ARCONIC CORP ARNC
July 25, 2022 - 10:25pm EST by
amorfati
| 2022 | 2023 | ||||||
| Price: | 29.15 | EPS | 2.55 | 3.60 | |||
| Shares Out. (in M): | 106 | P/E | 11.5 | 8 | |||
| Market Cap (in $M): | 3,083 | P/FCF | 5.5 | 4.74 | |||
| Net Debt (in $M): | 1,523 | EBIT | 0 | 0 | |||
| TEV (in $M): | 4,612 | TEV/EBIT | 0 | 0 | |||
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Description
Overview
Arconic Inc. (ARNC) is a manufacturer/supplier of rolled aluminium products for industrial uses. The company's offerings categorically comprise of 1) rolled sheets and plates, 2) architectural products/systems (such as aluminium windows, doors, and coatings - for buildings), and 3) extrusions. The company currently serves 5 end-markets of
- ground transportation (primarily auto),
- aerospace,
- building and constructions,
- industrial products,
- packaging.
ARNC has 21 primary operating locations in 8 countries comprising of US, Canada, China, France, Germany, Hungary, UK, and Russia.
~80% of the revenue is derived from the rolled products division - producing flat-rolled aluminium coils, sheets, and plates. These are used as raw materials in the making of airplane frames, automotive body panels, industrial plates, soda cans, heat exchangers, etc. These rolled products are manufactured in ARNC's facilities located in China, Hungary, USA, UK and soon to be divested Russian location.
~15% of revenue is derived from Building and Construction products consisting of aluminium door frames, windows walls, entrances, building surfaces. This business is operated by the company's two subsidiaries of 1) Kawneer - which produces aluminium window walls, entrances, etc - and 2) Arconic Architectural Products - which produces aluminium bond sheets, surfaces, for buildings.
~5% of revenue - the remaining - is derived from aluminium extrusion products in custom shapes including cylinders, tubes, bars, etc. These accessory aluminium items are also aerospace, transportation and industrial manufacturing process.
By geography, sales are roughly ~60% US, 10% Russia, 10% China, and 20% Europe.
Cost structure
70% aluminium
11% labor
6% alloy materials
3-4% freight
2% energy
weighted cost of capital is around 10%. so the IRR of 35% in phase 3 and 25% in phase 4 still looks attractive.
Executive Summary
ARNC is undervalued compared to peers at a time when favorable growth tailwinds are breathing healthy demand for aluminium rolled products at all of ARNC's end markets in the foreseeable future. Further, ARNC is amidst the end of deploying capital to execute a few a 25-35% IRR (vs. WACC of 10%) projects that should be both achievable and rewarding to company / shareholders over the next 2-3 years.
Since the separation from Arconic parent (now renamed as Howmet Aerospace) in Feb 2019, ARNC has executed well on all of its major initiatives. From pension contribution reductions to cost cutting, to securing new long term contracts for different end markets, to weathering the disruptions of Covid, the company has done well. Volume growth has also seen a healthy trajectory, trending toward all time high coming out of covid. Yet ARNC currently trades at an abysmal 4.8x 2023 EV/EBITDA (consensus) with little leverage. This compares to competitor group valuation of ~6.5x 2023 EV/EBITDA and almost 3x leverage makes ARNC a very attractive short term play. The valuation gap between ARNC and its peer will likely shrink as more attention is paid to this stock. When I first came across ARNC in Oct 2020, sell-side coverage didn't really exist. Now there are about half a dozen, with a few bulge brackets involved, all positive on the stock. I believe that as the management continues to execute its initiatives while it's narrative and outlook becomes realized, the market should recognize the value in ARNC.
Investment Thesis #1 - Strong end-market demands translate into attractive organic growth
The price of ARNC's products as well as those of its competitors are generally driven by the cost of raw aluminium, from which aluminium are convert to valued-added, flat rolled and extruded products used by ARNC's end-market customers including car manufacturers, airplane manufacturers, industrial equipment manufacturers, aluminium/beverage cans producers, and makers of aluminium doors/frames and architecture products, etc. Because the price of raw aluminium are typically passed onto ARNC's end customers to account for fluctuations of price of aluminium, ARNC's revenue figures do not accurately reflect growth prospects. Instead, it's organic or volume growth of materials sold/produced that is a better metric for growth prospects.
