ARCONIC CORP ARNC
July 25, 2022 - 10:25pm EST by
amorfati
| 2022 | 2023 | ||||||
| Price: | 29.15 | EPS | 2.55 | 3.60 | |||
| Shares Out. (in M): | 106 | P/E | 11.5 | 8 | |||
| Market Cap (in $M): | 3,083 | P/FCF | 5.5 | 4.74 | |||
| Net Debt (in $M): | 1,523 | EBIT | 0 | 0 | |||
| TEV (in $M): | 4,612 | TEV/EBIT | 0 | 0 | |||
Sign up for free guest access to view investment idea with a 45 days delay.
- None found
Description
Overview
Arconic Inc. (ARNC) is a manufacturer/supplier of rolled aluminium products for industrial uses. The company's offerings categorically comprise of 1) rolled sheets and plates, 2) architectural products/systems (such as aluminium windows, doors, and coatings - for buildings), and 3) extrusions. The company currently serves 5 end-markets of
- ground transportation (primarily auto),
- aerospace,
- building and constructions,
- industrial products,
- packaging.
ARNC has 21 primary operating locations in 8 countries comprising of US, Canada, China, France, Germany, Hungary, UK, and Russia.
~80% of the revenue is derived from the rolled products division - producing flat-rolled aluminium coils, sheets, and plates. These are used as raw materials in the making of airplane frames, automotive body panels, industrial plates, soda cans, heat exchangers, etc. These rolled products are manufactured in ARNC's facilities located in China, Hungary, USA, UK and soon to be divested Russian location.
~15% of revenue is derived from Building and Construction products consisting of aluminium door frames, windows walls, entrances, building surfaces. This business is operated by the company's two subsidiaries of 1) Kawneer - which produces aluminium window walls, entrances, etc - and 2) Arconic Architectural Products - which produces aluminium bond sheets, surfaces, for buildings.
~5% of revenue - the remaining - is derived from aluminium extrusion products in custom shapes including cylinders, tubes, bars, etc. These accessory aluminium items are also aerospace, transportation and industrial manufacturing process.
By geography, sales are roughly ~60% US, 10% Russia, 10% China, and 20% Europe.
Cost structure
70% aluminium
11% labor
6% alloy materials
3-4% freight
2% energy
weighted cost of capital is around 10%. so the IRR of 35% in phase 3 and 25% in phase 4 still looks attractive.
Executive Summary
ARNC is undervalued compared to peers at a time when favorable growth tailwinds are breathing healthy demand for aluminium rolled products at all of ARNC's end markets in the foreseeable future. Further, ARNC is amidst the end of deploying capital to execute a few a 25-35% IRR (vs. WACC of 10%) projects that should be both achievable and rewarding to company / shareholders over the next 2-3 years.
Since the separation from Arconic parent (now renamed as Howmet Aerospace) in Feb 2019, ARNC has executed well on all of its major initiatives. From pension contribution reductions to cost cutting, to securing new long term contracts for different end markets, to weathering the disruptions of Covid, the company has done well. Volume growth has also seen a healthy trajectory, trending toward all time high coming out of covid. Yet ARNC currently trades at an abysmal 4.8x 2023 EV/EBITDA (consensus) with little leverage. This compares to competitor group valuation of ~6.5x 2023 EV/EBITDA and almost 3x leverage makes ARNC a very attractive short term play. The valuation gap between ARNC and its peer will likely shrink as more attention is paid to this stock. When I first came across ARNC in Oct 2020, sell-side coverage didn't really exist. Now there are about half a dozen, with a few bulge brackets involved, all positive on the stock. I believe that as the management continues to execute its initiatives while it's narrative and outlook becomes realized, the market should recognize the value in ARNC.
Investment Thesis #1 - Strong end-market demands translate into attractive organic growth
The price of ARNC's products as well as those of its competitors are generally driven by the cost of raw aluminium, from which aluminium are convert to valued-added, flat rolled and extruded products used by ARNC's end-market customers including car manufacturers, airplane manufacturers, industrial equipment manufacturers, aluminium/beverage cans producers, and makers of aluminium doors/frames and architecture products, etc. Because the price of raw aluminium are typically passed onto ARNC's end customers to account for fluctuations of price of aluminium, ARNC's revenue figures do not accurately reflect growth prospects. Instead, it's organic or volume growth of materials sold/produced that is a better metric for growth prospects.
