FCF ratio of 14x, the terminal value would stand at $3.9 billion.

If we sum everything and use a WACC of 8.70%, the total net present value of future FCF would stand at close to $3.04 billion. Besides, with cash of $13 million and debt of $444 million, my equity forecast would be $2.61 billion. Finally, I obtained a target price of $127.2 per share.

The competition for Materion varies depending on the type of product in which we study the situation. Regarding advanced insulation systems, we can highlight NGK Insulators (OTCPK:NGKIF), IBC Advanced Alloys Corp. (OTCQB:IAALF), Ningxia Orient Tantalum Industry Co., Ltd., Le Bronze Alloys, Minotti Metals, SA, KME AG & Co., KG, Aurubis AG (OTCPK:AIAGF), MKM Mansfelder Kupfer und Messing GmbH, AMPCO Metal, Chuetsu Metal Works Ltd, American Beryllia Inc., CBL Ceramics Limited, CoorsTek, Inc., and Ulba Metallurgical. The main competitors of the electronic materials segment are Honeywell International, Inc. (HON), Praxair, Inc., Solar Applied Materials Technology Corp, Grikin, and Ametek Electronic Components and Packaging (AME).

I checked the EV/FCF ratio of competitors. Many of them are larger than Materion, and operate in different markets, however including their EV/FCF ratio appears better than not including anything at all. Many competitors trade at more than 31x FCF, so I believe that my EV/FCF ratio of 14x-15x appears conservative.

By 2022, 16% of sales came from sales to the air defense industry. This is the maximum concentration of revenue by market that Materion reports in its reports. It is a risk in the sense of diversification, of course, since changes in these commercial relationships would affect the company's future performance. Besides, let's note that many of these contracts are with the U.S. Government. Cancellation, changes in the contracts, or budgetary constraints could damage the company's future revenue growth.

In 2022, 16% of our value-added sales were to customers in the aerospace and defense end market. A portion of these customers operate under contracts with the U.S. Government, which are vulnerable to termination at any time, for convenience or default. Some of the reasons for cancellation include, but are not limited to, budgetary constraints or re-appropriation of government funds, timing of contract awards, violations of legal or regulatory requirements, and changes in political agenda. If cancellations were to occur, it would result in a reduction in our revenue. Source: 10-k

There is also a significant risk coming from changes in technologies, new products from competitors, or new emerging technological trends. If Materion fails to offer what existing clients need, its products could become obsolete. A recent example was given by management in the last annual report. Thermal and mechanical performance is very relevant for wireless communications. In this regard, have a look at the following lines.

Next-generation solutions may quickly render an existing product obsolete and unmarketable. For example, for many years thermal and mechanical performance have been at the forefront of device packaging for wireless communications infrastructure devices. In recent years, a tremendous effort has been put into developing disruptive thermal spreading materials which requires newer technology that replaces the traditional approach of building package. Source: 10-k

Finally, among other potential risks, I believe that failure to access sufficient supply of metals could affect the company's production capacity. In the annual report, management included a lack of precious metals, but I would apply the same risk to other types of metals.

We use gold and other precious metals in the production of some of our products. We obtain most precious metals from consignors under consignment agreements. The consignors retain ownership of the precious metals and charge us fees based on the amounts we consign and the period of consignment. Because we do not control the consigned inventory, we may not be able to access the inventory to meet our forecasted needs, which could adversely impact our results of operations. Source: 10-k

Materion delivered backlog growth in 2022, and expects further EPS growth in 2023. Considering the company's position in the electronic materials and performance materials industries and the guidance given, I am optimistic about 2023. If Materion's research and development efforts continue to increase as in the past, I believe that technological innovation will likely enhance FCF generation. Of course, there are some risks from failure to access sufficient supply of metals or concentration in the air defense industry. With that, I believe that Materion appears cheap in the market.

This article was written by

11Kv Compact Substation Disclosure: I/we have a beneficial long position in the shares of MTRN either through stock ownership, options, or other derivatives. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.