In late September, Alcoa (NYSE:AA) announced that it had decided to break itself in two. It wasn't exactly surprising news, but it still has major implications for investors. One key group that should be keeping an eye on this split is dividend investors. Although Alcoa's paltry 1.3% or so yield isn't too enticing today, the breakup is likely to change some things.
What's going where?
The split taking place in the second half of 2016 will break Alcoa into an Upstream company, which makes aluminum, and a Value Add company, which makes things out of aluminum. It's the logical place to cleave the two apart because they have vastly different business profiles.
For example, Value Add is all about growth. This division has not only been on an acquisition binge in recent years, but demand for high-tech parts is also significant in key growth industries. For example, aerospace demand is projected to be as high as 9% over the next few years. And even in slower-growth markets Alcoa serves, such as automobiles, aluminum is expected to take market share from other materials (heavier steel, in the auto example). So not only is there an obvious opportunity to buy growth, but there's also growth built into the Value Add side of things.
The Upstream assets, meanwhile, are far more mature and dealing with the same difficult commodities market that all commodity players have been struggling through since roughly 2011. That's meant downsizing, cutting costs, and improving efficiency. It's going reasonably well for the Upstream business on this front, but that doesn't change the negative view that Mr. Market has of commodity-focused businesses.
But these broad profiles speak volumes about dividends. Growth-oriented companies usually don't make large dividends a priority. However, mature and capital-intensive businesses such as Upstream often do focus on returning value to shareholders through dividends. So, going in, it's likely that the Value Add company will maintain a relatively low dividend.
Upstream is more of a wild card right now. It's dealing with a difficult commodity market that's left others, such as Freeport McMoRan (NYSE:FCX), in a weakened position and resulted in often deep dividend cuts. True, Freeport has a lot more problems right now, including too much debt and the lingering impact of its ill-timed oil acquisition, but this headline-grabbing dividend cutter is far from the only example. Even BHP Billiton (NYSE:BHP), one of the strongest miners, looks like it's pulling back on its pledge to continue increasing its dividend
So whether or not Upstream starts life with a large distribution isn't clear, but the business model suggests that it could eventually be a big dividend payer. In fact, Alcoa is currently telling investors that Upstream will focus on "prudent return of capital to shareholders." That strongly suggests a focus on dividends.
Helping things along on this front is that, from what Alcoa is saying right now, the Value Add business is set to take on a big chunk of Alcoa's debt. Upstream is targeted to be at the high end of the below-investment-grade space. So it should have the financial leeway to pay a notable distribution. Moreover, because of the nature of the business, it should have plenty of depreciation expenses to power the cash flow that actually supports a dividend -- regardless of what earnings are.
However, there's another twist you'll want to think about. Upstream may pay a larger dividend than Value Add after the break up, but which one will grow faster? The answer should be pretty obvious: Value Add's expected growth should allow it to boost distributions far more quickly than Upstream.
Moreover, Upstream will have to balance commodity markets and distributions. So even if commodities start to head higher, pushing profits up, Upstream will probably take a conservative stance with dividend growth. Investors generally view it as far worse to set a dividend level that's not sustainable than to set a conservative payout that is sustainable. So, indeed, "prudence" is likely to be the big story -- taken another way, don't look for much dividend growth.
So, as an income investor, you'll want to take a long, hard look at yourself before you take a long, hard look at Alcoa's proposed split-up. Whether you prefer Value Add's likely lower but higher-growth dividend or Upstream's likely larger but slower growth, one is really more about you than Alcoa.
Reuben Brewer has no position in any stocks mentioned. The Motley Fool owns shares of Freeport-McMoRan Copper & Gold,. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.