Here's Where Alcoa Sees Future Success Despite Disappointing Earnings

By Dan

Image: Alcoa.

Lightweight-metals company Alcoa has gone through a lot in recent years, with major acquisitions to broaden the company's production capacity beyond its historical focus on aluminum, and get the metal maker on track for accelerating future growth. Yet when it reported its third-quarter results, Alcoa left investors wondering whether that growth will actually materialize, especially as the company seeks to break itself into two separate parts.

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Alcoa stock fell sharply following the quarterly report, but company executives still think that Alcoa's long-term prospects are sound. Let's take a closer look at five specific things Alcoa executives said in the company conference call on October 8 that tell where they see the best chances of success.

CEO Klaus Kleinfeld was asked to explain some of the reasoning for splitting Alcoa into two pieces, one focused on the value-add component of its business and the other on upstream production. One of the reasons involved trying to unlock shareholder value from the value-add side of Alcoa, where he pointed to the recent move from Warren Buffett to acquire industry peer Precision Castparts . Looking at the multiple that Precision Castparts got, Kleinfeld argues that the extensive overlap between Precision's business and Alcoa's point to a higher multiple for the value-add business once it trades independently.

At the same time, though, Kleinfeld was quick to point out that Alcoa doesn't really envision major strategic changes in the way its various divisions do business once the anticipated split-up is complete. Upstream will continue to focus on cutting costs and building up a competitive advantage as a low-cost provider of primary metals, and value-add will look for new opportunities for high-end custom parts for key customers.

What matters, though, is that investors will be able to invest in the side of the business that they understand and like the most. To Kleinfeld, that might remove some pressure from investors who don't necessarily understand every element of Alcoa's business as much as corporate executives do.

One big announcement Alcoa made in its earnings release was that it had won a $1.1 billion contract with Lockheed Martin for its joint strike-fighter program to provide titanium. Yet as Kleinfeld noted, Alcoa already had a substantial relationship with Lockheed and the F-35 program, with bulkheads and forgings among the components it supplied for the aircraft.

The CEO believes that its titanium acquisitions will not only open up brand-new business, but also lead to deeper relationships with its existing customer base. With the vote of confidence that Lockheed made, Kleinfeld thinks that other major aerospace players will have a similar reaction going forward.

The acquisitions that Alcoa has made are designed to open up all these new growth opportunities, but they also lead to a certain amount of complexity in accounting. CFO Bill Oplinger noted that, when you step up existing inventory on an acquired company to current market value, you don't get any profit margin when you subsequently sell that inventory.

In addition, Alcoa spent money on improvements related to its Micromill project, as well as expanding capacity in global rolled products. Combined with the strong dollar, that's how Alcoa explained its earnings shortfall.

In expanding on the Micromill, Kleinfeld once again talked about the many advantages the process has over conventional production techniques. The end material that the Micromill facility produces is 40% more formable and 30% stronger than aluminum, with similar strength to steel despite being 30% lighter and twice as formable.

Meanwhile, from a process standpoint, production is much faster and twice as energy efficient, and the facility footprint is just a quarter of a standard mill. Alcoa is looking at how to expand availability of the Micromill to maximize the profit potential, and Kleinfeld clearly thinks it's a high-growth prospect worth pursuing.

Despite having to deal with disappointed investors, Alcoa did its best to explain its present condition and its capacity for future growth. From the stock's reaction, not every investor believes that Alcoa is in as good shape as its executives think, but time will tell whether management is too optimistic, or whether investors have missed out on a bargain opportunity to own Alcoa shares at a lower price.

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Dan Caplinger has no position in any stocks mentioned. The Motley Fool recommends Precision Castparts. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

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