Why Alcoa Still Needs to Abandon Its Silly Breakup

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In late September, Alcoa Inc. (NYSE: AA) announced that the company will split into two independent, publicly traded companies, one focused on upstream production and midstream products, and the other focused on downstream, or what Alcoa calls value-add, products like rolled and engineered aluminum. Existing Alcoa shareholders will own all outstanding shares of both companies and the separation is intended to qualify as a tax-free transaction for federal income tax purposes. The separation is expected to be completed in the second half of next year.

The upstream company will retain the Alcoa name and the value-add company will get a new name prior to the closing of the separation, and it will be the fourth-largest aluminum producer in the world. The new, slimmed-down Alcoa includes five business units that today make up Global Primary Products – Bauxite, Alumina, Aluminum, Casting and Energy. In the third quarter, the combined upstream businesses reported revenue of $2.2 billion and after-tax operating income of $153 million.

The innovation and technology-driven value-add company will include the Global Rolled Products, Engineered Products and Solutions and Transportation and Construction Solutions units. In the third quarter, these combined business segments reported revenue of $3.4 billion, after-tax operating income of $257 million and adjusted EBITDA of $508 million.

The value-add company has benefited from the market boom in commercial aviation. The aerospace market accounts for about 40% of the pro-forma revenues for the value-add company. Revenues from the automotive sector are expected to rise to $1.8 billion by 2018.

The outlook for commodity aluminum pricing improves slightly from a World Bank estimate of $1,671 inflation-adjusted dollars per metric ton in 2015 to $1,764 per metric ton in 2025. Better than nothing, but not much better.

As two companies, one with promising if uncertain growth prospects and the other at the whim of the commodities market, it appears that Alcoa is dividing itself into a high-risk commodity business that will get no help from the value-add business.

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In order for the separation to pay off for existing Alcoa shareholders, the commodity-based business is going to have to rein in costs, probably shed more assets and hope that commodity prices don’t continue to slide. If everything works out as Alcoa’s management reckons it will, this could happen. If not, though, the upstream business will be adrift on its own without the life-preserver of the value-add business.

Unless the value-add business doubles, it cannot make up for the loss to shareholders of the upstream business. This breakup has all the makings of a silly — and avoidable — mistake.