In its SEC regulatory filing disclosing its stake in Alcoa (AA), Elliott Management noted that it found Alcoa “dramatically undervalued by the public market.” Elliott also added that Alcoa’s split would “create value substantially above the current share price.”
In our analysis of Alcoa’s split, we noted that the split makes strategic sense. Upstream and downstream companies have completely different investment propositions. Plus, markets have a totally different view of commodity and value-added component assets. In August 2105, Warren Buffett’s Berkshire Hathaway (BRK-B) announced the acquisition of Precision Castparts (PCP) for ~$37 billion, including PCP’s debt. Alcoa sees PCP and Constellium (CSTM) as its competitors in the value-added space.
In its 3Q15 earnings conference call, Klaus Kleinfeld, Alcoa’s chief executive officer, drew parallels with Buffett’s acquisition of PCP. According to Kleinfeld, Buffett paid $37 billion for PCP, which has $10 billion in annual revenues. Kleinfeld added that there is a $6 billion overlap between PCP’s revenues and Alcoa’s value-added revenues.
There can be several reasons why PCP commanded a higher valuation compared to Alcoa. PCP’s profit margins are currently higher than Alcoa’s value-added business. PCP’s leverage ratios are also currently lower than Alcoa’s consolidated leverage ratios. Currently, PCP forms 5.17% of the iShares US Aerospace & Defense ETF (ITA).
Please read How to Play the Aluminum Industry: A Comparative Analysis to learn which factors drive different companies’ valuations.
The valuation multiples of commodity assets and high-precision component manufacturing are quite different, as can be seen in the graph above. After the split, markets should value Alcoa’s commodity and value-added businesses separately. This should help in the price discovery of the two assets.
The value-added company would command a premium compared to the upstream company, which we can see from looking at the growth prospects and the prevailing low commodity price scenario.
In the final part of this series, we’ll explore how Elliott Management plans to add value to Alcoa.