Commodities

Liam Denning is a Bloomberg Gadfly columnist covering energy, mining and commodities. He previously was the editor of the Wall Street Journal's "Heard on the Street" column. Before that, he wrote for the Financial Times' Lex column. He has also worked as an investment banker and consultant.

Rather than a clean divorce, the end result of Alcoa's separation could be more of a friends-with-questionable-benefits affair. 

The company's much-anticipated initial filing detailing its plans to split dropped early Wednesday morning. To recap, shareholders are set to own an upstream alumina and aluminum production company called Alcoa, and a sexier engineered-products maker named Arconic.

The plan, announced last September, has always made sense strategically. The troublesome issue, as in many relationships, concerns money. While in most divorces arguments center on dividing up the assets, with Alcoa it is all about apportioning the debts. These weighed in at $7.7 billion, net of cash, at the end of March. Pension and other retirement obligations add up to another $5.6 billion. Against all this, Alcoa's current market capitalization is just under $12 billion.

The upstream business, with its more-volatile profits, is not exactly a darling of the lending crowd. So the plan was for the legacy debt to stay with Arconic. To help ease that burden, the new Alcoa would issue some new debt and hand over the cash.

That is indeed what Alcoa is going for, but with a twist.

The new Alcoa aims to issue $1 billion of debt and give Arconic that cash. That is less than some had expected earlier this year -- I speculated a figure of $1.5 billion here.

Based on the lower figure, the leverage ratios look OK, but not great. Alcoa as a whole is forecast to make $2.6 billion of Ebitda this year, according to figures compiled by Bloomberg. Assume the legacy business accounts for 30 percent of that, with Arconic making the rest. On that basis, Arconic's pro-forma net debt would be about 3.5 times Ebitda, while the upstream arm would be at 1.5 times. Factor in the post-retirement obligations -- which rating agencies will, to some degree -- and those ratios shoot up to 5.2 and 4.9 times, respectively. Ouch. 

So, good-looking as it is, Arconic's balance sheet could use a touch-up. Hence, it was revealed Wednesday, Arconic will keep a stake of up to 19.9 percent in the upstream business. The idea is that this amounts to another source of liquidity, with Arconic planning to sell the shares over the course of 18 months after the split, though it may also take up to 5 years to dispose of them.

It's a creative step and worth trying in order to get the split done. Equally, though, an account full of Alcoa shares isn't some low-risk money-market fund:

Aluminum Coin
In the past 18 months, Alcoa's stock has risen above $17 and slumped below $7
Source: Bloomberg

Underlying the volatility in the chart above is the ebb and flow of expectations about aluminum prices, which are in turn buffeted by hopes of China reining in production. The first line of Bloomberg Intelligence's mid-year review of the market gives you a sense of how those hopes often turn out:

Chinese aluminum makers may add more capacity than the rest of the world combined this year, giving them more clout in global markets.

This feeds directly into the leverage math at the heart of Alcoa's plans. Since they were announced last September, the consensus earnings estimate for Alcoa's Ebitda in 2016 and 2017 has fallen by a combined $2.8 billion, or 34 percent.

Lower Common Denominator
Consensus Ebitda forecasts for Alcoa as a whole have slumped since the split was announced
Source: Bloomberg

If Alcoa's Ebitda was still expected to be $3.9 billion this year -- and assuming the same split -- the pro-forma net debt ratios would be just 1.1 times for the upstream business and 2.4 times for Arconic. Under those circumstances, a clean break would have been likely.

As it stands, the retained stake should provide some comfort that Arconic can shoulder the lion's share of the debt. Hence, Alcoa's 10-year bonds maturing in 2024 rallied sharply back above par value on Wednesday.

The stock didn't, though, despite aluminum's continued recovery from its post-Brexit dive. This may reflect lingering uncertainty about the split going through. A legal spat with Australian partner Alumina Ltd. drew questions on Wednesday's call. Meanwhile, Alcoa will need a nod from the IRS to keep the spin-off tax free while incorporating the new structure of Arconic keeping a stake in the upstream business.

That stake will also hang over the new shares of that business from day one, creating a self-fulfilling cap on its value to Arconic. And Arconic itself is no longer quite the pure product engineer envisaged originally, at least for now. This less-than-final divorce, while born of circumstance, emphasizes just how difficult it is for Alcoa to shake off the burdens of the past. 

This column does not necessarily reflect the opinion of Bloomberg LP and its owners.

To contact the author of this story:
Liam Denning in San Francisco at ldenning1@bloomberg.net

To contact the editor responsible for this story:
Mark Gongloff at mgongloff1@bloomberg.net