The profitability of individual flat rolled makers is shaped by a combination of the maker's relative position in the flat rolled market, the demand of the end-markets, and the efficiency of their industrial operation. Significant capital investments are required to operate in this industry, in order to achieve technological capabilities and customer qualification standards. As such, the industry saw consolidation to achieve/sustain economies of scale.
The demand side of flat rolled and extruded products are driven by economic growth, substitutions, cyclicality. The supply side is determined production capacity, substitutions available, and trade flow between regions. The estimates for the next 5 years generally puts flat rolled market growth at 4-6% CAGR. Yet 60% and 20% of ARNC business is generated from North American and Europe, respectively. Demand in these markets are expected to grow at 6%+ CAGR over the next 5 years.
Arconic has a #1 supplier in global aerospace rolled products, and #2 in North America ground transportation, industrial packaging and building construction. Given its dominance, ARNC should be able to grew at if not above the industry's general growth estimate of 6%+ CAGR in its core markets of NA and EU.
Topline growth is essentially firing on all cylinders as demand for ARNC's products from all end market are growing because of both short term and medium term fundamentals. This macro tailwind of growth is a very important consideration and constitutes a central tenant to a bullish thesis. ARNC currently supplies aluminium rolled and architectural products to 5 end markets in a pretty balanced composition; and all 5 markets are expected to grow positively in the near future years because of the fundamentals in each of the industries.
In the near term, 4/5 of end markets are expected to grow double digits organically this year. In aerospace, OEMs are increasing build rates and ordering more aluminium sheets. ARNC aerospace sales grew 32% organically y/y in Q1/22 and guidance for FY is revised up to 30-40%. Building & Constructions sales is expected to grow 15-20% this year because ARNC is mostly involved in North American non-residential construction - which is growing unlike residential builds. In Industrial, an across the board global rebound in industrial activities also lifted organic sales to 10% in the first quarter and is expected bring double digits growth for the full year. Packaging also grew nicely on an organic basis as the ARNC ramped up its North American packaging plant at Tennessee. The location expands aluminium rolled products capacity by 600mm lbs and has been fully utilizable as of Q2/22.
Over the medium term to 2026, several dynamics supports favorable organic growth. First, there is pent up demand for autobody sheets that is currently blunted by the damp in car production stemming rom semiconductor supply chain disruptions. Once this disruption abates, auto production should recover over the next year or two, so ground transportation sales are expected to recover quite aggressively as experienced by the aerospace segment. Electric Vehicle also present a new growth vector. EV is 25% to 35% more aluminium intensive than comparable internal combustion engine vehicles and ARNC has strong EV aluminium involvement that will benefit from EV growth. ARNC EV revenue is expected to double in 2022 to $250mm. commercial vehicle historically constitutes 30% of ground transportation revenue also growing at high single digits. New emission regulations will be implemented in 2024 to 2027, driving pre-buy demand in 2023 to 2026. Second, aerospace demand recovery also extends into the medium term. Boeing and Airbus are expected to grow deliveries at 15% per annum over the next few years and ARNC is well contracted with both OEMs. Third, packaging growth also present sensible growth areas for ARNC. ARNC's packaging business is predominantly focused in North America, where current supply is extremely tight. Yet ARNC just expanded capacity by 600mm lbs as of Q2/22. This newly online ARNC capacity should be well utilized over the next several years when other can sheet makers late to the parties are scrambling to bring online 30 new can lines over the next 3 to 5 years.
Aerospace, the pause in air travels precipitated by covid has slowed new airplane productions, in turn dampening demand for airplane construction materials such as airframes made out of rolled aluminium sheets. ARNC's aerospace sales declined from $1.3bn in 2019, to $820mm in 2020, to $630mm in 2021. With air traveling resuming, OEM build rates are recovering, inducing once again demand for airplane aluminium sheets. 2022 should be an inflection year. ARNC already reported Q1/22 sales up 32% y/y on an organic basis; management expects Q2/22 y/y to be even better on an organic basis. For the full year, the company is now guiding to a 30-40% organic sales increase, an upward revision from 25-35% previously expected before Q1/22. If revenue recovers to pre-pandemic levels in 2024 as management is guiding to, aerospace sales should also double over the next year. In Q3/21, ARNC also signed a $2 billion forward contract with 3 OEM that span to the end of 2020s, another sign that things are improving. In packaging, d
There is also pent up demand for aluminium sheets and rolled products from the end markets in ground transportation and aerospace as covid-induced supply disruptions and travel restrictions abate. In 2021, automotive demand accounted for less than 40% of ground transportation sales while the number is generally 70%+. This means that in normalization, ground transportation sales alone could double over the next year or two.
