Alcoa (NYSE:AA) recently conducted a ground breaking ceremony for its planned $275 million expansion of the Tennessee operations. The expansion is being carried out to meet the rapidly growing demand for aluminum in the auto production segment and is supposed to be completed by mid-2015.
While the automotive sector has been lagging in recent times, Alcoa is adopting a long-term perspective with this move. The company expects the demand for aluminum for auto production to double by 2025 from the current levels. 
As we have argued in the past, Alcoa’s future growth is likely to come from value-added products that it supplies to the automotive and aerospace sectors. The company’s fortunes currently tend to be volatile because of its dependence on aluminum prices which don’t always reflect the fundamentals of demand and supply.
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Alcoa’s Value Added Products
Alcoa manufactures value added products in two business segments: Global Rolled Products (GRP) and Engineered Products and Solutions (EPS). Both divisions meet the needs of the automotive segment among others.
The GRP segment produces and sells aluminum plate, sheet and foil. Products in this segment include rigid container sheet, which is sold directly to customers in the packaging and consumer market and is used in the production of aluminum beverage cans. This segment also includes sheet and plate used in the aerospace, automotive, commercial transportation and building and construction markets.
The EPS division produces titanium, aluminum, and super alloy investment castings, forgings and fasteners, aluminum wheels, integrated aluminum structural systems, and architectural extrusions used in the aerospace, automotive, building and construction, commercial transportation and power generation markets. These products are sold directly to customers and through distributors. This division also manufactures hard alloy extrusions products, which are sold to customers in the aerospace, automotive, commercial transportation, and industrial products markets. 
The GRP and EPS divisions have been largely responsible for cushioning the impact of weak aluminum prices. Consider Alcoa’s Q2 2013 results. In the GRP division, after-tax operating income (ATOI) declined marginally on a sequential basis to $79 million from $81 million due to low metal prices, largely offset by productivity gains and higher volumes. But in the EPS division, ATOI rose sequentially from $173 million to $193 million due to innovation, productivity gains and higher sales volumes. In fact, the EPS division recorded its best ever EBITDA margin in the second quarter. Thus, these two divisions were relatively insulated from the impact of low aluminum prices.
To appreciate the resilience and importance of these divisions, one needs to consider the earnings numbers for the Primary Metals division whose performance is dependent on aluminum prices. Here, falling London Metal Exchange (LME) prices impacted ATOI negatively by $81 million and was the major reason why ATOI fell from $39 million in Q2 2012 to a negative $32 million in Q2 2013. ((Alcoa Q2 2013 Earnings Presentation, SEC))
The Tennessee Expansion
In its Q2 2013 earnings presentation, Alcoa projected that the aluminum body sheet content per vehicle in North America will rise from 14 pounds in 2012 to nearly 55 pounds in 2015 and 136 pounds in 2025. This represents a mind-boggling ten-fold increase in aluminum content per vehicle over the next 13 years. According to the company, the increase in aluminum intensity per vehicle will occur due to the new U.S. Corporate Average Fuel Economy (CAFE) standards which demand better fuel economy in vehicles from manufacturers. This can be achieved by replacing steel with aluminum to make vehicles lighter.
In order to meet the industry’s projected needs, Alcoa needs to expand its production capacity. It has already been doing so by investing nearly $300 million for the expansion of its Davenport Works plant in Iowa. This project is currently underway and scheduled to be completed by the end of 2013. However, it would be sufficient to meet the projected increase in demand only till 2015. The expansion of the plant in Tennessee is aimed at taking care of the incremental demand beyond 2015. Most importantly, the long-term supply contracts with customers are already in place for incremental growth in production volume.
As a result of this expansion, we expect growth in revenues and margins for the GRP and EPS segments beyond 2015. Since the company hasn’t yet disclosed details about the expected additional revenue stream, we will have to wait till the next earnings conference call to get a better idea of the same. However, any step that Alcoa takes to expand its value-added products business is certainly positive for its valuation and share price.
We have a Trefis price estimate for Alcoa of $7.Notes:
- Alcoa Breaks Ground on $275 Million Auto Expansion in Tennessee, Alcoa News Release [↩]
- Alcoa 2012 10-K, SEC [↩]