Alcoa Continues Strategic Shift Towards Value-Added Products With New Aerospace Facility

Alcoa ( AA ) recently announced that it has broken ground on an aerospace facility in La Porte, Indiana. The facility will produce nickel-based superalloy jet engine parts. The aerospace facility in La Porte is the latest in a series of steps taken by the company to rebalance its product portfolio towards value-added midstream and downstream products. The intent behind this strategic shift towards value-added products is primarily to reduce the company's dependence on its upstream businesses due to weak aluminum prices.

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La Porte, Indiana Facility

The $100 million-aerospace facility in La Porte, Indiana will expand the company's reach from structural engine components for business and regional jets to large commercial aircraft, including narrow and wide body aircraft, as well as military airplanes.

The plant will increase the Company's capacity to supply engine parts for narrow-body aircraft. It will also expand the company's market reach to wide-body airplanes, as it will enable Alcoa to produce parts nearly 60% larger than the components it makes today. These components are used in the compression and hot sections of the engine. This will enhance Alcoa's jet engine components portfolio. The company is already the global leader in jet engine airfoils. Construction of the plant has started and is expected to be complete by Q4, 2015.

Alcoa's strategic shift towards its midstream and downstream businesses is driven by low aluminum prices, negatively affecting its upstream businesses.

Aluminum Prices

Aluminum has diverse applications in industry. It is an important input in the packaging, aerospace, automotive, construction, commercial transportation, power generation, capital goods and consumer durables industries. Thus, demand for aluminum is broadly correlated with industrial growth. The European debt crisis and slowing Chinese growth have contributed to the decline in aluminum demand and consequently prices over the last few quarters.

On the supply side, production capacity has not been reduced corresponding to the fall in demand. Persistently high aluminum inventory levels relative to demand are keeping LME aluminum prices depressed. While LME prices are not the actual realized prices for Alcoa, they do indicate a broader trend in global aluminum prices. Despite inventories being at a record high, market forces have failed to rationalize supply through the shutdown of smelting capacity. Though global aluminum majors like Alcoa and Rusal have announced smelting capacity cuts, the same cannot be said of the Chinese companies. This is primarily due to state intervention in the form of provision of subsidies or renegotiated power contracts to smelters, which serve as a disincentive to cut production. China accounts for around 43% of the world's aluminum production and the expansion in production by Chinese producers has more than made up for capacity cuts by global majors. Thus, this oversupply situation is set to continue and is likely to keep prices depressed.

The average realized price per ton of aluminum for Alcoa has fallen consistently over the last three years. The average realized prices for aluminum have fallen from $2,636 per ton in 2011 to $2,243 in 2013. (( Alcoa's 2013 10-K , SEC))

Alumina has historically been priced as a percentage of the more liquid and transparent aluminum price quoted on the LME. This is because the spot market for alumina is very thin. Alcoa has implemented a move to price alumina based on an index of spot prices, to better reflect demand-supply conditions for alumina. However, even a move towards spot pricing for alumina is unlikely to raise realized prices for alumina dramatically. Alumina is mainly smelted to produce aluminum. With the oversupply expected to persist for aluminum, alumina prices are also expected to remain under pressure.

In view of the low aluminum prices, the company has cut back its smelting capacity. Alcoa's base smelting capacity has reduced from 4.227 million tons at the end of 2012 to 3.953 million tons at the end of Q1 2014. Further, the company had 675,000 tons of idle capacity out of its base smelting capacity of 3.953 million tons. (( Alcoa's 2013 10-K , SEC))

Strategic Shift

Low aluminum prices have put pressure on margins in the company's Alumina and Primary Metals segments, which represent Alcoa's upstream businesses. In order to compete effectively in such an environment, the company has made concerted efforts to rebalance its portfolio towards its value-added products. The value added products have pricing premiums over the upstream businesses and command higher margins. Thus, the Global Rolled Products (GRP) and the Engineered Products Services ( EPS ) divisions have played an increasingly important role over the last three years.

The GRP segment is mainly involved in the production and sale of aluminum plate, sheet and specialty foil. This segment's products are sold to customers in packaging and consumer goods, aerospace, automotive, brazing, building and construction industries. The EPS segment's products include titanium, aluminum and superalloy investment castings, fasteners, aluminum wheels, integrated aluminum structural systems, architectural extrusions, forgings and hard alloy extrusions. These products are sold to customers in the aerospace, automotive, building and construction, commercial transportation and power generation industries.

Alcoa's shift towards value-added products is reflected in its revenue figures. The percentage contribution of the GRP and the EPS segments sales to the total revenues has steadily increased. This figure stood at 52.1%, 54.4%, 55.7% and 57.2% at the end of 2011, 2012, 2013 and Q1 2014 respectively. In calculating these figures, we have only considered third party sales. The company's value-added products accounted for 76% of the company's total segment after-tax operating income.

Along with the automotive segment, Alcoa is betting big on its aerospace customers to drive sales of its value-added products. In the aerospace segment, Alcoa has raised its forecast for growth in production from 8% to 9% for 2014. The company expects strong performance from its large commercial aircraft and regional aircraft segments. The combined backlog of 10,675 aircraft units for Boeing and Airbus represents eight years worth of production. For Alcoa, this represents sustained demand for its aerospace products for the medium term. Further, the company expects strong aviation demand from Asia and the Gulf region.

The start of construction of the aerospace facility in Indiana is the second major development in the aerospace segment for Alcoa in 2014. The company recently signed a long-term agreement worth $290 million to supply aluminum sheet to Spirit AeroSystems over five years. Spirit is one of the largest designers and manufacturers of aerostructures for commercial, military, business and regional jets in the world.

These investments are growing Alcoa's aerospace business, which had revenues totaling $4 billion in 2013. This represents around 17% of Alcoa's revenues of $23 billion in 2013.

What Lies Ahead

We expect the company to continue to focus on its value-added products in the near and medium term. We expect the supply glut to persist for aluminum, keeping prices subdued. In such an environment, the fortunes of the company's upstream business will be more dependent on productivity gains rather than top line growth. Revenue growth for the company will be driven by the company's GRP and EPS divisions, especially by the automotive and aerospace sales. Thus, Alcoa's portfolio transformation towards value-added products is set to continue.

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The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

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