Over the long term, the switching to EV vehicles is anticipated to increase the demand for aluminium rolled sheets because EV require 1/4 more aluminium sheets/materials as raw materials. This will bring strong secular demand for aluminium rolled sheets. Beverage cans and industrial packaging are increasingly shifting to aluminium as business and consumers adopt the sustainability trend. This is also expected to boost industrial demand for aluminium sheets to mid and high mid CAGR.
Investment Thesis #2 - Growth projects to yield large incremental EBITDA growth
Phase 1 project complete. As early as 2020, amidst the weathering of pandemic disruptions, ARNC had set EBITDA growth initiatives that've been well executed since. In addition to realizing several cost cutting programs during covid (including $100mm CEO and management pay cut, $200mm headcount and cost optimization), a Phase I growth project was announced to permanently provide up to $300mm of annual incremental EBITDA through expanding the production capacity for aluminium/beverage cans and industrial flat rolled products by 600mm lbs. True to management's earlier guidance, the project completed in Q2/22 this year. Though the full amount of $300mm will not be realized immediately, the company now has the infrastructure at its Tennessee facility to feedthrough an additional 600mm lbs per annum of aluminium sheets for beverage cans and industrial products. This available capacity coincides with ARNC having just expanded into the North American can sheet market and secured a $1.5 billion contract for 2022 to 2024. There is also currently supply shortage for North American can sheets as imports for can sheet remain all time high and the US market is expected to remain in a deficit for can sheets until 2026. 6 can manufacturers have announced 30+ can lines that would eventually compete with ARNC's completed phase 1 project. However, these competitors projects are not expected to complete for another 3-5 years. In the meantime, ARNC's phase 1 completion position the company well to quickly take advantage of the demand for can sheets in North America. In 2022, ARNC expects to realize ~$50mm EBITDA growth from the phase 1 project that is associated with volume growth/demand of can sheets.
It's reasonable to expect that over the next few years, capacity from this complete phase 1 project will be gradually activated. Therefore, I'd expect the $300mm of annual EBITDA growth (from 2019 level) to progressively flow into ARNC's EBITDA figure.
Phase 2 and Phase 3 projects are nearing completion. In addition to the just completed phase 1 project, Phase 2 and Phase 3 projects involving upgrades at 3 plants are also nearing completion. These projects are what's termed "under the rooftop" projects as they do not involve erecting infrastructures at new locations. Instead, they are incremental, low-risk, highly achievable upgrades at existing plants that essentially seeks to de-bottleneck production capacity. The below diagram illustrates the production process for aluminium flat rolled products. The process starts with melting/casting raw aluminium. ARNC's phase 2 and 3 projects will allow the company to increase melting/casting capacity for more raw aluminium. Additionally, one of the process involve hot and then cold milling processed aluminium to flat sheets. To commensurate the increasing melting/casting capacity, ARNC will also increase capacity for hot/cold milling that will process the increased raw aluminium fed through the melting/casting process. In sum, these projects allows for more throughput of ARNC products, at reduced per unit costs.
Phase 2 was announced in Q3/21 and are expected to complete in H1/23 while Phase 3 projects are expected to complete by 2024/2025. Together, they deliver run rate annual EBITDA growth of $275mm, of which 50% will stem from cost reductions, and the remaining to be realized/activated via volume growth. In other words, even if there were no volume growth, as long as these projects complete, ARNC should see EBITDA growth of $130mm over the next 3 years (5% EBITDA CAGR).
Icing on the cake is that the capex of $600mm+ associated with these projects have mostly been deployed. Management noted on the most recent Jun 6 investor day call that spending associated with these projects will complete by YE2022, so there should little drag on FCF in 2023 to 2025 from growth capex.
JPM Analyst: Just in terms of the Phase 3 CapEx, could you talk about the cadence of that spending?
A - Timothy D. Myers: Yeah, so we are essentially complete with the spending on the Davenport casting installation, doing the qualifications, we're starting to ramp it up. The Lancaster we're waiting for the last of the major equipment to be delivered. So I'd say the majority of that spending will be complete by the middle of the fourth quarter. Everything will be sunk by the end of the year.
