|Shares Out. (in M):||490||P/E||23||13|
|Market Cap (in $M):||12,747||P/FCF||21||16.5|
|Net Debt (in $M):||8,000||EBIT||1,236||1,495|
|TEV (in $M):||20,700||TEV/EBIT||17||14|
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Arconic is at the beginning of a multi-year inflection in revenue growth:
Arconic’s highest margin end market, Aerospace, stands to benefit greatly as new engine programs ramp, aircraft production rates increase leading to 8% CAGR in Aerospace revenue from ’16-’19 (which adds 3.2% revenue CAGR for the company as a whole)
Other Arconic businesses are growing, or at worst steady (automotive up high teens, commercial transport up HSD, international beverage Can up LSD, etc.)
Arconic has been mismanaged for a decade, new CEO Chip Blankenship starts in January 2018 and has a good track record. He will begin to close the margin gap to competitors (>1000 bps margin lag in Engineered Products and Solutions Segment vs Precision Castparts (“PCP”))
Company has the opportunity to return up to $3B (c.25% of current market cap) through end of 2019 and still stay within their self-imposed 2.5x debt/EBITDA leverage ceiling
Elliott has 6 of 13 board seats (one of which is Elliott Senior PM/Head of US Restructuring Dave Miller) at Arconic increasing likelihood of shareholder friendly moves such as repurchases, dividends and spins
As a new spinoff from Alcoa (October 2016), Arconic is not widely understood by the street, and aside from Elliott there are no significant HF (2nd largest owns 50bps) or major MF owners (none own more than 1%). When the new CEO starts and then issues targets we think the name will attract investor attention
Before the recent tax law changes, Arconic was a ~34% tax payer over the long term, and should benefit greatly from the tax rate cut to 21% and increase in capex expensing. We estimate $8 of tax upside and only ~25% of this is in the stock already, leaving $6 remaining
Note: “Elliott’s projections” case based on financials from Elliott presentation titled “A New Arconic” released 4/11/17
Arconic (ARNC) has three major business segments:
Engineered Products and Solutions (EPS) - This is their gem business accounting for 45% of revenue and 60% of EBITDA. 75% is high margin parts sold to jet engines and airplane airframes
Global Rolled Products (GRP) - This is 40% of revenue and 25% of EBITDA. Rolled sheet metal sold into airframes, autos and various other use cases. Above average quality business
Transportation and Construction Solutions (TCS) - This is 15% of revenue and EBITDA. Sales are half aluminum wheels for commercial trucks and half aluminum cladding for high rise construction. Ok quality business given the trucking business is cyclical (troughed in 2016 and on the upswing)
Arconic is a downstream metal company that split out of Alcoa in October of 2016. While the company’s legacy is Aluminum and this comprises the bulk of revenue, 60% of 2017 EBITDA comes from a segment, Engineered Products and Solutions (EPS), that is largely comprised of Titanium and Nickel (Aluminum is only 20% of revenue in this segment). These other metals are significantly higher margin than aluminum and are the gem businesses.
The EPS segment (45% of revenue) sells components to a number of end markets, though primarily its products end up in aircraft and aircraft engines (~75% of 2016 EPS revenue). The remainder is split between gas power plant turbines (10%), commercial transport (5%), and other businesses such as oil and gas, mining, automotive and so on (10%). The components this business provides to aircraft are cheap relative to the aircraft cost, but highly critical, comprising of fasteners designed to hold the aircraft together, metal components for the hot area of the engine and similar key parts. As a result, EBITDA margins are the highest of ARNC’s segments at 21% in 2016, though there is still a considerable gap (~900 bps on a comparable products basis) to main competitor Precision Castparts (PCP). This business stands to benefit significantly as next generation aircraft engine programs ramp (more content per engine vs. previous generations), and as Boeing and Airbus continue to ramp overall aircraft production rates.
