Alcoa Continues Aerospace Push With $1.1 Billion Pratt & Whitney Deal

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Alcoa (NYSE:AA) recently signed a 10-year agreement worth $1.1 billion to supply jet engine components to jet engine manufacturer Pratt & Whitney, a division of United Technologies Corporation (UTC). As per the terms of the agreement, Alcoa will supply several key engine components, including the forging for the first ever aluminum fan blade for jet engines. [1]

The deal is the latest in a series of developments for Alcoa in the aerospace sector. Aerospace remains at the center of Alcoa’s shift towards value-added products, as it looks to reduce its dependence on its commodity businesses.

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Alcoa’s Aerospace Push

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According to the terms of  the deal, Alcoa will supply components for Pratt & Whitney’s PurePower PW1000G, V2500, GP7000 and several other regional jet and military engines. The PurePower engines will be used in some of the world’s highest volume aircraft, including the next-generation Airbus A320 neo. The transaction includes UTC’s ‘One Company’ terms and conditions, which provide a common contracting approach between UTC and Alcoa divisions and thus facilitate future collaboration. (( Alcoa Announces Jet Engine First in $1.1 Billion Supply Agreement with Pratt & Whitney, Alcoa News Release))

Alcoa is betting big on its aerospace customers to drive sales of its value-added products. The company maintained its outlook of 8-9% global sales growth in 2014 for the aerospace segment, during its second quarter earnings conference call. [2] The large commercial jet segment is expected to grow at 12.1%, driven by a strong commercial jet order book, which represents nine years of production. The strong order book is also reflected on the jet engines side with 23,000 engines on firm order. Demand for regional jets is expected to grow at 13.2%. For Alcoa, this represents sustained demand for its aerospace products for the medium term. Hence, it has increased its exposure to the aerospace segment.((Alcoa’s Q2 2014 Earnings Presentation, Alcoa Website))

In 2014 alone, several major developments in the aerospace segment have taken place for Alcoa. In June, the company announced the $2.85 billion acquisition of jet engine components maker Firth Rixson. ((Alcoa’s Transformation Accelerates, Will Acquire Firth Rixson To Grow Global Aerospace Portfolio, Alcoa News Release)) Prior to that, it had announced a $25 million expansion of the Alcoa Power and Propulsion facility in Hampton, Virginia. ((Alcoa Boosting Aerospace Capabilities in Virginia to Meet Demand for Next-Gen Aircraft Engine Parts, Alcoa News Release)) The company had also announced the setting up of a $100 million facility in La Porte, Indiana for the production of nickel-based superalloy jet engine parts. ((Alcoa Expands in Indiana to Capture Growing Aerospace Demand for Advanced Jet Engine Parts, Alcoa News Release)) It also signed a long-term agreement worth $290 million to supply aluminum sheet to Spirit AeroSystems over five years. Spirit is one of the largest designers and manufacturers of aerostructures for commercial, military, business and regional jets in the world. [3]

Alcoa’s aerospace revenue of $4 billion in 2013 accounted for around 17% of its total revenue for the year. ((Alcoa’s 2013 10-K, SEC)) With several recent developments in the aerospace segment, its share of the company’s revenue is set to grow.

Shift to Value-added Products

Alcoa’s aerospace push is central to its shift towards its value-added products, as it looks to reduce its dependence on its commodity businesses. The sale of aluminum and alumina constitutes Alcoa’s upstream commodity businesses. Demand for these commodities is broadly correlated with economic growth. These commodities suffered a steep decline in prices as the European debt crisis and slowing Chinese growth contributed to the decline in aluminum demand over the last few years. On the supply side, production capacity, particularly in China has not been reduced corresponding to the fall in demand. This resulted in an oversupply situation, which kept prices subdued. ((Alcoa, Rusal’s Aluminum Production Cuts Not Enough With China Smelting, Metal Miner)) High London Metal Exchange (LME) aluminum inventory levels relative to demand also kept a lid on prices. [4] This inventory has been built up partially as a result of aluminum being tied up in financing deals, which were made possible due to low interest rates. ((Aluminum Price Premiums: Disconnect Between LME and Reality Continues, Metal Miner))

In view of uncertainty regarding aluminum prices, the company has shifted its focus towards value-added products, which command greater pricing premiums and higher margins as compared to the upstream businesses. Alcoa’s shift towards value-added products is reflected in its revenue figures. The percentage contribution of the Global Rolled Products and the Engineered Products and Solutions segments, which represent Alcoa’s value-added businesses, to the company’s total revenues has steadily increased. This figure stood at 52.1%, 54.4%, 55.7% and 58% at the end of 2011, 2012, 2013 and first half of 2014, respectively. [5] In calculating these figures, we have only considered third-party sales. The company’s value-added products accounted for 72% of its total segment after-tax operating income in the first half of 2014. (( Alcoa’s Q2 2014 10-Q, SEC))

Thus, Alcoa’s business strategy seems to be quite clear- a shift towards value-added products, driven by the aerospace segment.

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Notes:
  1. Alcoa Announces Jet Engine First in $1.1 Billion Supply Agreement with Pratt & Whitney, Alcoa News Release []
  2. Alcoa’s Q2 2014 Earnings Conference call Transcript, Seeking Alpha []
  3. Alcoa Signs Long-Term Supply Agreement With Spirit AeroSystems For Aluminum Sheet, Alcoa News Release []
  4. LME Aluminum Prices, LME []
  5. Alcoa’s 2013 10-K, SEC []