Aloca Inc's (NYSE: AA) pending breakup is a fascinating development for this integrated aluminum giant. But it gets even more interesting when you compare it to the proposed purchase of Precision Castparts (NYSE: PCP) by Berkshire Hathaway (NYSE: BRK-A) (NYSE: BRK-B). In fact, if you compare the two deals, buying Alcoa now could be an amazing investing opportunity. Here's why.
It depends on how you look at it
Today, Alcoa is an integrated aluminum company. It makes the commodity (its Upstream business) and uses what it produces to create things like jet engine parts for others (what it calls it's Value Add business). But that's set to change, as the company plans to split itself in two, creating an Upstream company and a Value Add company.
Aloca in two parts. Image source: Alcoa.
But here's some interesting math to consider. Berkshire's is paying roughly $32 billion for Precision, a company that makes things like jet engine parts. That values Precision at around 3.3 times trailing-12-month revenue of about $9.7 billion. Although Berkshire CEO Warren Buffett himself noted that this was expensive, explaining to CNBC that, "This is a very high multiple for us to pay," the fact that he did pay it is telling. Clearly he sees value in a company that makes specialized parts.
Now take a look at Alcoa. The aluminum giant's value-add business had about $3.4 billion in revenue in the third quarter. If you take that as a run rate, the annual revenue from just this business would be about $13.5 billion (remember this business is growing, so this is likely to be a conservative estimate). Alcoa's market cap is a little over $12 billion, which is, essentially, the price the market is willing to pay for the entire company. That's a multiple of less than 1 times the revenue run rate of just the value-add business.
If Buffett is willing to pay 3 times revenues for a company similar to just this single division, then it's very possible that the market is undervaluing Alcoa's shares
How similar are they?
Precision describes itself as, "...a worldwide, diversified manufacturer of complex metal components and products..." The bulk of its business is in Aerospace but, essentially, it makes highly technical parts for jet engines and power turbines.
Precision Castparts top-line breakdown. Source: Precision Casparts
Alcoa's Value Add business is more diversified, but generally does the same thing as Precision. Sure Alcoa's business includes some sluggish segments like packaging. but Aerospace is a big and growing component (40% of Value Add revenues). Two acquisitions this year have augmented this business and it's likely more will come once the Value Add business is a stand alone entity.
While turbines provide a meager 3% of Value Add sales, Alcoa gets nearly 20% of Value Add sales from automobiles and trucks. Auto is an area in which aluminum is increasingly displacing steel. So this difference is probably a net positive for Alcoa.
Alcoa's value add buiness' top-line breakdown, Source: Alcoa
By the numbers
There's a bit of difference when it comes to profitability, however. Precision's EBITDA margin in fiscal 2015 was in the high 20% area. Alcoa reports the EBITDA margin in its Value Add segment to be in the low 20% range. So Precision's business is more profitable. But Alcoa's results aren't exactly chopped liver.
That said, Alcoa's been growing its Value Add business fairly aggressively, with aerospace revenue up 40% year over year in the third quarter and flat rolled auto sales up a massive 133%, though from a much smaller base than aerospace. For comparison, Precision's jet engine part sales inched up 4% in its most recent quarter, but military sales fell 14%. Airframe products' sales dropped 9%.
This isn't a clean comparison because Alcoa's numbers include acquisitions, but it gives an idea of what's going on under the covers and it looks like Alcoa's Value Add business is growing at a time when Precision's is in limbo because of the pending acquisition by Berkshire.
The fly in the ointment here is that Alcoa's split up is far from complete. While details are a little light at this point, one thing that Alcoa has thrown out there is that Value Add is likely to get saddled with much of Alcoa's debt. That's fair since recent acquisitions have focused on the Value Add business. But debt makes up around 40% of Alcoa's capital structure versus a more manageable 30% at Precision Castparts.
The thing is, Value Add accounts for only about 60% of Alcoa's business. In other words, depending on how the break up is made, debt could be a big issue for Alcoa's Value Add business. Looked at a different way, Precision's interest expense in the recently reported quarter was only about 1.5% of sales. Alcoa's interest expense was about 2.2% of sales--but 3.6% of Value Add revenue. A big difference and more than double the size of the expense at Precision.
The Bottom line
Precision Castparts appears to be more profitable and in better financial shape. But even if Alcoa's Value Add business isn't quite as good as Precision Castparts, the price being assigned to Alcoa by the market is very cheap in comparison. Moreover, the market seems to be valuing the rest of Alcoa -- its upstream business -- at less than zero. Sure, this is the "old Alcoa" that is struggling through a difficult commodity market, but, using Berkshire's deal as a measure, you're pretty much getting a comparable business to Precision Castparts with one of the world's largest aluminum makers for free. It's hard to argue with that. If Berkshire's Precision deal is any indication, it looks like Mr. Market is wildly undervaluing Alcoa today.
