Primary Analysis: Arconic Launches $900M Issuance of Senior Secured Notes Due 2030 to Partially Fund Apollo’s Pending Acquisition; Initial Price Talk of 8.75%-9% Offers Attractive Relative Value

 
Relevant Items:
Preliminary Offering Memorandum
Historical Financials on Fundamentals by Reorg
 
Note: Reorg Fundamentals team published public-side analysis on Arconic and its term loan B last week. The forecasts provided by Reorg herein match the Reorg Fundamentals report and use a number of assumptions based on the company's commentary about go-forward strategy, peers’ commentary and macroeconomic assumptions. If you are a lender on this transaction and would like to see the full report published last week, click HERE.
 
On May 4, Arconic announced that it is being acquired by Apollo and Irenic Capital Management in a deal that values the company at an enterprise value of approximately $4.8 billion. The enterprise value represents a 5.9x multiple, based on LTM pro forma adjusted EBITDA of $820 million. Including a $883 million pension liability, the multiple climbs to 7x, or 9.4x based on adjusted EBITDA excluding $100 million of estimated cost savings and $115 million of operational outages. The acquisition is expected to close by the end of the third quarter.

The transaction will be financed with approximately $2.3 billion in common equity provided by the Apollo consortium. The debt financing package includes a new five-year $1.2 billion ABL facility (same size as the existing facility), seven-year $1 billion senior secured term loan B, $900 million senior secured bonds and $725 million in unsecured debt. The unsecured debt is expected to be held by the Apollo consortium. The loan-to-value ratio for the deal including the pension liability is 52.3%, or 37.3% through the first lien debt.

The transaction results in a relatively small increase in secured debt from $1.65 billion to $1.9 billion (2.2x LTM pro forma leverage), while total net debt increases by about $1 billion to $2.5 billion (3.1x LTM pro forma leverage) primarily resulting from the issuance of the unsecured debt to the Apollo consortium. Adjusted for pension liability, total net leverage slightly exceeds 4x. Liquidity will primarily consist of the undrawn $1.2 billion ABL with no maturities prior to 2030.

Apollo says it brings extensive aluminum industry expertise to Arconic after its previous investments in Constellium, Noranda and Aleris. On the basis of this experience, it says it believes cost savings of at least $100 million annually have been identified while it also intends to shift the company’s focus from volume growth to value enhancement through more limited and more targeted capital projects to reduce costs and capital intensity.
 
Arconic is a leading downstream aluminum fabricator serving the ground transportation, aerospace, packaging, building and construction, and industrial end markets. An estimated 70% of its variable costs (and 55% of its total costs) are metal costs which are passed through to customers under long-term contracts, resulting in highly stable unit margins and minimal commodity price risk. The volume outlook is for growth across all of its end markets, particularly within the ground transportation and aerospace end markets. We believe the best Arconic comparables are Novelis and Constellium.

Initial price talk for the new senior secured bonds is 8.75%-9% or an approximate 475-500 bps spread, which is well above the 250 to 275 bps spreads for the bonds of Novelis and Constellium, which have adjusted leverage of approximately 3x and 4x, respectively, compared with Arconic’s pro forma adjusted leverage slightly in excess of 4x.

Prior to the announcement of the Apollo acquisition, Arconic’s existing senior secured note issues generally traded in the mid-90s with a spread of about 350 bps. We believe the incremental 125 to 150 bps spread implied by the initial price talk reflects slightly increased senior secured leverage, the addition of $725 million of unsecured debt and the private equity ownership of the company which could potentially lead to more aggressive financial policies over time. We view the indicated pricing as attractive even when taking into consideration the PE ownership. These relative value considerations, the leverage profile (see Reorg Fundamentals forecasts below) and the high-quality nature of the asset make the deal attractive in our view.
                 