Arconic’s second biggest segment, Global Rolled Products (GRP) sells rolled aluminum to end markets largely overlapping with the EPS business, though the split is significantly more fragmented. It accounts for 40% of revenue and 25% of EBITDA. A number of these businesses are high margin with good growth prospects. Their aerospace business (metal for fuselages and wings) is 19% of 2016 revenue and benefits as aircraft production ramps. 25% of this business is automotive, and is growing roughly 20% yearly as manufacturers switch steel out for aluminum to save weight and improve fuel economy. Another 7% is commercial transport which is largely aluminum for commercial trucking applications, this also stands to benefit as the truck cycle rebounds. The remainder of the business is less exciting. An industrial products business (21% of sales) with a number of miscellaneous businesses is forecast to grow at 1-2% a year. A low margin international aluminum Can business is growing slowly. And a US Can business (11% of 2016 sales) earns roughly 0% EBITDA margin and is being shut down (these Can plants can be relatively easily converted into automotive plants). This business underperforms peers on margin (12% EBITDA margin today) and utilization metrics and stands to benefit both as production ramps and as costs are taken out.
Arconic’s final segment (15% of revenue and EBITDA) is Transportation and Construction Solutions (TCS). This business is split roughly evenly between a commercial transportation business and a building and construction business, with a small LATAM extrusions business as well. The commercial transportation business is largely aluminum wheels for trucking which stands to grow as the trucking cycle rebounds and as existing trucks switch steel wheels out for aluminum to save weight. The building business provides aluminum paneling for high rises, and is generally a GDP grower with business across the world. While margins are hard to benchmark as there are no clear competitors to this business, this segment has the highest ROIC (17%) and thus seems to be well run.
Segment EBITDA forecast ($M)
Arconic is in at beginning of a multi-year inflection in revenue growth – Arconic has posted flat growth for two consecutive years, owing largely to declines in its GRP business offset by slow growth in its EPS business. 2017 represents a floor for GRP as they shut down the low margin US Can business, and EPS growth is set to accelerate on the back of new commercial jet engine programs and commercial aircraft production rate increases at Boeing and Airbus
Arconic’s highest margin business, aerospace, stands to benefit greatly as new engine programs ramp and aircraft production rates increase – Aerospace benefits in two ways in the coming years. First, the number of aircraft produced by Airbus and Boeing per year is supposed to ramp at 5.5% CAGR from ’17 to ’20. Second, Arconic has gained share and has more content per aircraft and engine on new programs. We have confirmed these share gains based on conversations with industry executives. As an example of these gains, on the LeapX (a new A320 neo/737Max engine) Arconic has 103% more content versus the previous generation engines (see resulting revenue uplift below). These contracts are locked in past 2020, and guarantee both price and volume, ensuring a steady ramp. This results in their Aerospace business (42% of 2017 revenue) growing at 8.3% CAGR over the next two years. This revenue growth should have high incremental margins, as these are largely Arconic’s highest margin businesses and investments to build the plants have already been made and this ramp should fill existing plant capacity
ARNC Revenue per engine – Note significantly higher revenue growth in New Generation programs
Source: Company disclosures
Delivery schedule by engine – Note significant uplift in high revenue LeapX/PW1100G shipments
Source: Airline Monitor Commercial Engine Market Forecast
Arconic A320/737 engine revenue estimates (numbers in millions)
Source: Our math based on prior two charts
