· The Arconic-Alcoa split favors Arconic disproportionately as the former would be rated investment grade and the latter could have BBB- rating
· The split is based on the rationale that management focus on the upstream and the downstream businesses are quite different qualitatively and therefore incompatible.
· Arconic is poised for taking advantage of the disruptive growth in automotive where it still holds No.2 position, while on all its other businesses it holds No.1 position
Arconic, the newly created entity, will be splitting from Alcoa, as the holding company of all downstream assets of Alcoa. The "arc" of progress, coupled with the "iconic" products in Aluminum that Alcoa has been so famous for led to the framing of the name Arconic.
The split of upstream and downstream in the case of Alcoa comes after almost twelve years of the Novelis-Alcan split. But the rationale now could be quite different.
Metal businesses, whether in Steel or Aluminum, have two distinct business models. One is the integrated model, like erstwhile Alcoa and secondly we have the disintegrated model (separate upstream and downstream). Both these models have pros and cons, but the business cycles have influenced the outcomes more than what the models stand for.
The rationale of an integrated model is that while upstream businesses could be very volatile in terms of cash flows or margins due to vagaries of international prices, the downstream provides the stability throughout the upturns and downturns with a pass-through model. On the other hand the high margins during the upturn of business cycles make the allowance for asset heavy upstream to survive the onslaught of a downturn and stand on its own feet; essentially the cushion effect of the downstream is largely misplaced.
The Arconic-Alcoa split is a breakaway from the integrated model that Alcoa espoused for more than hundred years of its existence and it has some solid arguments to go for it now. But I am of the view that the split leaves Arconic on a stronger wicket than Alcoa.
Let me deal with the arguments for the split:
1. The first argument and the most potent one is the growth trajectory of the upstream versus the downstream showed the most lopsided picture. While Alcoa's upstream has been cutting capacity and moving through a negative growth in the last three years, its value-added downstream has been on an upswing and is now poised for a disruptive growth.
In fact what Alcoa has been preaching all these years, 'earning the right to grow" is actually being practiced. The upstream businesses lost its 'right to grow' after the 2008 downturn; subsequently those smelting capacities that were on the third and fourth quartile of the cost curve had to be closed. Smelting capacity has thus been reduced from 4.2 Million ton to 3.4 Million ton. The downstream businesses, consisting of Rolled Products, Engineering Products & Solutions and the Transportation and Construction Solutions, showed healthy signs of growth buoyed by the margins. Market growth in Automotive was aided by light-weighting considerations and aerospace saw industry moving out from the structural issues.
The downstream businesses have growth trajectory as explained below in the communique circulated on November 2015 in the Alcoa website:
· Global Rolled Products forecast approximately $1 billion of revenue growth for the three-year period, with 2016 adjusted EBITDA per metric ton at or above average historical highs of $344;
· Engineered Products and Solutions (NYSEARCA:EPS) forecast approximately $3.1 billion of revenue growth between 2013 and 2016, with adjusted EBITDA margin of approximately 23 percent next year; and
· Transportation and Construction Solutions, the new segment formed in third quarter 2015 comprising two businesses formerly part of EPS-Alcoa Wheel and Transportation Products and Alcoa Building and Construction Solutions-and the Latin American Extrusions business, forecast approximately $500 million revenue growth over the three-year period, with adjusted EBITDA margin of at least 15 percent in 2016.
The communique makes it clear that Arconic is poised for a disruptive growth and the split would favor Arconic to disassociate itself from the current problems of Alcoa's upstream.
2. The second argument is that the management focus on the upstream and the downstream businesses were quite different qualitatively and therefore incompatible. Many of the constituents could be confused by two parts of the same company, one aggressively taking out capacity and the other building them. The technology and market understanding of these two entities were no way connected and therefore the focus of management could be defused by the need to protect one entity at the cost of the other.
This is clearly going to favor Arconic at the cost of Alcoa.
3. The current S&P rating of the upstream is BBB- as per this WSJ report and the downstream is on the other hand investment grade. Such an incompatible mix could never have been understood well financially from investor standpoint.
Even going by revenues the upstream looked smaller given the current prices of aluminum and as per the report, "Revenue in the future raw materials business would have been $13.2 billion for the 12 months ended in June 2015, while the unnamed business, now known as the "value-add" company, would have posted $14.5 billion in sales for the same period."
This potentially favors Arconic the most.
But we should not on the other hand miss the cons. The separation of entities comes with the retinue of contracts between the two, which would include shared resources, metal supply contracts, shared assets, etc, which are always prone to structural bias; the debt structuring of these two entities will show some peculiarities as well.
Arconic starts on a clean slate with an investment grade rating; what happens to debt that is in the junk rated territory in Alcoa remains to be seen. Therefore the split fails to satisfy investors holding both sides of the pole.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.