Alcoa - Transformation To Aerospace Continues After Acquiring Firth Rixson

| About: Alcoa, Inc. (AA)


Alcoa acquires Firth Rixson in a nearly $3 billion deal.

The deal adds growth, higher and steady margins and further expansion into the fast growing aerospace business.

After the huge run so far in 2014 and over the past year, I am cautious to jump on the bandwagon.

Alcoa (NYSE:AA) is joining the merger and acquisition frenzy after it announced the multibillion dollar deal to acquire Firth Rixson in order to expand its presence in the aerospace industry.

The anticipated growth, secured long term contracts, high margins and anticipated cost savings are making investors enthusiastic despite a more than fair deal price. The continued move away from the volatile aluminum business to a steady, high-margin and growing aerospace industry is applauded by investors. Amidst this transformation Alcoa is becoming a more appealing business.

The Highlights Of The Deal

Alcoa announced that it has entered into a definitive agreement to acquire privately-held Firth Rixson in a $2.85 billion deal.

The company is a leader in jet engine components and was previously owned by Oak Hill Capital Partners.

Under terms of the deal, Alcoa will pay $2.35 billion in cash, $500 million in stock and even award a potential $150 million in earn-out agreements.

The deal is expected to close by the end of this year.

Strategic Rationale

The deal adds to Alcoa's aerospace business, perhaps the most compelling growth opportunity for Alcoa. The company is now able to focus on a broader range of opportunities in the industry, by adding high growth and value-adding engine components.

Firth Rixson holds strong market positions in key components like rings which are produced with nickel superalloys and titanium. The company also supplies engine forgings. Besides the aerospace industry it also supplies the markets for industrial gas turbines and landing gears. These solutions are very much geared to the trend of more fuel-efficient plane engines as well as reduced emissions, creating huge potential for solid growth in the coming years.

The deal will bolster margins and reduce the reliance on volatile and lower margin businesses which traditionally have been a huge problem for Alcoa.

Financial Implications Of The Deal

Firth Rixson posted revenues of about a billion in 2013, yet revenues are seen at roughly $1.6 billion by 2016. EBITDA is seen at $350 million in 2016 but has not been specified its profitability for 2013.

Sales for Firth Rixson are expected to grow at a compounded annual growth rate of 12% between now and 2019, which are simply astonishing numbers. What is comforting is that 70% of growth is already secured through long-term agreements which creates a huge deal of visibility into future cash flows.

Given the $2.85 billion price tag, the business is valued at 2.8 times sales reported for 2013, and 1.8 times sales anticipated for 2016. The deal is valued at 8.1 times EBITDA which is foreseen for 2016.

Despite having little product overlap with Alcoa's existing aerospace business significant cost savings and synergies are anticipated. Synergies are driven by purchasing and productivity improvements, and are anticipated to reach a $100 million per annum by 2019.

The deal will be neutral to 2014s earnings, and is expected to be accretive thereafter.

Valuing Alcoa

Back in April, Alcoa reported its first quarter results. The company has access to $665 million in cash and equivalents. Total debt of $7.7 billion results in a net debt position of roughly $7.0 billion. While this is still sizable, the company has been cutting its net debt position in recent years. Following the announced deal, Alcoa will see its net debt position increase towards $9.5 billion.

The company has arranged a committed bridge facility with Morgan Stanley to finance the deal.

On a trailing basis, Alcoa has reported revenues of $22.6 billion on which it posted a big $2.6 billion GAAP loss. In traditional fashion, Alcoa's earnings are often impacted by sizable ¨one-time¨ charges.

With shares trading around $15 following the deal, equity is valued at roughly $17.5 billion. This values the company at 0.8 times sales.

The company's quarterly dividend of $0.03 per share provides investors with a merely 0.8% dividend yield.

Strategic Overview

Earlier this month, Alcoa gave an updated strategic presentation. The company has been around for 125 years, being the original inventor of the aluminum process.

The company has been focusing more on the downstream business which adds the most value, positioning the company even better for future with the latest deal.

Investors Are Happy

While a long term investment in Alcoa has resulted in detrimental returns, investors who stepped in on January 1 have seen roughly 40% returns. Similarly, shares have nearly doubled over the past year alone. Shares are up 3% on the back of the announcement, which translates in to a $400-$500 million market valuation jump, comforting management in the rationale behind the deal.

Increased optimism about the prospects for aluminum prices and the strategic focus to high growth and the higher margin aerospace business has created enthusiasm among investors. The deal will increase aerospace revenues by about 20% to $4.8 billion on a 2013 pro-forma basis. Alcoa predicts that Firth Rixson will increase the revenue contribution from a billion in 2013 to roughly $2 billion by 2019.

Some of the premium valuation of the deal can be justified given the $100 million cost synergies estimate which will only be fully realized by 2019. Note that by the end of 2016, Alcoa anticipates an annual run rate of $40 million in anticipated synergies.

Back in January, I last checked out the prospects for Alcoa following the fourth quarter earnings release. I concluded that the company is a tricky case in terms of a potential investment opportunity.

The company's earnings statements is seeing legacy charges hitting the bottom line in a continuous manner. At the same time it was already apparent that the company was making productivity gains by lowering the cost curve and shifting towards higher value adding activities.

This made me more optimistic amidst a steadily improving balance sheet. Still I unfortunately concluded to watch the stock from the sidelines given the continued and myriad of ¨one-time¨ charges hitting the bottom line. While good trends have continued to show up, I am obviously much more cautious now after the big run up.

Disclosure: The author has no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.