The profitability of individual flat rolled makers is shaped by a combination of the maker's relative position in the flat rolled market, the demand of the end-markets, and the efficiency of their industrial operation. Significant capital investments are required to operate in this industry, in order to achieve technological capabilities and customer qualification standards. As such, the industry saw consolidation to achieve/sustain economies of scale.
The demand side of flat rolled and extruded products are driven by economic growth, substitutions, cyclicality. The supply side is determined production capacity, substitutions available, and trade flow between regions. The estimates for the next 5 years generally puts flat rolled market growth at 4-6% CAGR. Yet 60% and 20% of ARNC business is generated from North American and Europe, respectively. Demand in these markets are expected to grow at 6%+ CAGR over the next 5 years.
Arconic has a #1 supplier in global aerospace rolled products, and #2 in North America ground transportation, industrial packaging and building construction. Given its dominance, ARNC should be able to grew at if not above the industry's general growth estimate of 6%+ CAGR in its core markets of NA and EU.
Topline growth is essentially firing on all cylinders as demand for ARNC's products from all end market are growing because of both short term and medium term fundamentals. This macro tailwind of growth is a very important consideration and constitutes a central tenant to a bullish thesis. ARNC currently supplies aluminium rolled and architectural products to 5 end markets in a pretty balanced composition; and all 5 markets are expected to grow positively in the near future years because of the fundamentals in each of the industries.
In the near term, 4/5 of end markets are expected to grow double digits organically this year. In aerospace, OEMs are increasing build rates and ordering more aluminium sheets. ARNC aerospace sales grew 32% organically y/y in Q1/22 and guidance for FY is revised up to 30-40%. Building & Constructions sales is expected to grow 15-20% this year because ARNC is mostly involved in North American non-residential construction - which is growing unlike residential builds. In Industrial, an across the board global rebound in industrial activities also lifted organic sales to 10% in the first quarter and is expected bring double digits growth for the full year. Packaging also grew nicely on an organic basis as the ARNC ramped up its North American packaging plant at Tennessee. The location expands aluminium rolled products capacity by 600mm lbs and has been fully utilizable as of Q2/22.
Over the medium term to 2026, several dynamics supports favorable organic growth. First, there is pent up demand for autobody sheets that is currently blunted by the damp in car production stemming rom semiconductor supply chain disruptions. Once this disruption abates, auto production should recover over the next year or two, so ground transportation sales are expected to recover quite aggressively as experienced by the aerospace segment. Electric Vehicle also present a new growth vector. EV is 25% to 35% more aluminium intensive than comparable internal combustion engine vehicles and ARNC has strong EV aluminium involvement that will benefit from EV growth. ARNC EV revenue is expected to double in 2022 to $250mm. commercial vehicle historically constitutes 30% of ground transportation revenue also growing at high single digits. New emission regulations will be implemented in 2024 to 2027, driving pre-buy demand in 2023 to 2026. Second, aerospace demand recovery also extends into the medium term. Boeing and Airbus are expected to grow deliveries at 15% per annum over the next few years and ARNC is well contracted with both OEMs. Third, packaging growth also present sensible growth areas for ARNC. ARNC's packaging business is predominantly focused in North America, where current supply is extremely tight. Yet ARNC just expanded capacity by 600mm lbs as of Q2/22. This newly online ARNC capacity should be well utilized over the next several years when other can sheet makers late to the parties are scrambling to bring online 30 new can lines over the next 3 to 5 years.
