Implications of an Alcoa-Alcan Merger: Is Bigger Really Better?

After two years of discussing how they can work together, Alcoa (AA) has said it will now make a hostile bid for Alcan (AL). The resulting company would once again be the world's number one producer of aluminum and bring forth great economies of scale and the waters shall part and ... sorry, I got carried away there.

The deal is this: Alcoa would give Alcan's shareholders $73.25 per share in cash and stock, for a total of $27 billion. The bid includes $21.5 billion in cash, with the remainder in Alcoa stock. (That's right – 21.5 billion dollars in cash.) Great news, right?

Alcan stock was up 34.5% to 82.11 by close of market Monday, well above the value of the offer. Strangely, Alcoa also rose, though only a modest 8% to 38.63.

Why the unusual performance? Were the stocks undervalued and the market only now rising to the occasion? Are there other suitors for Alcan’s hand, possibly better looking and less hostile, like BHP Billiton Ltd (BHP) or Rio Tinto (RTP)? Did every investor wake up Monday morning, see the news and realize that there is this metal called aluminum and it's in everything and, heck, I gotta get me some?

The Obvious

In the last decade, large competitors in aluminum are springing up everywhere – Russia, the Middle East, even China (though they lack the low-cost electricity required to really manufacture aluminum on a large scale. The increased supply is rising to meet surging demand, which is expected to double in the next 15 years, mainly due to growth in emerging markets.

Alcoa is looking at this new landscape and realizing that it needs to find ways to compete. Point number one is to lower the cost energy, which represents the key cost for aluminum producers. Alcan, of course, has access to tremendously cheap Canadian hydropower.

The two companies also overlap in surprisingly few areas, mainly in aluminum plate and other products for the aerospace industry, which would most likely be divested due to antitrust concerns. A merger would set Alcoa up in a much better position to compete in this new global environmet.

The Not So Obvious

It's not all upside, however: Standard & Poor's issued a press release that stated that, “Without a meaningful equity offering or asset-divestiture program that reduces debt on the balance sheet, it is highly unlikely the combined corporate credit rating will retain an investment-grade rating, which would represent at least a three-notch downgrade for Alcoa's and Alcan's existing corporate ratings[2]”. Today, S&P has them both graded at BBB+, and a three-notch downgrade would put the resulting entity at junk level. Ouch. I guess taking $21.5 billion dollars off the balance sheet raises some serious questions as to how the new entity would expect to service its debt. Of course, Alcoa thinks that it will be saving money within 3 years … but that's what they all say.

Another hurdle to deal with: regulators. This merger is really a reunion: Alcoa was split into Alcan & Alcoa in the 1920's due to antitrust issues. In an industry that has already seen its share of consolidation through mergers and acquisitions (the three-way merger of OAO Rusal, Sual and Glencore AG to form Rusal; Alcoa's acquisition of Pechiney; Hindalco Industries acquisition of Novelis), Washington is going to take a close look at any re-merger activity. Of course, Alcoa has been in talks with Alcan for two years and says that it's already discussed some concerns with regulators. Still, the hostile takeover muddies the waters.

Our Take?

Both stocks are up mostly on the visibility. Very rarely are hostile takeovers good for all concerned, and the price being paid – especially the cash component – presents real financing difficulties.

The merger makes some tactical sense in a shifting aluminum market – particularly one that’s adjusting to higher global energy prices. But with merger mania sweeping Wall Street, the recent upside in share prices may be riding more optimism than analysis.