When news broke last week that Alcoa (NYSE:AA) was buying titanium airplane parts manufacturer RTI International (NYSE: RTI), the stock market's reaction was immediate: RTI shares soared 39% in a day.
Alcoa shares didn't.
Shareholders wish Alcoa would wait
Instead, shares of aluminum mining, smelting, and manufacturing giant Alcoa shed more than 5% in response to the news last Monday, and they trade even lower today. It seems shareholders would have preferred that Alcoa wait, sit, and think a spell before deciding to do this deal -- and maybe not do it at all. But why? If a merger with Alcoa is good news for RTI, then why isn't the converse true?
The answer, in a word, is: price.
Price is what you pay. Value is what you get -- or don't
In buying RTI, Alcoa agreed to pay an enterprise value of $1.5 billion for its new subsidiary. The valuation breaks down pretty simply:
- Alcoa will trade 2.8315 Alcoa shares for each of RTI's 30.76 million shares outstanding. That's roughly 89.1 million Alcoa shares, times Alcoa's pre-announcement share price of $14.48, equals $1.26 billion being paid in stock.
- Acquiring RTI, Alcoa will also inherit that company's cash reserves of $330 million, and its $517 million in convertible debt -- resulting in a net addition of about $187 million to the target's enterprise value.
So, when all's said and done, $1.26 billion plus about $0.19 billion equals an enterprise value of $1.45 billion. Round it off, and you've got the $1.5 billion "enterprise value" that made all the headlines last week. (Albeit, now that Alcoa's share price has shrunk, the value's actually closer to $1.4 billion today).
So, is that a good price?
Alcoa's bid of $1.4 billion to absorb RTI values its new subsidiary at roughly 1.8 times RTI's annual sales of just under $800 million, and a staggering 44 times annual profit. What's more, RTI is a poor cash generator of a business, producing less than $24 million in free cash flow last year (just 77% of reported net income under GAAP, according to S&P Capital IQ figures). This results in an even less attractive valuation of 60 times free cash flow that Alcoa is paying, when RTI is valued on free cash flow.
For comparison, when valued on enterprise value, Alcoa's own shares currently trade for multiples of 1.0 times sales, 97 times earnings, and 52.5 times free cash flow. So, depending how you look at it, Alcoa's paying a premium for RTI's sales, but getting its earnings at a discount (to Alcoa's even more richly valued, heavily indebted shares), and paying a premium again for free cash flow. By two measures out of three, shareholders look right to be skeptical of the purchase price.
Method in the madness?
Why is Alcoa paying so much for RTI? It's not improving its growth prospects much. According to analysts polled on Yahoo! Finance, the two companies' projected growth rates over the next five years are very similar: 11.3% for Alcoa, 12% for RTI.
Rather, Alcoa seems to be aiming to diversify its business away from aluminum, targeting "non-aluminum downstream revenues [equal] to 64 percent of total downstream sales." And more broadly, Alcoa is placing a bet on "growing aerospace demand for titanium" as the aerospace industry moves away from aluminum, and more toward composite-built airliners such as Boeing's (NYSE:BA) 787 Dreamliner, and Airbus's (OTC:EADSY) A350 XWB (the European planemaker's first plane to be more than 50% composite).
Alcoa says it's also expecting to extract $100 million worth of "synergies" from combining its operations with RTI's. And it expects RTI's titanium business to become much more profitable in future years than it is today, predicting an EBITDA margin of 25% by 2019, versus just 14.5% last year.
Whether these explanations justify the sky-high price tag on the merger remains to be seen. For now, though, shareholders don't seem optimistic -- and neither am I.