Alcoa Completes Firth Rixson Acquisition As Part Of Ongoing Strategic Shift Towards Value-added Products

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Alcoa (NYSE:AA) has announced the completion of its acquisition of Firth Rixson, a leading jet engine components manufacturer. [1] The company had announced the Firth Rixson aqcusition in June. The total consideration for the acquisition is $2.85 billion, consisting of $2.35 billion in cash and $500 million in stock. [2] In addition, there is a potential $150 million earn-out, the payment of which depends on Firth Rixson’s performance through 2020. [3]

The acquisition is a part of Alcoa’s ongoing strategic shift of its product portfolio towards value-added products, which are more profitable as compared to its upstream businesses.

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Benefits of the Acquisition

The acquisition of Firth Rixson will widen Alcoa’s jet engine components portfolio. Through this acquisition, Alcoa has become the number one global producer of seamless rolled jet engine rings, engineered from nickel-based superalloys and titanium. The company has also become one of the world’s leading suppliers of vacuum melted superalloys, which are used to make aerospace, industrial gas turbines, oil and gas products and structural components for landing gear applications. It has also entered into a highly specialized segment of jet engine forgings that require isothermal forging technology. [1]

The acquisition is a significant boost to Alcoa’s aerospace revenue. It grows Alcoa’s aerospace revenue in 2013 by 20% on a pro forma basis, from $4 billion to $4.8 billion. [2] The acquisition will boost Alcoa’s overall revenue by $1.6 billion by 2016, and by $2 billion by 2019. [1]

The acquisition will also result in significant cost synergies, primarily driven by purchasing and productivity improvements, optimizing internal metal supply, and leveraging Alcoa’s global shared services. Cost savings are expected to exceed $100 million annually by the fifth year after completion of the acquisition. ((Alcoa’s Transformation Accelerates, Will Acquire Firth Rixson To Grow Global Aerospace Portfolio, Alcoa News Release))

The acquisition of Firth Rixson is a part of Alcoa’s ongoing product portfolio transformation towards value-added products, as it seeks to reduce its dependence on volatile aluminum prices.

Aluminum Prices

Aluminum has diverse applications in industry. It is an important input in the packaging, aerospace, automotive, construction, commercial transportation, power generation, capital goods and consumer durables industries. Thus, demand for aluminum is broadly correlated with industrial growth. The European debt crisis and slowing Chinese growth have contributed to the weakness in aluminum demand, and consequently prices over the last few quarters. [4]

On the supply side, production capacity was not reduced corresponding to the subdued demand conditions witnessed over the last few quarters. Persistently high aluminum inventory levels relative to demand have kept London Metal Exchange (LME) aluminum prices depressed. This inventory was 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)) Despite inventories being at a record high, market forces failed to rationalize supply through the shutdown of smelting capacity. Though global aluminum majors like Alcoa and Rusal did make significant smelting capacity cuts, the same was not true of Chinese companies. This was primarily due to state intervention in the form of provision of subsidies or renegotiated power contracts to smelters, which serve as a disincentive to cut production. China accounted for around 45% of the world’s aluminum production in 2013, and the expansion in production by Chinese producers more than made up for capacity cuts by global majors. [5] ((Alcoa, Rusal’s Aluminum Production Cuts Not Enough With China Smelting, Metal Miner)) This oversupply situation kept aluminum prices depressed over the last few quarters.

Aluminum prices have rebounded recently. Global smelting capacity cuts in response to low prices have finally taken effect. LME warehouse stocks of aluminum were down around 10% in July, since the start of the year. [6] In view of the global smelting capacity cuts, as per a poll conducted by Reuters in July, the market for aluminum is expected to move from an oversupply of 235,500 tons in 2014 to a deficit of 4,444 tons in 2015. [7] LME aluminum prices averaged roughly $1,800 per ton over the course of the third quarter in 2013. These prices have averaged close to $2,000 per ton in the third quarter this year. [8] However, global smelting capacity restarts in response to higher aluminum prices are expected to lower or eliminate the extent of the deficit next year. In addition, the trajectory of Chinese economic growth will influence aluminum prices to a large extent. With slowing Chinese growth, there is unlikely to be any significant upside to aluminum prices. A significant proportion of Alcoa’s alumina pricing contracts are based on LME aluminum prices. Thus, the uncertainty in aluminum prices affects Alcoa’s Alumina business segment as well. In view of the uncertainty regarding aluminum prices, Aloca has sought to reduce its dependence on its commodity businesses.

Portfolio Transformation

Alcoa’s shift towards value-added products is reflected in its revenue figures. The percentage contribution of value-added products, represented by the Global Rolled Products and Engineered Products and Solutions business segments, to the company’s total revenues has steadily increased. This figure stood at 52.1%, 54.4%, 55.7% and 57.1% in 2011, 2012, 2013 and the first nine months of 2014, respectively. ((Alcoa’s 2013 10-K, SEC)) [9] In calculating these figures, we have only considered third-party sales. Value-added businesses will drive Alcoa’s results in the near future, with cost reductions expected to keep its commodity businesses competitive.

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Notes:
  1. Alcoa Acquires Firth Rixson, Grows Global Aerospace Portfolio, Alcoa News Release [] [] []
  2. Alcoa’s Transformation Accelerates, Will Acquire Firth Rixson To Grow Global Aerospace Portfolio, Alcoa News Release [] []
  3. Accelerating Alcoa’s Transformation, Alcoa Company Presentation []
  4. LME Aluminum Prices, LME []
  5. U.S. Geological Survey Mineral Commodity Summary-Aluminum, 2014 []
  6. Aluminium prices hit 17-month highs, Financial Times []
  7. Aluminium smelter restarts seen undermining global deficit outlook, Reuters []
  8. LME Aluminum Prices, LME []
  9. Alcoa’s Q3 2014 10-Q, SEC []