Arconic is the second-largest player among its closest peers, which include Hindalco-owned Novelis and publicly listed Constellium and Kaiser. Arconic has a balanced business across five key markets with no overdependence on any single market or customer, and the five segments all have favorable macro trends. The company stands out among the selected industry players with a substantial market presence within its sales portfolio in both the ground transportation and aerospace sectors (it’s the largest Boeing supplier and No. 2 for Airbus). Both end-market outlooks project a CAGR of approximately 10% and 9% for the period spanning 2022 to 2026E, respectively. Moreover, the company holds a considerable hard asset value with property, plant and equipment of $2.4 billion and net working capital position of $1.1 billion, driven by $926 million of receivables and $1.7 billion of inventories.

Arconic is expected to remain at a relatively low capital expenditure rate compared with other players in the industry, with estimated annual maintenance spending from $150 million to $160 million. Arconic’s management has several times highlighted its disciplined capital allocation toward lower-risk, higher-return projects.

In terms of EBITDA guidance, Arconic presented a pre-transaction 2023 estimated adjusted EBITDA range of $650 million to $700 million, which trails the marketed pro forma EBITDA of $820 million, though this figure includes $100 million of estimated cost savings and $115 million of operational outages addback. In terms of peer EBITDA guidance, Constellium’s 2023 guided growth is broadly in line with Arconic’s guided growth. Constellium 2025 adjusted EBITDA growth guidance of 27% above LTM EBITDA is also comparable to Arconic’s 33% growth (as per proxy) to 2025, as compared with $605 million LTM adjusted EBITDA excluding Russia.
 
From a valuation standpoint, the 7x pro forma multiple paid for Arconic is below Constellium’s 7.8x. The multiple expands when cost savings are excluded toward about 9x, but it still remains within comparable M&A transactions as shown below, as well as trading comps.
 
Over the past three years, Arconic and the selected comparables experienced a consistent growth in revenue, with notable recovery following the Covid-19 pandemic. However, in 2022 (fiscal year 2023 ended Mar 31 for Novelis), the revenue growth rate displayed a deceleration primarily attributed to the headwinds of supply-chain disruptions and inflation impacts in volatile market conditions. These factors exerted pressure on costs, leading to a slower growth rate during the fiscal year.
 
Arconic’s net M&A activities show limited historic appetite for acquisitions. Novelis and Kaiser each engaged in transactions within the industry. Novelis pursued a strategic expansion of its aluminum rolled products portfolio, resulting in synergistic advantages and cost-saving opportunities. Similarly, Kaiser made a strategic re-entry into the packaging industry.

Arconic demonstrated a higher cash conversion rate relative to its peers, averaging 69%. Despite the relatively high cash conversion, management said that the company will focus on harvesting the investments made over the prior three years to unlock value while limiting future growth to high-return, low-risk projects. Historically, Arconic has spent about 60% to 65% on sustaining capital expenditures, focusing on productivity and growth. The group highlighted a $550 million capex project outlined in its 2022 investor day presentation.
 

On the EBITDA growth side, Arconic is broadly in line with the industry trend during the years 2019 through 2022, and the growth rate is in range with the group including Kaiser, Novelis and Constellium. The EBITDA margin of Arconic is relatively flat at the period from 2018 through 2022 and keeps at an average level among the comparable companies.

The outlier in EBITDA margins is Kaiser, which attributed the decline to significant supply-chain issues specifically related to magnesium and hot metal supply at the company’s Warrick operation and reduced packaging and plate shipments in the third quarter of 2022, because of a magnesium-related force majeure coupled with the planned outage at its Trentwood operation. In addition, higher inflation-driven costs during the year, which the company is aggressively working to offset through pricing actions, cost-reduction efforts and efficiency improvement projects further affected results.
 
Margins in the industry looked as follows:
 
Apollo highlighted its extensive experience in the aluminum industry, saying that Arconic will be its fourth significant investment following its transactions involving Constellium, Norando and Aleris. Given this experience, Apollo believes it has identified $100 million to $170 million of potential cost savings primarily related to raw material optimization, procurement, avoidance of public company costs, and productivity initiatives, of which $100 million are assumed in its pro forma EBITDA calculation, along with avoidance of $115 million of recent plant outages. Apollo further emphasized its intention to dramatically shift the company’s capital allocation away from investments focused on volume growth to those focused on enhancing value through reducing costs and capital intensity. An additional capital allocation priority will be the reduction of debt along with continued reduction in pension liabilities. Finally, Apollo emphasized the stability of unit margins (and minimal commodity risk exposure) given the metal cost pass-through mechanisms in the company’s long-term contracts with major automotive, aerospace and packaging companies.