Though was some preliminary mention of a phase 4 project, nothing has been decided yet. and even if Phase 4 capex were announced, there would be further benefits associated with that investment. As of now, not considering the phase 4 project yet, sustaining capex from 2023 to 2025 would be what I estimate at $150-$200mm given that 2022 maintenance capex of only $145mm.
Quantifying these growth projects into figures, I estimate that EBITDA can grow from $845mm guided in 2022 to $950 billion in 2025. This is assuming that the Phase 2 and Phase projects complete in H1/23 and in 2024, respectively, on schedule. The EBITDA improvement from cost reduction alone would grow EBITDA from $845mm to ~900mm, without any volume growth. Add in some of the the $100mm EBITDA growth company expects from aerospace recovery, $50mm EBITDA improvement from ramping up the can sheet volume from the completed phase 1 project, EBITDA should be comfortably over $900 million before factoring in any volume growth gains associated with phase 2 and phase 3 projects. Compared to the company's projection of $1.2 billion in EBITDA by YE2025, the $950 billion figure appear to be highly realistic/achievable.
Investment Thesis #3 - FCF to turn positive from the reduction of capex, pension contribution and working capital
Continuing from the above line of thought that that EBITDA could grow from $845mm in 2022 to $950mm in 2025, the below then considers other line items after EBITDA to reach free cash flow in the upcoming years.
Except for the 3 yellow highlighted items, all items are either small or predictable, so they've been estimated at progressively increasing levels in the below. 3 line items deserve highlights as they've held significant impact on FCF.
Change in working capital expected to become favorable for FCF. Change in working capital is dictated by the cost of raw aluminium purchased as input. When aluminium price increases, working capital contribution are required, reducing free cash flow. From 2020 to 2022, LME aluminium price had more than doubled from ~$1,500/mt to ~$4,000/mt as of Mar 2022. This uninhibited climb in aluminium price had costed over $500mm of working capital contribution over the past 2 years that could've been FCF.
However, this climb in aluminium price is simply not sustainable. Not only has supply/demand started to loosen, history indicates that aluminium price has never gone above $4,000/mt over the past 3 decades. Therefore, continued cash contribution to working capital is highly unlikely, as the working capital draw is triggered by the change/increase in aluminium price as opposed to the absolute level of aluminium price.
Indeed, price has already reversed. And for every $100/mt price reduction in aluminium price, Arconic expects to yield cash return of $20mm in working capital. As price has faded from $4,000/mt to $2,500/mt, ARNC is already expecting a $200mm cash return thus far post Q1/22. This cash release from the decline in aluminium price is expected to continue in future quarters.
The current LME futures curve is pricing in $50/mt increase per year in aluminium price in the 2023 to 2025. Based on the working-capital-to-aluminium-price sensitivity provided ARNC, cash contribution to working capital for 2023 to 2025 would translate into a meager $10mm per year (vs. $120mm in 2020, ~400mm in 2021, and $60mm in 2022). The minimal working capital draw would leave $100s of millions EBITDA pass through to become free cash flow in the coming years.
Future pension contribution expenses minimal. The biggest draw on FCF over the past 2 years since ARNC separated from Howmet is the pension liabilities which required yearly contributions. These pension liabilities required cash contribution of almost $700mm over the past 2 years that could've otherwise been FCF. As early as 2020, ARNC has been executing two annuitization programs that would significantly bundle/reduce pension liabilities and future cash flow contributions. In short, the annuitization programs have been successful. Future pension contribution is expected to be only <$40mm per year. This also free up 100s of millions to flow through to FCF.
Large chunks of growth capex already spent. As management mentioned in the Jun 6, 2022 Investor Day, Phase 2 and Phase 3 capex will be sunk by the end of 2022. This means that the $600mm capex required has already been spend. Capex without these growth expenditure will significantly reduce capex. Given that 2022 maintanence capex was only $145mm, 2023 to 2025 annual capex without any overwhelming capex outlay should be less than $200mm per year.
In sum, I project the company will generate from 2022 to 2025 in almost $1 billion in FCF. NPV, that's already 1/3 of current market cap.
Investment Thesis #4 - Sales of Building & Construction segment at at accretive multiples
At its Jun 6, 2022 Investor Day, Arconic announced that it's exploring the sale of its largest business division within the building and construction segment. Recall that ~15% of total revenue is generated from selling doors, windows, architectural aluminium products to the Building and Constructions end-market. Within this segment, ARNC's Kawneer business operation is a major supplier of aluminium doors, windows, entrances, etc.