Aerospace, the pause in air travels precipitated by covid has slowed new airplane productions, in turn dampening demand for airplane construction materials such as airframes made out of rolled aluminium sheets. ARNC's aerospace sales declined from $1.3bn in 2019, to $820mm in 2020, to $630mm in 2021. With air traveling resuming, OEM build rates are recovering, inducing once again demand for airplane aluminium sheets. 2022 should be an inflection year. ARNC already reported Q1/22 sales up 32% y/y on an organic basis; management expects Q2/22 y/y to be even better on an organic basis. For the full year, the company is now guiding to a 30-40% organic sales increase, an upward revision from 25-35% previously expected before Q1/22. If revenue recovers to pre-pandemic levels in 2024 as management is guiding to, aerospace sales should also double over the next year. In Q3/21, ARNC also signed a $2 billion forward contract with 3 OEM that span to the end of 2020s, another sign that things are improving. In packaging, d
There is also pent up demand for aluminium sheets and rolled products from the end markets in ground transportation and aerospace as covid-induced supply disruptions and travel restrictions abate. In 2021, automotive demand accounted for less than 40% of ground transportation sales while the number is generally 70%+. This means that in normalization, ground transportation sales alone could double over the next year or two.
Over the long term, the switching to EV vehicles is anticipated to increase the demand for aluminium rolled sheets because EV require 1/4 more aluminium sheets/materials as raw materials. This will bring strong secular demand for aluminium rolled sheets. Beverage cans and industrial packaging are increasingly shifting to aluminium as business and consumers adopt the sustainability trend. This is also expected to boost industrial demand for aluminium sheets to mid and high mid CAGR.
Investment Thesis #2 - Growth projects to yield large incremental EBITDA growth
Phase 1 project complete. As early as 2020, amidst the weathering of pandemic disruptions, ARNC had set EBITDA growth initiatives that've been well executed since. In addition to realizing several cost cutting programs during covid (including $100mm CEO and management pay cut, $200mm headcount and cost optimization), a Phase I growth project was announced to permanently provide up to $300mm of annual incremental EBITDA through expanding the production capacity for aluminium/beverage cans and industrial flat rolled products by 600mm lbs. True to management's earlier guidance, the project completed in Q2/22 this year. Though the full amount of $300mm will not be realized immediately, the company now has the infrastructure at its Tennessee facility to feedthrough an additional 600mm lbs per annum of aluminium sheets for beverage cans and industrial products. This available capacity coincides with ARNC having just expanded into the North American can sheet market and secured a $1.5 billion contract for 2022 to 2024. There is also currently supply shortage for North American can sheets as imports for can sheet remain all time high and the US market is expected to remain in a deficit for can sheets until 2026. 6 can manufacturers have announced 30+ can lines that would eventually compete with ARNC's completed phase 1 project. However, these competitors projects are not expected to complete for another 3-5 years. In the meantime, ARNC's phase 1 completion position the company well to quickly take advantage of the demand for can sheets in North America. In 2022, ARNC expects to realize ~$50mm EBITDA growth from the phase 1 project that is associated with volume growth/demand of can sheets.
It's reasonable to expect that over the next few years, capacity from this complete phase 1 project will be gradually activated. Therefore, I'd expect the $300mm of annual EBITDA growth (from 2019 level) to progressively flow into ARNC's EBITDA figure.
Phase 2 and Phase 3 projects are nearing completion. In addition to the just completed phase 1 project, Phase 2 and Phase 3 projects involving upgrades at 3 plants are also nearing completion. These projects are what's termed "under the rooftop" projects as they do not involve erecting infrastructures at new locations. Instead, they are incremental, low-risk, highly achievable upgrades at existing plants that essentially seeks to de-bottleneck production capacity. The below diagram illustrates the production process for aluminium flat rolled products. The process starts with melting/casting raw aluminium. ARNC's phase 2 and 3 projects will allow the company to increase melting/casting capacity for more raw aluminium. Additionally, one of the process involve hot and then cold milling processed aluminium to flat sheets. To commensurate the increasing melting/casting capacity, ARNC will also increase capacity for hot/cold milling that will process the increased raw aluminium fed through the melting/casting process. In sum, these projects allows for more throughput of ARNC products, at reduced per unit costs.