Management highlighted the attractive volume outlook for each of its main end markets, particularly the automotive and aerospace end markets. Further, it emphasized that it has previously operated with a similar capital structure and has been successful in reducing its pension liabilities to less than $1 billion from about $2 billion following its separation from Howmet Aerospace in 2020.
Main conference call questions were related to the magnitude of annual cash outlay for pension liabilities (about $120 million annually), the timing and potential for debt reduction (possible use of FCF after pension outlays for debt reduction), and the potential for significant acquisitions (not a priority).
   

• Leading provider of aluminum rolled products and complex building systems with broad scale and diversity: Arconic is the second-largest player among its key competitors, with an expansive product portfolio and end market diversity. These encompass aerospace plate, packaging can sheet, auto body sheet and extrusions, and differentiate it against competitors. Arconic’s customer base includes thousands of companies across the globe varying in size from small to large original equipment manufacturers. The top customer accounts for less than 10% of revenue.
   
• Base case forecast shows a robust financial profile: Reorg Fundamentals base case, which is conservative compared with the proxy statement and some of the peer’s guidance, forecasts Arconic generating free cash flow (albeit in limited amounts) relatively early on and growing to near $200 million by 2027. This, alongside EBITDA growth, supports the deleveraging profile. Management noted on the call that while asset integrity will be the near-term focus for capital allocation, deleveraging is the natural opportunity thereafter.
   
• ESG tailwinds driving accelerating demand for aluminum: Aluminum is lighter than steel and more recyclable than plastic, making it superior for reducing vehicle emissions and being reusable. Approximately 75% of all aluminum produced is still in circulation today as a result. A further tailwind is the global shift to electric vehicles, as EV’s are 25% to 35% more aluminum intensive.
   
• Long-term customer contracts and relationships: The company has maintained long-term contracts with blue-chip customers such as Ford, Stellantis and Boeing, and over 30 years of relationships with Ryerson and Thyssenkrupp. This creates recurring revenue for Arconic and steep barriers to entry.
   
• Stable earnings with pass-through mechanisms mitigating commodity risk: Arconic operates under a pass-through pricing construct in which pricing (per ton) includes both the underlying metal costs and a premium for value-added services to produce a semi-finished product. Within this mechanism, the metal costs constitute about 55% of the overall cost structure, thus facilitating the mitigation of commodity price risk exposure.
   
• Strategic asset base: Some $175 million in growth capital has been invested in the Davenport, Iowa, Alcoa, Tenn., and Lancaster, Pa., facilities since 2019 to maximize the efficiency of the facilities and improve their capabilities. Arconic’s facilities are often located near its customers, enabling the company to serve them on a localized basis, facilitating shorter lead times on mission-critical applications. Gross PP&E on the balance sheet amounts to $7 billion, but net of depreciation amounts to $2.3 billion.
   
• Growing and resilient end-market outlook: Each of the end markets that the company serves is expected to grow over the next four years, with the most significant growth occurring in the aerospace and ground transportation end markets, which historically have been the company’s most profitable. Despite this, risk of economic downturn is present given the cyclical nature of a number of the downstream industries.
   
• Experienced existing management team: Each member of the management team has over 30 years of experience and successfully navigated the company through the pandemic. Sales (excluding Russia) increased to $8.1 billion at year-end 2022 from $5 billion at year-end 2020. In addition, management successfully reduced the net pension and OPEB liabilities to less than $1 billion while also investing in the company’s growth projects in Iowa, Pennsylvania and Tennessee.
   
