Alcoa: No Longer An Interesting Risk-Reward Situation

| About: Alcoa, Inc. (AA)

Summary

Alcoa outperformed after a favorable earnings report, which actually masked the deterioration in its Value-Add operations.

By this article's estimates, Value-Add by itself is worth less than the current price, and the free optionality is gone.

Returns from here will be driven by better commodity prices and asset sales.

There is low visibility for either, and the stock no longer represents a compelling investment, in my view.

Alcoa's Q2

Alcoa (NYSE:AA) reported adjusted Q2 EPS of $0.15 versus a consensus of $0.09. The beat was from much better than expected results (although expectations had soured severely coming in) in Primary Metals, particularly on the cost side, with ATOI coming in at $41 million compared to Q1 levels of $14 million. Results in the other segments were either in line with or slightly ahead of Street estimates. While H2 2016 estimates are benefitting from an improving upstream environment, AA's guidance for its Value-Add (Arconic) businesses for 3Q was generally weaker than expected, relative to both Street numbers and management's own guidance. The company's expectations for its end markets are being revised downwards after every quarter, it seems.

In Q1, the company announced a substantial revision downward for its revenue guidance in its EPS segment. Whereas it previously expected $7 billion-plus of revenue, it expected slightly above $6 billion. In this quarter, the outlook continued to sour. AA expects its end markets to continue to soften. In Aerospace, it sees global sales growth of 3%, as opposed to the 6-8% it expected in Q1 (keep in mind, these expectations were already revised down from the 2015 projections). It continues to emphasize no further reductions in growth expectations for Automotive, Construction, Packaging, and other smaller end markets. In my view, there is certainly a lack of credibility and what seems to be an inability to have proper visibility into the end markets. Investors don't seem to think so, and the stock went up in value after the earnings release, but I have my doubts. In any case, the free call option on the aluminum aspect of the thesis (which was my original view on the company) no longer holds.

Form 10 and Valuation

A few weeks ago, Alcoa filed its Form 10 to let investors know the pro forma capital structure of each company and allow investors to better value it post split. Terms of the split were different from my own expectations, and it appears Arconic will be more leveraged than previously thought. Management announced that the upstream ("Upstream" or "New Alcoa") company will have $1.236 billion (it will retain $236 million and issue $1 billion to Arconic) in debt. Unfunded pensions and other post-employment benefits (OPEB) will be split $2.6 billion upstream and $3 billion downstream. Another surprise was that Arconic will own roughly 20% of Upstream company at the time of the split. The company continues to target a 2H16 separation, although it seems contingent on resolution of the Alumina Limited (AWC)/Alcoa consent dispute, with a court date set for September 20. AWC claims that the spin-off qualifies as a change of control that triggers AWC's right of first refusal on Alcoa's 60% AWAC ownership (structured as a JV). It may be the case that the 20% ownership will allow the entities to maintain an affiliated status, which would prevent the legal proceedings from derailing the split. It may also be the case that Arconic wants to wait until the macro environment for New Alcoa/Upstream improves, to extract maximum value. Even so, it will probably lead to a HoldCo discount that is difficult to determine pre-split, and will likely mean that the full SOTP value will not be realized for a while.

Debt levels should be manageable, but more on the higher side, at both companies. The majority of the burden of debt has fallen on the downstream assets. AA was targeting an investment-grade rating for it, but now that goal may be infeasible. Arconic's leverage (including pensions) would be approaching 3.9X on 2016E estimates, based on management forecasts (see below). However, downstream will own ~20% of the upstream company, an asset it plans to monetize within the next 18 months if the markets are supportive. Liquidation of the shares would reduce leverage, but this is sensitive to commodity prices and not easy to predict with a high degree of certainty. This net debt level for Arconic is higher than most commercial aerospace companies, where Net Debt/EBITDA typically averages closer to the 1.0x-2.0x range. Sell-side analysts have referred to the Upstream stake (recall that Arconic will retain 20%) as a source of funding, but this assumes management will monetize it. This would trigger a tax bill and is unlikely, in my view. So, I am not considering the stake as a source of cash (and it doesn't impact the overall Enterprise Value to begin with).

Given the underperformance of AA's downstream businesses, I don't believe management's forecasts should be treated with such certainty. Moreover, it clearly is not as high-quality an asset as Precision Castparts (NYSE:PCP). As seen below, I don't believe PCP is a perfect comparable. In the 2008-15 period, AA's EPS segment averaged 21.2% EBITDA margins, well below PCP's average margins of 28.5%. Arconic's consolidated margins are being in part impacted by the lower-quality GRP business, which averaged 7.4% over the 2008-2015 time frame.

Click to enlarge

(Source: JPMorgan)

Assuming management's revenue targets and margin targets are satisfied, the company can earn the following:

EPS

TCS

GRP

Total

Revenue ($M)

6000

1985

6100

14085

EBITDA ($M)

1380

267.975

579.5

2227.48

Margin (%)

23%

13.5%

9.5%

Click to enlarge

To this, we can add Arconic's proportional share of pension funding contribution for 2016 - in my valuation, I'm capitalizing pension obligations. Overall contribution is $300 million, so Arconic's share is about $160 million. Taking this EBITDAP at an 8.5X multiple results in the following:

Value ($M, except per share)

2016E EBITDAP

2388.189

EV/EBITDA

8.5

Enterprise Value

20299.61

Less: Net Debt

5764

Less: Pension

3000

Equity Value

11535.61

Value (per AA share)

8.57

Click to enlarge

Finishing Thoughts

With the value of Upstream evidently impaired, in my view, I don't believe AA represents an attractive risk-reward any longer. Keep in mind that for Arconic to even meet these targets, it needs to deliver well beyond what its annual run rate implies. With the downward trajectory that management has noted in the end markets, this seems unreasonably optimistic. EPS, for example, is run-rating below $6 billion and 21% EBITDA margins. Underperforming guidance would result in multiple compression too. If EBITDAP is lower by 10% and the multiple shrinks to 8X, that cuts $1/share of value from AA. With AA in the high $10s, it does not represent an attractive risk-reward, in my view. That is, unless the commodity outlook improves markedly and the call option of upstream operations ends up being worth paying $2/share for. I don't share this view, and have no particular expertise evaluating hard commodity companies. Also, it may be the case that Alcoa has a number of "hidden" assets on its balance sheets. These include its JVs, energy assets, and the like. These are non-core, non-cash generative assets typically, and may have value to a strategic. Activist involvement from Elliott will probably result in some monetization, and this could be accretive to the overall value. That being said, I don't have much visibility into what these could be worth. My original thesis was that I was getting Upstream for free - which no longer holds. This is both because the stock has had an impressive run and because the Value-Add businesses have had their values impaired.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

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.