This subsidiary generates 85% of BCS EBITDA, equating to $110mm in 2021. According to management, recent precedent transactions suggests selling multiples of 9 to 13x trailing EBITDA vs. current ARNC multiple of 6.4x trailing EBITDA.
If Kawneer is swapped at cash at 9-13x trailing EBITDA for the current implied trailing EBITDA of 6.4x, there would be net accretion of $2.7 to $6.9/sh. This is additional upside for ARNC.
Key Risks
Delays or unexpected complications at Phase 2 and Phase 3 projects. My core thesis for ARNC is EBITDA and FCF growth in the coming years stemming from volume growth and a reduction in pension, capex, and working capital contributions. The EBITDA growth is vitally premised on phase 2 and phase 3 project up and running, or else the EBITDA ramp up wouldn't be there because ARNC won't be able to take advantage of the growing demand/volume for its products. If these projects runs into delays or complications, the story for ARNC would be broken or at least cracked. Given ARNC's track record and that phase 2 and Phase 3 projects are low-risk upgrades, the likelihood of phase 2/3 execution running amok is low, but this is a risk worthy of consideration, because should this low probability event occur, the stock will convulse. Therefore, it's important to continue monitor the statuses of these projects.
Prolonged disruptions in auto and/or aerospace recovery. Russo/Ukraine conflict drags on, disrupting all kinds of supply chains including that of semiconductors, which heavily supports the auto industry. The semiconductor shortages isn't expected to abate until 2024, so the overhang on demand for aluminium from the automotive industry is going to persist for awhile. This cloud will eventually pass, but until then, the path to recovery for the automotive end-market will be patchy. Disappointments in quarterly growth/recovery could trigger sell-offs in ARNC. Aerospace recovery presents similar risks, as OEM build rates going higher is still hinged on air travel coming back to life, but a world timidly returning to its pre-pandemic way of life is vulnerable to setbacks. Both Aerospace and auto recoveries in the next two years will be eagerly welcomed by the market, but short term setbacks could be buzz-kills for the stock.
Forced selling of the Russian operation. The Russian facility in Samara, Russia was put up for sale in May 2022, as ARCN joins Western companies exodus of Russia and cites that sanctions imposed by the Russian government and legal dispute with Russian Federal Anti-Monopoly Services have made operations uneconomical. As a condition of owning the Samara plant when ARNC's parent company Alcoa first bought the plant, Samara holds contractual obligations to support materials to the Russian military complex. This has continued to the present day But as the Ukraine war progressed, ARNC found it increasingly difficult to continue to support the Russian war effort as Western sanctions mounted and Russia increasingly took restrictive measures that preemptively sought to ensure operations from ARNC. until ARNC stopped pursuing new contracts in Russia in Mar 2022. Cash generated from the Russian operation is already trapped in the Russia but the plant cannot be shut down lest its employee may face criminal charge on the grounds violating national security interest of disrupting supply to the war effort. The facility employs about 3,000 people and accounts for 16% of ARCNC's revenue in 2021. Even as Q1/22 production are hitting record volumes (Q1/22 revenue of $233mm/EBITDA of $18mm vs. Q1/21 revenue of $195mm and EBITDA of $19mm), ARNC decided to sell off the plant (or could be forced to). A charge of up to $500mm made be recorded for the disposal. Russia has conducted precedent cases of forcing foreign operators to dispose assets to Kremlin-linked buyers at discounted price. In this case, ARNC has not commented on whether a buyer is found, but it's probable that the plant will transfer ownership to a Russian operator. A divestiture will require approval from both Russia and USA, though the stock STOCK DIDN'T REACT MUCH TO THE NEWS IN LATE MAY]
Weaker economic conditions. This is a macro variable that should not be neglected. Current bond market is pricing in weaker inflation figures and an impending recession in the next year. If we are entering a recession, demand from automotive and aerospace end-markets would be weak. This will likely weigh on the stock, albeit a temporary concern.
