Why Alcoa Is Trading Tinfoil and Siding for Airplanes and Spaceships

NEW YORK (The Deal) -- Alcoa (AA), maybe the best-known name in the aluminum business, is betting that its future will be brighter if it were more well known for aerospace. It's an expensive gamble, which highlights the difficult choices the company has before it.

Last week, New York-based Alcoa said it has agreed to buy RTI International Metals (RTI) for $1.5 billion, adding the Pittsburgh-based maker of titanium and related specialty components just a year after spending $2.85 billion to buy aerospace-focused Firth Rixson.

Less noticed but equally important, Alcoa also said it was putting 500,000 metric tons of smelting capacity and 2.8 million metric tons of refining capacity on review for possible curtailment or divestiture. That move, a response to global declines in the price of the material, could affect 14% of Alcoa's global smelting capacity and 16% of its total refining capacity. Already 19% of Alcoa smelting capacity worldwide is idle.

The moves, taken together, show that Alcoa is "dead serious about transitioning the portfolio," says Sterne, Agee analyst Josh W. Sullivan.

With good reason. Aluminum trades at $1,817 per tonne on the London Metal Exchange , down from $2,055 per tonne as recently as November and well off 2011 highs of $2,678. Analysts warn the metal could have further to fall, citing weakness in Asia and lethargic economies throughout Europe.

Alcoa, to its credit, has long been searching for ways to stay ahead of a feared glut in demand for aluminum. The company last decade attempted to help consolidate the market by launching an unsuccessful hostile $33 billion offer for rival Alcan Inc. The push downstream is an attempt to diversify the business and make it less reliant on metal pricing: Alumina now makes up just 20% of Alcoa's after tax operating income.

But the shift is a costly one, and not without risk. The RTI deal -- which offered holders of the target a nearly 50% stock premium -- is priced at 13 times trailing Ebitda (earnings before interest, taxes, depreciation and amortization), well above rival Precision Castparts'  (PCP) 10.8 multiple. Alcoa, by comparison, currently trades at an enterprise value of 6.8 times trailing Ebitda, which provides a sense of what Alcoa CEO Klaus Kleinfeld is trying to accomplish.

Alcoa counters that it expects RTI to grow rapidly in the years to come. And if consolidating RTI with its other aerospace holdings allows it to become more of a vertical one-stop shop that manufacturers prefer to deal with over niche contractors, then the combination might open up new opportunities that were not available to either one as a standalone.

UBS Securities analyst Brian MacArthur estimates that should Alcoa succeed in realizing $30 million in synergies and expand the business by 5% to 7% in the coming years, the purchase price would be a more modest 8.9 times estimated 2016 Ebitda.

Still worrisome is that Alcoa is paying up to buy into the middle, if not late, stage of the commercial aerospace up cycle, and could be hit hard should demand for new, more fuel-efficient jets wane. That's a fear that so far has not materialized even as oil prices have sunk, but Alcoa investors need to be careful that the company is not trading exposure to one cycle for exposure to another.

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