Arconic Is Unstoppable

Arconic just released its third quarter earnings and did not disappoint as earnings came in above expectations, and full-year guidance has been raised.

The company\'s ongoing cost reduction measures are paying off big time on top of very strong organic sales growth.

Going forward, I expect further efficiency gains and a significantly higher stock price.

I have been looking forward to writing this article. Arconic (NYSE:ARNC) has been on my radar since the spin-off from Alcoa (NYSE:AA). Since then, the company has been transformed from a slow-growing inefficient company pressured by a slow economy to an earnings powerhouse. In August of this year, I wrote that the company's turnaround was paying off and that we should expect a breakout. That is exactly what happened. Although some cyclical companies seem to struggle, Arconic revealed rock solid earnings growth and reported strong guidance. The company's turnaround is working out perfectly and I expect further upside potential. Source: LancasterOnline

I love aerospace stocks. It's one of the biggest industries in the US and (indirectly) responsible for millions of jobs worldwide. However, the aerospace industry is large, and there are countless stocks related to this industry. Personally, I tend to prefer suppliers as they often benefit more than airplane manufacturers like Boeing (NYSE:BA) and Airbus (OTCPK:EADSF). Arconic is one of these companies. In the third quarter, the company reported adjusted EPS worth $0.58. This is well above expectations of $0.53 and 81% higher compared to the prior-year quarter.

A quick look at the last row of the table above shows that something 'magical' happened in 2017. Growth rates went from volatile and close to 0% to double-digit growth in almost every single quarter.

One reason is the focus on efficiency. As I discussed earlier, the company is restructuring itself after the spin-off from Alcoa. Previously, the company had three segments: engineered products and solutions, transportation and construction solutions, and global rolled products. In other words, the company covered pretty much the entire production of aluminum parts except for the production of actual aluminum - which is the core business of Alcoa.

Currently, the company consists of two business segments. Engineered products and forgings (EP&F) and global rolled products (GRP). The EP&F segment covers engine products, fastening systems, engineered structures, and forged wheels. The GRP segment covers global rolled products, aluminum extrusions and building and construction systems. Both the EP&F segment and GRP are going to be separated again creating the Howmet Aerospace Inc. (Remain Co.) and the Arconic Corporation (Spin Co.).

The third quarter numbers are pre-spin-off. The good news was that despite the ongoing economic decline, the company reported 1% higher revenue to $3.6 billion. Organic revenue was up a stunning 6%. EP&F organic revenue was up 8% while GRP organic revenue was up 5%. In other words, the segment that produces aerospace supplies outperformed total organic growth by 200 basis points.

Profitability was up as well. Total operating income excluding special items was up 36% while operating margin improved 340 basis points compared to the prior-year quarter and 20 basis points compared to Q2 of this year. The roughly $100 million surge in adjusted operating income was provided by a $36 million tailwind from higher prices, a volume boost worth $22 million, and lower raw material costs worth $39 million. This is somewhat a best case scenario, given that the economy is slowing. Aerospace demand is high while basic materials are down due to the fact that other manufacturing industries are showing lower demand.

A strong Q3 result is good. However, there is much more that justifies a long position. First of all, the company's ongoing divestitures will reduce annual revenue by $350 million. This is also the reason why I mentioned that organic revenue growth was way above total revenue growth of 1%. A large part of cash flow from divestitures will and has been spent on buybacks. So far, the company repurchased stock worth $1.1 billion year to date at an average price of $20.67. This translates to roughly 53.2 million shares. So far, there is still $400 million authorized to be used on further buybacks. Adding to that, Arconic is on track to complete the separation (Remain Co. & Spin Co.) in Q2 of 2020. Form 10 filings are expected to be available in the fourth quarter of this year. The appointment and recruitment of two boards and management reams is on track.

Moreover, the company revised its full-year guidance. Revenue is expected to be roughly $200 million lower than previously expected due to a lower aluminum price and the ongoing divestitures. Nonetheless, this still implies organic growth between 6% and 7%. Adjusted EPS has been updated from $1.95-2.05 to $2.07-2.11 as the benefits from lower costs and higher prices more than offset the aluminum extrusions operations decline and the negative impact from variable compensation.

With that said, I am not surprised the stock is up 75% this year. Note that the stock is still trading at attractive levels. In this case, 12.5x next year's earnings and 0.9x sales.

I expect further upside momentum. Note that this is based on economic sentiment staying at current levels. If the economy manages to bottom and rally, I think we are going to see even further upside momentum. I think $35 per share is a realistic target for the first half of 2020. On a longer term, I expect a sustainable uptrend backed by high organic growth, cost reduction, and share repurchases. We are dealing with a stock that gives us everything we need: higher profitability, a successful product portfolio, and high shareholder distributions. The 2019 performance has been great so far, but there is more to come!

Stay tuned!

I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

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This article serves the sole purpose of adding value to the research process. Always take care of your own risk management and asset allocation.