Other Arconic businesses are growing or at worst steady - Arconic’s automotive business (10% of 2016 revenue) is forecast to grow 16% in ‘18 based on multi-year contracts with the auto OEMS to supply aluminum used to lightweight vehicles (swapping out steel). The Commercial Transport business (10% of sales) is set to grow at a 9% CAGR from 2016 to 2019 as the truck cycle rebounds. The building and construction business (10% of sales) is a GDP grower. The international Can business (10% of revenue) is also a steady grower with multi-year contracts. The remaining “other” business (15% of sales) is harder to forecast but is made up of a diverse set of end markets (oil and gas, mining, off highway, etc) but is growing mid-single digits in 2017 to date and company forecasts low mid-single digit growth through 2019 in most of these businesses. Notably, this overview excludes their now small (1% of revenue in 2017, down from 5% in 2016) US Can business which is being shut down, and contributes essentially no EBITDA
Arconic has been mismanaged for a decade, new CEO provides opportunity for margin improvement. In Arconic’s most critical EPS segment, margins lag its main peer Precision Castparts (PCP) by as much as 910 bps on an apples to apples basis (>1000bps overall). Its GRP business posts a 5% return on capital, significantly below competitors (10% at Novelis). Company has low utilization – competitors appear to get 40-90% more revenue out of their assets. Targets have been consistently missed. The cause of this mismanagement is the previous CEO, Klaus Kleinfeld, who was fired in April after a campaign by Elliott. Comments on his term have been exclusively negative, ranging from an MS analyst who called him “so clueless” to a former senior ARNC executive who said Klaus was “not an operator” and “managed by consultant”. Given that Elliott has 6 board seats and was involved in the selection of the new CEO, it seems likely he will be better and more shareholder focused and there is significant opportunity to improve. Incoming (starting Jan ’18) CEO Chip Blankenship ran GE’s commercial engines division before successfully turning around GE’s appliance business, he also has a PhD in Metallurgy – all attributes that will be highly useful for this role. In his time running GE appliances, he took a business that was shrinking 5% a year and turned it into a 6% grower top line, and improved EBIT from 2013 to 2015 by over 120%, primarily via margin expansion. We expect similarly impressive results at Arconic
ARNC/PCP EBIT Margin Gap:
Source: Company filings
Source: Company disclosures, Our analysis
ARNC segment ROIC vs. Competitors:
Source: Company filings
Arconic has ability to return cash equivalent to c.25% of today’s market cap – We believe that the company can return $3.0B (on a $12B market cap) between now and end of 2019. The company is able to do this and still stay within their 2.0-2.5x net debt to EBITDA targets. With $1.8B on their balance sheet currently it is likely they will begin this return as soon as 1Q18 and the CFO has hinted as such in his public statements. Furthermore, given Elliott’s position in the boardroom (see next point) we believe they will receive a strong push to do so
Elliott has 6 board seats which increases likelihood of shareholder friendly moves – Elliott took a stake in Alcoa in November 2015, and began campaigning for a split of the upstream business (current day Alcoa) and downstream (Arconic). It was awarded three seats at Alcoa in February 2016, all of whom carried over to the Arconic side post split. Arconic named another three Elliott sponsored directors in May 2017 as part of the settlement post-firing of previous CEO Klaus Kleinfeld. On 12/19/17, Senior PM/Head of US restructuring Dave Miller replaced took one of their existing board seats. There are 13 seats, thus Elliott doesn’t have full control, however the high number of seats they do have seems likely to ensure Arconic is well aligned with shareholder interests
Arconic not widely understood by the street – As a new spin (Oct. 2016) Arconic is poorly understood by the street. It appears to have fallen in a bit of a gap in coverage areas – appearing to be too metal focused for aerospace and defense analysts and too aerospace for metals analysts. As a result, outside Elliott, there are no sizable Hedge Fund (largest HF owner other than Elliott owns 50bps) or Mutual Fund (no major US mutual fund such as T Rowe, Fidelity or Capital owns >1%) positions. Additionally, the sell side appears to not understand the story well given the conversations we’ve had and models we’ve reviewed. Many major firms don’t cover them at all (Barclays, Bernstein, BAML, Citi, Goldman and UBS all do not cover ARNC currently). This should change after the new CEO starts and soon after begins issuing targets. This, we believe, will result in buying pressure and re-rating upward
