Arconic Makes the Case It Was Right to Reject Buyout Offer

Aerospace component manufacturer Arconic (HWM 0.15%) took a lot of heat in January when its board nixed a potential sale of the company, with shares falling more than 20% on the announcement. It's true the private equity buyers were looking to do a deal on the cheap, but given Arconic's brief, tumultuous history as an independent, there were no guarantees the company would be able to extract significant value on its own.

In the months that have followed the rejection, Arconic and its new leadership team have gone a long way toward validating the decision to go it alone. The company has taken decisive steps to bring down costs and improve operations, which has led to improved quarterly results and a recovering stock that today trades above the rumored buyout price.

Ultrasonic testing of an aerospace plate at an Arconic facility. Image source: Arconic.

Even after gains, Arconic shares still appear to have room to run. Here's a look at the latest quarterly results, and an update on where things stand for the finished metal products manufacturer.

A rare beat and a raise

Arconic on Aug. 2 reported second-quarter earnings of $0.58 per share, $0.08 ahead of estimates, on revenue up 3.4% year over year to $3.69 billion. The beat was driven in part by strong cost controls, and following the earnings release Arconic increased its annual cost reduction commitment to $260 million from $230 million. The company predicts it will capture about $140 million of those annual savings in 2019, compared to the $120 million expected this year at the time of the previous earnings release.

Data source: Arconic. *Operating income and EPS figures are excluding special items

Earnings per share increased 57% year over year, driven by operational improvements, lower aluminum prices, and a decreased share count.

The company also raised its full-year earnings guidance to between $1.95 and $2.05 per share, a significant increase over its previous expected range of $1.75 to $1.90 per share and well above the $1.86 consensus. Free cash flow guidance was raised to $700 million to $800 million from $650 million to $700 million thanks to faster cost reductions and working capital gains. That number seems likely to improve further next year, as expenses appear likely to drop in 2020 as ongoing investments to make facilities more efficient wrap up.

Arconic, a maker of aluminum and other metal parts for the aerospace, automotive, and industrial sectors, was cobbled together by Alcoa via a series of mergers and acquisitions, and spun off on its own in 2016. Through most of its time as an independent it has struggled to meet expectations, as it became increasingly apparent that Alcoa did a poor job integrating the businesses it had purchased.

Arconic CEO Klaus Kleinfeld, who headed Alcoa prior to the split and who orchestrated the rollup that became Arconic, was ousted in April 2017 as part of a dispute with activist fund Elliott Management. It took the company nearly 10 months to hire his replacement, Chip Blankenship, who concluded after a few months on the job that Arconic is plagued by performance "variation" across its production sites that would require time and spending to solve.

Another breakup in the works

Blankenship left Arconic shortly after the January rejection of the buyout offer, replaced by board chairman and former TRW Automotive CEO John Plant. The new CEO needed little time to stamp his mark on the company: In February Arconic announced plans to separate its engineered products and forgings businesses from its operations making aluminum sheet and pledged to divest any unit that doesn't fit into one of those two categories.

The split, which Arconic expects to complete in the second quarter of 2020, would create a pure-play aerospace supplier, branded as Howmet Aerospace, that would manufacture engine components, fastening systems, engineered structures, and forged aluminum wheels.

Arconic aluminum alloy coils at its Davenport, Iowa, facility. Image source: Arconic.

The Howmet business will likely be of particular interest to investors, thanks to the multiyear backlog of orders enjoyed by both Boeing and Airbus, with whom Arconic has good business relationships Berkshire Hathaway in 2016 paid about 17.5 times forward EBITDA for aerospace metal component manufacturer Precision Castparts. Arconic, by comparison, currently trades at just over 12 times the high end of its full-year guidance.

Arconic provided a few new details about the split in its earnings review. Plant, who is 66, has pledged to remain as CEO through the separation; however, he has not decided if he wants to remain at one of the new entities once the split is complete. The company also anticipates total separation costs of between $130 million and $160 million, plus upwards of $35 million in one-time capital spending costs.

The company also hopes to raise upwards of $200 million via divestitures to offset the one-time costs associated with the separation.

The 737 MAX won't ground Arconic

Arconic is among the many aerospace suppliers with exposure to Boeing's troubled 737 MAX program, making a number of engine fasteners and airfoils for the jet. The company earlier this year warned it could face an earnings hit of $0.02 to $0.04 per share, or $9 million to $18 million, if the Boeing production slowdown continues until year's end.

Boeing continues to manufacture planes even as the 737 MAX remains grounded, and Arconic said that its updated guidance assumes the production rate will remain at the current 42 builds per month on air frames, and 48 barrels per month on aircraft engines, through the remainder of the year.

Arconic appears to be conservative in this guidance, with most engine suppliers still working at an assumed production rate of 50 or 52 barrels per month. While the 737 MAX continues to be a drag on the entire aerospace supply chain, investors can at least hope that Arconic in its guidance has limited the potential for a downside surprise, and there is the potential for a 737 MAX ramp-up into 2020 that could provide some upside for next year.

The clouds are lifting

Arconic shares, which traded below $17 apiece after the company rejected the reported $22.20-per-share buyout offer, today trade at just under $26 per share. While the restructuring is far from complete, and there is going to be continued uncertainty until the separation is done, the decision to go it alone so far looks like the correct one.

ARNC year to date data by YCharts.

There's likely additional upside potential. When Elliott Management was campaigning to oust then-CEO Kleinfeld in 2017, the hedge fund pegged Arconic's potential value at upwards of $54 per share, should operations get cleaned up and costs cut. That figure is dated and unreliable, but it seems reasonable that a stand-alone aerospace company in today's environment would command a higher valuation than where Arconic currently trades.

I've argued in the past it was largely poor management that led to Arconic's issues after it was split off from Alcoa, and under the watch of a veteran manufacturing CEO like Plant, Arconic seems to be making steady progress ironing out the operational issues and generating better profitability and free cash flow.

Arconic's biggest problem in recent years has been credibility. With Plant and his team making steady progress delivering on the promises they've made, investors are finally beginning to realize Arconic's full potential.