Variant Perception
Unglamorous, boring, and under-followed. I think most people would consider ARNC a boring stock. It's low volatility, low growth, low hype, and captures low interests from active institutional investors. The company though having deployed large chunks of capital, also needed no equity raising since its seperation from parent, so it's not like sell-side is rushing to ingratiate the company with keen coverage that would win over capital raising businesses. Further, For a supposedly stable free cash flow stock, it's also been running at a FCF deficit over the past two years. Its businesses in selling aluminium flat rolled sheets, beverage cans, and aluminium windows/doors also certify ARNC as a uninteresting industrial company involved in lackluster businesses that are important but seems like the plumbing of the economy that people don't really pay attention to. All these dynamics render ARNC under-appreciated. On the verge of higher growth and discount to already depressed multiple for the peer group, ARNC is at an inflection point where FCF is about to turn positive with upcoming EBITDA ramp up coinciding with reduction of pension, capex, and working capital contribution that took away 100s of millions per year in FCF. Even the sell-side shops that've started covering the name have become positive, the stock hasn't really budged. The stars are aligned for ARNC, but people aren't paying attention.
Long term demand for aluminium rolled products on a secularly rise. The current multiples for ARNC and for peer group simply do not reflect the secular rise of demand for aluminium rolled products from various end-markets. ARNC is currently trading at 4.8x EV/2023 EBITDA while its American traded peers KALU and CSTM are trading at 7.4x and 5.9x, respectively. The dynamic here indicate that not only is ARNC trading at a discount to peers, but that the industry is trading at middle of its historical valuation range.
Yet there is a surging of additional demand for aluminium sheets/rolled products, from beverage makers, packing and industrial customers, all opting for aluminium as a substitute of plastic, glass, and other materials that are less recyclable. According Beverage Industry as of Feb 2022, 70%+ of new beverage product introductions are in aluminum cans. Even aluminium canned wined bottles sales are on the rise. This switching to aluminium is a relatively new phenomenon only a few years and still have plenty of run-rooms. Can Manufacturers Institute (CMI) expects surge in demand for the production of aluminium bottles and cans over the next 5 to 10 years. In other words, the packaging demand for ARNC and its peers aluminium products is just starting. This will help as a significant growth driver
Moreover, the transition to EV has ushered in higher demand for aluminium rolled-products for vehicle production. EV vehicles are by design required to be lighter, so aluminium surface and components have become the go-to material. An average EV vehicle will quire 1/4 more aluminium rolled products. In fact, aluminium demand from vehicle production currently only accounts for 18% of all aluminium consumed in 2019. This percentage is expected to double over the next 30 years. Coupled to the just beginning growing production/demand of EVs, aluminium rolled-products are on the precipice of surging demand.
I believe these two secular macro vectors of growth are under-appreciated by the market. Along with the current bearish episode we are having in equities, ARNC is trading cheap.
Catalysts
Sustained/robust recovery in end-market demands. Ground transportation constitutes the largest end-market for ARNC. Historically representing ~35% of total revenue, ground transportation as a percentage of total revenue fell to a 22% of total revenue Q2/20 after experiencing ~60% y/y decline in the second quarter driven by North American auto-production shutdowns due to COVID. Indeed, Industry figures indicate that as early as Mar 2020, 93% of all US auto production had shutdown. Such included Ford, GM, Chrysler – all major customers of ARNC. However, recovery is a bound. In late Q2/20, GM, Chrysler and Ford all announced plans to reopen North American factories that account for 6% of US economy. Light vehicle Seasonally Adjusted Annual Sales (SAAR) then took since Q1/21 as the industry as covid disruptions persisted and weaker economic conditions plagued demand. At 13mm as of Jun 30, 2022, SAAR is still 2 million below historical average. This leaves meaningful room for recovery that would spur demand for auto sheets.
Sales of Kawneer. As expounded in earlier sections, a successful sale of Kawneer in line recent precedent transactions of 9-13 trailing EBITDA would be accretive to the company currently trading at 6.4x trailing EBITDA. Not only would the sale yield a $2.7/sh to ~$7/sh gain, ARNC would increase its cash position by likely over $1 billion. This liquidity could contribute to ARNC's unannounced Phase 4 growth project without dragging on free cash flow. Additionally, cash buyback or return via dividends would also be possible. A notable exit from the building and construction segment would also simplify ARNC's product lines to 90%+ aluminium flat-rolled market. This singular focus could streamline operations and reduce complexity while allowing ARNC to serve more its remaining end-markets with a greater focus.
Implementation of a dividend policy. With free cash flow finally turning positive in the absence of the concluded heavy drag from pension plan contribution and working capital draws from the rise of aluminium pricing, the company has mentioned reinstating dividend policy in the short term. With stable free cash flow expected in the future years, this dividend consideration is likely to materialize in the next year or so. The announcement of this dividend policy - probably 1 -3% - should attract some yield minded investors and further legitimize ARNC as a cash flow stable company.
