General Electric's (NYSE: GE) aviation segment recently announced a $1.5 billion long-term supply contract with Alcoa (NYSE: AA). The deal is good news for Alcoa, considering its quarterly results showed softening demand for aluminum, with prices having fallen 18% to $1,460 per ton over the past year. Needless to say, it's an interesting move for Alcoa investors to follow because it highlights the better business in their upcoming spin-off.
The $1.5 billion long-term supply contract
The contract allows Alcoa to supply component parts for GE engines and engine parts. Alcoa will provide aluminum, nickel-based superalloy, and titanium components, and the parts will be made in six U.S. states, plus France and Canada. The deal is important because it shows GE's and Alcoa's commitment to this high growth industry.
"We greatly appreciate GE's continued confidence in Alcoa's aerospace capabilities and are proud to support its advanced jet engine programs through this agreement," said Alcoa CEO and Chairman Klaus Kleinfeld.
Alcoa is a global leader in lightweight metals technology, and this deal puts an exclamation point on the growing demand for its aerospace division and its productive capabilities. The company secured around $9 billion in contracts for the aerospace division in 2015, including deals with Airbus and Boeing. Pro-forma revenue in the value-add business being spun-off was $14.5 billion through June 30, 2015. The aerospace division only accounted for ~$6 billion. These contracts come at a great time, given the drop in the raw commodity price of aluminum.
Alumina is a critical component of the business through its upstream operations. The drop in alumina and aluminum still weighed on earnings results for this segment, but the orders for aerospace continue to give hope to the business, which will soon be splitting in two.
The Spin-off
In late 2015, the company made an announcement to divide the company into two leading public companies: an upstream company and value-add company. The upstream business will be the commodity side of the business, and value-add will be the aerospace, automobile, and technology business. The transaction is expected to be complete in the second half of 2016 and will be a tax-free transaction for Alcoa shareholders.
Image Source: Alcoa investor presentation
In the most recent conference call, management discussed how the recent acquisitions of Firth Rixson and RTI International Metals helped strengthen the aerospace portfolio. Firth Rixson is a global leader in jet engine components, while RTI allows Alcoa to expand its titanium and specialty metals products for the aerospace industry. The integration of RTI is ahead of schedule, and Firth Rixson is behind. The slow pace of integration with Firth Rixson was a bit disheartening to hear. I expect things to ramp up in the coming months, but it was still not welcomed news to see that the acquisition was behind schedule.
The value-add company is the segment that interests me the most post-spinoff. Ultimately, this will be a higher-margin, better profit-generating business than the upstream business. Also, the growth of the aerospace division -- borne out by the recent long-term contracts with GE -- is a great sign for investors. As separate companies, each will be able to take advantage of opportunities quickly and more efficiently in their respective environments.
Image Source: Alcoa investor presentation
The value-add company appears well positioned to generate long-term sales and profit growth through its various contracts with global aerospace giants. Boeing continues to be one of the many platforms it will work on, including the 787 Dreamliner. GE and its partners have plans to make 15,000 engines in the coming years.
Bottom line
Despite Alcoa's recent earnings shortfall, the recent $1.5 billion contract from GE should be a welcome sign for investors and add further to the value of the spinoff. The commodity portion of the enterprise is fragile right now. However, there is growth in the aerospace, automobile, and technology business, so the company that investors will want to own coming out of the split will be the value-add portion.
Shares are already attractively priced at a forward P/E of 11.33, a P/FCF of 9.32, and an EV/EBIT of 11.28. So ultimately, Alcoa investors should welcome the split, as it will further unlock the value of the two businesses as separate entities.