Tax upside – Over the long term, ARNC has stated they are a ~34% tax payer. Further, they spend meaningful amounts on capex each year (have said to expect 5% of revenue a year) and thus benefit from accelerated depreciation. Thus, they are a clear beneficiary of tax reform (math below). We estimate roughly $2 of this is in the stock. Various tax tracking indexes ripped higher on 11/28/17 and the odds of passage also climbed substantially around that date in the prediction markets. The stock was $24 the prior day, and at $26 today, we believe that the stock has only priced in 25% of the upside leaving $6 left of easy tax-related upside
CATALYSTS / EVENT PATH
Tax (currently re-rating up, likely to continue for next 1-2 months) – The stock has begun to run up on the tax reform bill, and is up roughly $2 of the $8 of total upside. The stock has been climbing daily, but we think the stock will shoot up significantly slightly before/after the 4Q earnings release when analysts begin to update their numbers and the company gives clarity on the benefits, especially around the poorly understood bonus depreciation provisions
Capital return (As soon as 4Q17 earnings call) – Arconic has said it targets 2.0-2.5x net debt to EBITDA in terms of leverage. While the company was at 3.7x leverage as recently as 4Q16, it is deleveraging rapidly by selling its 20% stake in legacy Alcoa stock (sale of stake concluded in 2Q, company used almost all of $1.3B proceeds to repay debt). We anticipate that by 4Q17 ARNC will sit at 2.5x net debt to EBITDA. If the company seeks to hold this level, it will have $3.0B of cash to return through 2019, which represents 25% of today’s market cap. The company has mentioned they are looking at using this cash generated for repurchases as well as further debt reductions and reduction of pension liabilities. Given Elliott’s position, it seems hard to imagine that the cash will not go to something that increases the stock price
New targets laid out (Q1/Q2 2018) – It is likely that the new CEO lays out new, more ambitious targets, closer to Elliott’s numbers, after a 3-6 month period where he gets acquainted with the company (Elliott targets $3.1B of 2019 EBITDA vs. $2.3B street ests). While at times CEOs use this as an opportunity to revise guidance downward, this seems unlikely given Elliott’s ownership and board position. Furthermore, the interim strongly hinted in an August conference presentation that he believed the current 2019 targets ($2.5B EBITDA, $100M below our estimates) were conservative
New CEO choice will perform poorly – Incoming CEO Chip Blankenship has a good track record and very relevant experience rendering this somewhat unlikely. Further, given the overwhelmingly negative reviews for the previous CEO it seems it would be hard to do much worse. Furthermore, Elliott’s presence in the board room and involvement in the search should minimize this risk
Aircraft order cancellations, triggered by recession or otherwise – While this is inherently a risk, the order book is so massive at this point ($424B for Boeing as of Q2, or roughly 6.6 years at current production rates), that even significant cancellations are unlikely to curb production in the next few years. Indeed, the most recent recession had a very muted impact on production rates and so it seems as if the risk to company revenue and EBITDA in this segment is low
Source: Boeing Market Outlook 2017
Rising commodity Aluminum prices reduce company EBITDA – As a downstream Aluminum producer, Arconic’s contracts largely contain pass-through provisions. This can affect margins, a $100 LME price move will create a 20bps drag on margins. Still, while margins are affected slightly, total EBITDA is largely unchanged
Boeing’s Partnering for Success 2.0 (PFS2) program impacts revenue/margin – In July 2016 Boeing launched its PFS2 program aimed at achieving costs savings by streamlining its supply chain. This has admittedly caused some disruption in the past few quarters for the industry as some middlemen aerospace distributors have been cut out resulting in an air pocket in demand as they liquidate. This is unlikely to recur
More generally, there is a view that Boeing seeks to lower the cost of its aircraft to its customers by squeezing its suppliers and lowering the costs of aftermarket goods. While some in this space definitely face a risk, Boeing has limited leverage over Arconic given the duopolistic nature of their EPS business. Furthermore, Arconic’s Boeing/Airbus revenue is 90% OE, and relies very little on aftermarket sales. Thus, while more commoditized and aftermarket players may be affected in the coming years, Arconic likely faces little risk, and we’ve confirmed this in our conversations with industry experts.
