Morgan Stanley Values Alcoa Following Form 10 Filing

Morgan Stanley raised the price target of Alcoa Inc AA to $12 from $11 after Alcoa announced additional details on its split. The $1 increase in target price is mainly driven by a refreshed view on working capital release.

"We value the future Alcoa upstream company at $3.7/share (on the current share count which will likely change), assuming the New Co. can raise $1 billion in debt. Our valuation for Arconic (the future downstream company) shakes out at $8.4/share. Together, these values put our current AA share price target at $12," analyst Evan Kurtz wrote in a note.

Alcoa announced that the upstream company will have $1.24 billion in debt versus Morgan Stanley's max assumption of $2 billion.

"One surprise to us was that Arconic will own ~20 percent of the upstream company at the time of the split. We view this as a clever move to reduce dependence on debt capital markets," Kurtz noted.

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Kurtz, who has an Overweight rating on the stock, said debt levels should be manageable at both companies. The new capital structure puts upstream leverage at 1.1x excluding pensions and 2.3x including pensions, and the business is well-capitalized for a downturn.

However, the burden of debt fell on the downstream business. Arconic's leverage would be 3.6x before pensions and 3.9x including pensions. Meanwhile, the downstream business plans to monetize its 20 percent stake in the upstream company within the next 18 months, if the markets prove supportive.

"Liquidation of the shares would reduce leverage by 0.6x turns on downstream. Given the predictability of the downstream company's earnings stream, we view this as a reasonable amount of debt," Kurtz added.

Further, the analyst sees a "meaningful lift" in downstream profitability in winter 2017. In addition, Kurtz believes investor concerns on upstream cash burn are overblown, as the analyst expects portfolio adjustments and power cost deflation will continue to make the unit free cash flow positive.

At the time of writing, shares of Alcoa were up 1.43 percent on the day, trading at $9.23.