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What's Gone Wrong With Arconic Inc.?

By Reuben Gregg Brewer – Updated Aug 31, 2018 at 10:36AM

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Arconic shares are down nearly 20% so far in 2018; is the specialty parts maker's business model broken?

It has been a very bad year for Arconic Inc. (HWM -0.10%), with the stock around 28% off of its early January highs and down nearly 20% for the year. It is understandable that investors would be wondering what's gone wrong. The answer requires a little bit of history and shows that every business decision doesn't work out as planned. While there are problems, nothing appears to be beyond repair. Here's what investors need to know about Arconic's terrible stock performance so far this year.

A simple separation

In 2016, aluminum giant Alcoa Corporation (AA) broke itself into two companies, one to own the company's legacy aluminum assets and the other to own a growing specialty parts business. The largely commodity aluminum operations kept the Alcoa name while the specialty parts business was dubbed Arconic.

A man with his head down on a table in front of a graph with a line heading sharply lower.

Image source: Getty Images.

The idea was that Arconic's parts business had higher margins and greater growth prospects and would be rewarded for these traits if it were a stand-alone company. It hasn't exactly turned out as expected. In fact, Alcoa's stock is up around 90% since the breakup while Arconic's is up just 16% or so.

What's gone wrong?

The divergent performance of these two companies speaks to the first big issue facing Arconic. Since it no longer makes aluminum, it has to buy this key raw material for use in its business. Aluminum prices haven't exactly cooperated, and have risen over 20% since the breakup. There was a particularly sharp price spike earlier this year. That helps explain why aluminum was highlighted as a $37 million headwind to operating income in the first quarter and led the company to lower its earnings guidance. The metal remained a drag in the second quarter, as well, depressing operating income by $20 million. Alcoa, on the other hand, benefits from higher aluminum prices.

Although the aluminum price has retreated from its first-quarter peak, it remains an important issue for investors to watch. Commodity prices can be volatile and have a large impact on Arconic's business results. However, shifting commodity prices is not a sign that Arconic's business is in any kind of trouble.

ARNC Revenue (Quarterly) Chart

ARNC Revenue (Quarterly) data by YCharts

In fact, the company's revenue grew 8% in the first quarter and 10% in the second. Organic revenue was up 4% and 5%, respectively, as well. It appears that there is ample demand for the specialty parts that Arconic makes, with ongoing strength in the aerospace and automotive end markets, among others.

The bigger issue for the company today is operational. There are two pieces here. The first is a drag on results, but it's not necessarily bad -- Arconic has had trouble keeping up with demand in select business segments. That puts a damper on sales and will require additional investment to solve, which will increase costs over the near term. The company increased its capital spending plans by around 7% over its initial guidance for the year, but the larger issue is that solving these problems is likely to be a multi-year effort. That means capital spending could be elevated for several years. Although not ideal, having to invest to keep up with strong demand isn't the worst thing in the world.

The second issue, however, is around quality control. As The Motley Fool's Lou Whiteman recently noted, Arconic was created via a series of mergers. Integrating those companies hasn't gone as smoothly as expected, and variations in the quality of the specialty products the company produces have shown up across its production footprint. That will also require additional spending to fix, but speaks to a more fundamental problem. If Arconic's parts aren't consistently of the highest quality, it could lose business. This is one for investors to watch very closely because it has to be solved if Arconic is to thrive.

ARNC Chart

ARNC data by YCharts

Interestingly, it was recently reported by Reuters that Arconic is holding material discussions about going private, a step up from the rumors that have been swirling for some months. The company has activist investors on its board and solving the production issues it is facing might be easier if it didn't have to answer publicly to investors. The stock rose on the news, as you would expect, but still remains well off its early year highs. This, however, suggests that going private now would be better for the buyers than for Arconic's long-term shareholders who are suffering with notable stock losses.

Probably best to avoid for now

If you own Arconic shares, there's no particular reason to sell at this point. The company can't control aluminum prices, and it realizes there are operational issues and is taking steps to address them. With strong demand being one of the "issues" here, the operational problems aren't all bad, either. Moreover, if it is taken private, there's likely to be a premium paid to current prices. So continuing to hold appears to be the best option if you own the shares and are underwater.

That said, investors who are not currently shareholders should probably avoid the stock until it gets the quality issues under better control. Add in the uncertainty surrounding the going-private rumors and it's just not worth the risk for most investors, since any price bump would quickly disappear if the rumors prove false.

Reuben Gregg Brewer has no position in any of the stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. The Motley Fool has a disclosure policy.

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