VALUATION AND RETURNS
Reward case: In our reward case, our biggest difference to the street comes from the performances of both the EPS and GRP Segment (see exhibit 1 on next page). In EPS we assume 10% CAGR revenue growth (all numbers ’17-’19 unless stated otherwise), versus 6% for the street, and 500bps of EBITDA margin uplift versus 250bps for street (and 400bps for company goals). We believe the street fails to grasp the growth story and incremental margins provided by the ramp in aerospace revenue. The company has stated that their markets are growing at 7% CAGR over that period, and that they believe they should grow above that. Given what we know about their revenue per engine and aircraft, we are inclined to agree. Furthermore, the street appears to put little value on cost savings opportunities and the value of increased utilization of existing assets.
On GRP, again we are more optimistic than the street. While our growth CAGR is only slightly more optimistic (+100 bps), we are significantly more optimistic on the EBITDA margin side. The company gets 150bps of tailwind between 2016 and 2019 simply by shutting down its zero margin US Can business, yet over this same period the street estimates an improvement of only 60bps, implying it believes the margin picture on the other businesses is actually worsening. We believe it will get +200bps over that time period. The street case seems unlikely, as revenue growth is coming from GRP’s highest margin segments (automotive and aerospace). Further, the company’s utilization is low, and this growth will be largely off existing factories, and thus margin should rise a good deal, perhaps more than our estimates.
The returns in this case are quite promising. We should expect that a ~40% increase in EBITDA from 2017 to 2019, on levered stock ($10B of gross debt/pension versus $12B of market cap today) generates 72% upside in a two year period based on a flat EBITDA multiple. There is further upside if the company uses the excess cash it will have on hand in 2019 (will be able to return $3.0B through 2019 and still remain within leverage targets) for something accretive such as a share repurchase. Additional upside ($6) will result via tax law changes
Risk Case: In this case we assume the street is right. Perhaps this happens via the EPS ramp taking longer than expected due to operational issues. Perhaps this happens because the other businesses underperform despite a strong performance from aerospace. Either way the street still implies $500M of EBITDA growth from 2016 to 2019, and without multiple compression this means we should expect significant returns (stock up ~50%). However it seems likely that underperformance will be met with significant declines in multiple, and given leverage this impacts the business a good deal. Thus, with 5 turns of EBITDA multiple compression versus our base case, we forecast the stock to decline 27%. Admittedly, it is hard to pick the correct multiple for this case, and it is somewhat arbitrary, however we are comforted by how steep the multiple decline must be for this stock to go down meaningfully over a two year period.
Sum of the Parts: This is not one of our main scenarios, but we’ve performed this to validate our valuation. Based on our targets, there is 116% upside in two years year. Even if the company significantly underperforms our expectations and their targets, there is meaningful upside (up 18%) even one year out (for backup on these multiples see comparables section, our math is simply using average of competitor multiples)
Note – Street estimates hand calculated from analyst notes/models. Bloomberg consensus numbers are not correct/meaningful likely due to recency of spin
Return math by case:
Note: The EBITDA multiple is plugged to incorporate tax upside. At flat EBITDA multiple, giving no value for tax upside, stock would be at $45 including cash flow generated. It is worth noting that a downside case of ~27% decline needs 4 turns of EBITDA multiple declines versus today and ignores any benefit from tax upside (note that EBITDA multiples used below are not forward multiples, but TTM instead).
Comparables – Note that given the competitive dynamics of these businesses and the fact that many of the competitors are private (PCP, Novelis), few direct comps exist. PCP numbers shown are where stock was for most of 2015 prior to acquisition by Warren Buffett (deal was 12.4x EBITDA)
Revenue Modeling Detail:
Tax, capital return, new targets
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