Successful completion of Phase 2 and Phase 3 projects. The current growth prospects hinges on the successful completion of Phase 2 and Phase 3 projects. Given the successful track record of ARNC's previous projects also completed on schedule, it is highly probably that Phase 2 will complete by H1/23 and that Phase 3 will complete in 2024. These low-risk facility upgrade projects will allow ARNC to expand current production capacity at a time when demand/volume growth is anticipated and the industry supply is tight. The cost optimization aspect of these projects will also reduce cost. In all, these projects will enable the EBITDA growth guided by company. Nothing more tangible than the EBITDA improvements generated from these projects will be more positive for the stock.
Valuation
Base Case sees 45% upside. The below calculation for the base case scenario assumes that the company hits its 2022 EBITDA mid point guidance of $845mm. Additionally, EBITDA is assumed to ramp up to YE2025 based on the aforementioned EBITDA boosts factors already spoke about. Namely, the company assumes that with aerospace recovery, an additional $100mm of annual run-rate EBITDA growth is expected from 2022 levels. I've assumed only $75mm. Volume growth in future years derived from the Phase 1 project is assumed by the company to be $50mm. I've assumed $25mm. Phase 2 and Phase 3 projects are expected to complete in 2023 to 2025 and at full utilization with volume growth, expects $275mm. I've assumed ~$138mm, which is derived from only the cost optimization benefits of these projects, with no volume growth benefits factored in.
Moving below from the EBITDA, I've then projected a few line items before the FCF figure. Most importantly, I've assumed working capital and pension plan cash contributions to significantly decline based on what was addressed in Investment Thesis #3. Capex is also expected to be reduced given that the company currently has budgeted no major growth projects that would require elevated levels of capex. But lack of growth capex in future years should not stymie growth because Phase 1 project that expands production capacity by 600mm lbs per year is just coming online as of H1/22. Phase 2, and 3 projects yet finished, have seen their required capital deployed this year, so even without contributing growth capex, the company will have significant running room to accommodate volume growth. Without growth capex, sustaining capex is only $150mm per annum. To be conservative, I've still assumed 2023 to 2025 total capex of $200mm to $250mm per year.
Finally, for post-2025, I've assumed an terminal FCF growth rate of 3%. This should be a highly achievable figure given the secular growth trends for alumnium flat rolled demand taking place in ARNC end-markets.
In sum, these figures arrive at $/sh fair value of $42/sh, a 45% upside from current level.
Bull case sees 100%+ return; bear case sees limited downside. The bull case assumes ARNC hits closer to the top end of its EBITDA guidance range and ramps up to a higher run-rate EBITDA by YE2025 that is more in line with current guidance of $1.2 billion by YE2025. The bear case assumes ARNC falls below EBITDA guidance this year and slowly ramps up to only an extra $50mm EBITDA by 2025, abysmally lower than $300mm+ in EBITDA ramp up that is assumed by the company during the same timeframe. Note that even in the bear case, I've not assumed EBITDA to decline. This is because given the fundamentals of the industry and ARNC's strong positioning, it's just too unrealistic to assume that the company will see volume/EBITDA contraction over the coming years when all tailwinds are supporting growth.
Summary
Arconic remains undervalued since I started following the stock in H2/20. Though it's marginally outperformed peers since, a healthy upside still exist from the current $29/sh level. The company has executed its growth initiatives, pension obligation reductions, cost-reduction programs extremely well over the past several years, along with competent management over disruptions brought about by the pandemic. Yet, it's still not getting the recognition it deserves. I maintain that this is because ARNC is a boring stock, under-followed, under-appreciated, and in the unsexy business of producing aluminium sheets for industrial users. Even its better covered peers (KALU, CSTM) barely gets any attention from active investors or hedge funds.
Nonetheless, ARNC is at an inflection point of becoming FCF positive. The macro tailwinds is supportive in every end-market served by ARNC. Positioning itself well for the uptick in demand from several trends (including the recovery of aerospace demand, greater adoption of aluminium used by industrial, packing, and beverage users) the company has been executing growth projects with IRR of 25-35% (vs. WACC of 10%). A Phase 1 project has been just completed as of Jun 2022 that provides ARNC more production capacity at its Tennessee facility. This completion is ahead of 30+ projects from competitors coming online over the next 3 to 5 years as competitors are rushing to take advantage of the tight supply for aluminium sheets in North America. In the near future years, this completed project should be utilized at capacity nicely, boosting EBITDA. Phase 2 and Phase 3 projects are also nearing completion. The company expects to grow run-rate EBITDA by 40%+ over the next 3 years.
