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Aerospace, Not Auto Will Drive Alcoa's Earnings Higher

There's been a lot of buzz regarding the penetration of aluminum producers into the automotive market. This buzz has been a major driver of Alcoa's (NYSE: AA  )  rally this year. Alcoa predicts that auto sheet demand in North America will grow at a pace of 50% annually. Yet, the automotive segment brought just 6% of Alcoa's value-add revenue last year. The biggest contributor for Alcoa's value-add revenue was the aerospace segment with $4 billion of revenue. Recently, the company announced an acquisition of Firth Rixson, which will further grow its aerospace portfolio. This move will likely lead to more upside for Alcoa's shares.

Spending money where it matters most
The rationale for this deal is very sound – spend money on the segment that brings most profits. What's more, Alcoa's own estimates tell that aerospace sales will grow 8%-9% this year, while automotive sales will grow 1%-4%. While the aluminum auto sheet growth estimates are impressive, this growth comes from a low base.

What's more, steel suppliers like U.S. Steel (NYSE: X  ) and AK Steel (NYSE: AKS  ) have not hung out the white flag to the aluminum invasion. Alcoa believes that the share of aluminum mass in SUV will rise from 9% today to as much as 37% in the future. However, these estimates seem to assume little resistance from steel producers. Meanwhile, both U.S. Steel and AK Steel stated they were taking the threat from aluminum seriously, and were ready to work on future products that will compete with aluminum, especially on the cost side.

Whether one believes that aluminum will grow as big as optimists predict or not, one thing is for sure – this is mostly a story about the future. At the same time, aerospace is what brings earnings now.

Top line and bottom line growth ahead
Last year, Firth Rixson scored $1 billion in revenue. This number is projected to grow to $1.6 billion in 2016, and the big part of this estimate is based on existing long-term arrangements. This is what Alcoa needs now, as its first quarter revenue fell 6.5% from last year's number. One could argue that the bottom-line growth is more important than the top-line growth, but there was no bottom-line growth either.

The acquisition will cost Alcoa $2.85 billion, consisting of $2.35 billion cash, $500 million of Alcoa's stock and a $150 million potential earn-out. As Alcoa had just $665 million of cash at the end of the first quarter, the purchase is financed with debt. This will likely bring Alcoa's total debt to $10 billion. This is a rather big number, but the company can afford some additional leverage.

The growth of aerospace segment is surely worth the spending. While Alcoa estimates that the transaction will be neutral to earnings in the first year, it is likely to be accretive thereafter. This is exactly what the company needs, as possible growth in the auto sheet segment will demand more investment, and, thus, will not be a major contributor to the bottom line in the near future.

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Vladimir Zernov

Vladimir Zernov believes that fundamental analysis works best with energy and materials stocks and covers them on Motley Fool.

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