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Will Alcoa’s 2Q16 Margin Expansion Boost Its Valuation?

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Margin expansion

Market participants (DIA) who are bullish on Alcoa (AA) like to point to Berkshire Hathaway’s (BRK-B) acquisition of Precision Castparts. Berkshire acquired Precision Castparts (PCP) at a trailing-12-month EV-to-EBITDA (enterprise value to earnings before interest, tax, depreciation, and amortization) of 13x. In light of the PCP acquisition, some analysts believe that Arconic could be worth more than the combined entity.

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Valuation discount

To be sure, Alcoa currently trades at a steep discount to what Warren Buffett paid for Precision Castparts. However, Arconic isn’t totally comparable to PCP. Among other factors, Arconic’s lower EBITDA margins have led to a valuation discount between Alcoa and PCP. (You can read more about this in “Arconic Isn’t Precision Castparts, and the Market Knows That!“)

Notably, in 1Q16 Alcoa lowered the long-term guidance of the EPS (Engineered Products & Solutions) segment. Previously, Alcoa had a three-year price target of $7.2 billion in revenues, with an EBITDA margin of 23%.

The company reduced the target to revenues of $6 billion–$6.2 billion, with an EBITDA margin of 21%–22%. Pricing pressure from aircraft manufacturers (BA) (EADSY) was the key reason behind this lowering of business targets.

2Q16

Alcoa’s EPS segment posted an EBITDA margin of 22.5% in 2Q16 as compared to 21% in 1Q16. Improved margins could help Arconic’s valuation multiples once it’s listed as a separate company later this year. The increase in margins seems driven by productivity improvement and better performance of Alcoa’s RTI acquisition. Meanwhile, synergies from the Firth Rixson acquisition also helped the EPS segment in the quarter, though pricing pressures were a drag on the 2Q16 performance.

In the next and final part of this series, we’ll explore the 3Q16 downstream guidance provided by Alcoa.

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