Pension contribution, capex, and working capital draws are also decreasing in the tunes of a several hundred millions dollar per year. This reduction coupled with the ramp up of EBITDA culminates to a growing FCF profile that will finally transform ARNC into a traditional cash flow stable, probably dividend paying, industrial company. Even projecting a sub 4% terminal growth rate, DCF suggests fair value in the $40s/sh handle.
ARNC is also still trading at a notable discount to peers, though it has better margin, lower leverage, and higher consensus growth rates. The culprit here is likely that ARNC started trading Apr 1, 2020 and right out of the gate had to sort out a few items such as reducing pension liabilities and executing projects that it never had the opportunity to under the parent company. These tasks are now behind the company, so the future is bright.
I expect a 45% upside from $29/sh level based on my valuation. The downside is really limited at the current level since it's only trading at a 4.8x EV/NY EBITDA. Even if assuming a much slower EBITDA ramp up, and a terminal growth rate on par with inflation, ARNC should not be worth less than 4x. To assume negative EBITDA growth is just too unrealistic, since all the growth projects are starting to ramp up, and end-market demands are robust for as far as the eyes can see. Therefore, my downside is 5%.
ARNC is a buy at this level.
I do not hold a position with the issuer such as employment, directorship, or consultancy.
I and/or others I advise hold a material investment in the issuer's securities.
I and/or others I advise hold a material investment in the issuer's securities.
Catalyst
Sustained/robust recovery in end-market demands. Ground transportation constitutes the largest end-market for ARNC. Historically representing ~35% of total revenue, ground transportation as a percentage of total revenue fell to a 22% of total revenue Q2/20 after experiencing ~60% y/y decline in the second quarter driven by North American auto-production shutdowns due to COVID. Indeed, Industry figures indicate that as early as Mar 2020, 93% of all US auto production had shutdown. Such included Ford, GM, Chrysler – all major customers of ARNC. However, recovery is a bound. In late Q2/20, GM, Chrysler and Ford all announced plans to reopen North American factories that account for 6% of US economy. Light vehicle Seasonally Adjusted Annual Sales (SAAR) then took since Q1/21 as the industry as covid disruptions persisted and weaker economic conditions plagued demand. At 13mm as of Jun 30, 2022, SAAR is still 2 million below historical average. This leaves meaningful room for recovery that would spur demand for auto sheets.
Sales of Kawneer. As expounded in earlier sections, a successful sale of Kawneer in line recent precedent transactions of 9-13 trailing EBITDA would be accretive to the company currently trading at 6.4x trailing EBITDA. Not only would the sale yield a $2.7/sh to ~$7/sh gain, ARNC would increase its cash position by likely over $1 billion. This liquidity could contribute to ARNC's unannounced Phase 4 growth project without dragging on free cash flow. Additionally, cash buyback or return via dividends would also be possible. A notable exit from the building and construction segment would also simplify ARNC's product lines to 90%+ aluminium flat-rolled market. This singular focus could streamline operations and reduce complexity while allowing ARNC to serve more its remaining end-markets with a greater focus.
Implementation of a dividend policy. With free cash flow finally turning positive in the absence of the concluded heavy drag from pension plan contribution and working capital draws from the rise of aluminium pricing, the company has mentioned reinstating dividend policy in the short term. With stable free cash flow expected in the future years, this dividend consideration is likely to materialize in the next year or so. The announcement of this dividend policy - probably 1 -3% - should attract some yield minded investors and further legitimize ARNC as a cash flow stable company.
Successful completion of Phase 2 and Phase 3 projects. The current growth prospects hinges on the successful completion of Phase 2 and Phase 3 projects. Given the successful track record of ARNC's previous projects also completed on schedule, it is highly probably that Phase 2 will complete by H1/23 and that Phase 3 will complete in 2024. These low-risk facility upgrade projects will allow ARNC to expand current production capacity at a time when demand/volume growth is anticipated and the industry supply is tight. The cost optimization aspect of these projects will also reduce cost. In all, these projects will enable the EBITDA growth guided by company. Nothing more tangible than the EBITDA improvements generated from these projects will be more positive for the stock.
| show sort by |