• Strong private equity sponsor with sector experience: Apollo has been investing in the metals sector for nearly two decades, including the carve-out of Arconic’s peer Constellium from Rio Tinto and bringing it to IPO two years later. It has assembled a strong team dedicated to partnering with Arconic management and supporting the company’s long-term vision. Apollo is also known to be an aggressive sponsor from a lender standpoint, however.
   

 

• Prolonged recession, deteriorating demand and weak earnings: Metal operations are capital intensive and generally have high fixed costs. Arconic may not be able to reduce costs and production capacity on a sufficiently rapid basis to keep up with rapidly declining demand, negatively affecting near-term profitability.
   
• Macroeconomic susceptibility: The company continues to face inflationary pressure on the price of aluminum, materials, transportation, energy and labor. It is vital that Arconic continues to pass on price adjustments to customers. Prolonged periods of high inflation make it more difficult as customer contracts can be for extended periods of time and difficult to adjust.
   
• Cyclical end markets: Arconic is subject to cyclical fluctuations in global economic conditions and lightweight metals end-use markets. Many of the downstream industries are cyclical, such as the aerospace, automotive, commercial transportation and building and construction industries. The demand for Arconic’s products are sensitive to, and quickly affected by, demand for the finished goods manufactured by their customers in these industries. Demand may change as a result of changes in regional or worldwide economies, currency exchange rates or energy prices.
   
• Raw materials supply risk: Arconic has a limited number of suppliers for raw materials within annual or long-term contracts for a majority of its supply requirements. The company faces risks of not being able to renew or find replacements for long-term supply contracts, which could force it to seek less favorable alternative sources. Conversely, if raw material prices decline, suppliers can withdraw capacity from the market until prices improve, which may cause periodic supply interruptions.
   
• Increased competition due to industry consolidation: As competitors strengthen their market positions in an evolving industry and explore strategic alliances, Arconic may see market share losses as competition intensifies. Similarly, consolidation among Arconic’s customers may result in customers who are better able to command increased leverage in negotiating prices and other terms of sale, which could also hurt the company’s profitability.
   
• Aluminum substitution risk: Arconic’s aluminum offerings compete with products made from other materials, such as steel, glass, plastics and composite materials, for various applications. Higher aluminum prices relative to alternative materials tend to make aluminum products less competitive. The willingness of customers to accept substitutions for aluminum, or the ability of large customers to exert leverage in the market to reduce the pricing for aluminum products, could materially adversely affect the company’s financial position, results of operations and cash flows.
   
• Aggressive sponsor: Apollo is a more aggressive sponsor, which may limit deleveraging and increase risk to the company’s ratings.
   

 
Note: The above financial forecasts were created by Reorg Fundamentals. These forecasts utilize a number of assumptions derived from the company as well as macroeconomic assumptions. If you are a lender on this transaction with access to private financials, please see HERE to gain access to the full report.

We expect Arconic’s 2023 revenue to decline, driven by the sale of the Samara facility, which generated $903 million in 2022. We forecast base case revenue growth in line with global GDP growth and below the projected end-market growth as shown in the lender presentation. This is closer to the growth shown in the proxy case, which reflects the proxy statement forecast. The low case projects near-term economic weakness, which translates into anemic sales growth. Our base case EBITDA forecasts some of the cost savings coming in and operational outages rolling off in 2023, with a more robust improvement in the back end of the forecast period. We sensitized the spending upward in the near term, given 2023 guidance according to the fourth-quarter presentation.
 

Note that our model accrues cash on the balance sheet. If this cash were deployed toward reducing debt, interest cost would be lower, translating to a steeper deleveraging trajectory.

A summary of our projections, including the projections from the proxy statement, is below:
 
Our projections show base and proxy case deleveraging driven by EBITDA growth and cash generation, but our low case, which forecasts a weak economic environment, translates into neutral cash generation. In this case, leverage declines marginally based on adjusted EBITDA as we give credit to some cost savings and also see EBITDA growth in the back end of the forecast period.
 
Below is the overview of the cost saving opportunity, as shown by the company:
 
Full financials for Fundamentals by Reorg subscribers are being updated HERE. To request a trial of Fundamentals by Reorg, please email sales@reorg.com.