Alcoa's Fourth Quarter The Best Of A Bad Situation

Posted: Jan 11, 2012 10:35 AM by Stephen D. Simpson, CFA A lot of investors spend their time looking for best of breed investments; the best-run companies within particular sectors. However, what should an investor do when the entire breed is in disrepute and on the way to the pound? Alcoa (NYSE:AA) does indeed have a claim on being one of (if not the) best aluminum company out there, and is undervalued on long-term averages, but investors will struggle to get ahead with this name if aluminum prices don't rebound. (For more, see Earning Forecasts: A Primer.) A Tough End to the Year Alcoa arguably made the best of a bad situation in the fourth quarter. Results weren't bad relative to expectations, though there was some "noise," but absolute performance certainly showed some weakness. Revenue rose 6% from the year-ago level, but fell 7% from the prior quarter. Given that the price of aluminum, as traded on the London Metal Exchange, fell about 12% sequentially, that's actually a pretty good performance. Revenue was the least weak in engineered products, falling just 1%, while alumina, primary metal and flat-rolled, all saw double-digit sequential drops. Profitability was likewise weak. Adjusted EBITDA fell 46% from the prior quarter and there were substantial sequential profit declines across the operating groups. Engineered was again the relative standout, with just 12% sequential profit erosion, while profits in primary metals and flat-rolled were down significantly. Will Capacity Cuts Do the Trick? In response to feeble market prices, Alcoa recently announced that it would close or curtail almost 12% of its global capacity (about half a million tons). This is a logical move when prices are so low, but if rivals like Century Aluminum (Nasdaq:CENX), Noranda Aluminum Holding (NYSE:NOR), Kaiser Aluminum (Nasdaq:KALU) or Rio Tinto (OTBCC:RTPPF) don't take similar steps, how much good will it do? Even if Alcoa is one of the more efficient operators, that doesn't mean that rivals won't run at a loss and that could suppress a recovery. As things are, Alcoa has its work cut out for it. Alcoa saw an average realized price of about $1.08 per pound during the fourth quarter, but spot prices today are around 94 cents. Even as Alcoa has a stronger downstream position than its peers, and is therefore more insulated from spot aluminum prices, that's still a very difficult market in which to make a buck. It's also worth noting, though, that current aluminum prices seem to be below current industry marginal production costs. Chinese aluminum smelters are thought to need prices of $1.00 to $1.05 to break even, and the market clearly isn't there. With ongoing demand in aerospace, autos,

trucks and construction across the globe, it would seem that prices should be stronger, but that has been true for a while now. The Right Markets ... To a Point Alcoa is often talked about as a play on aerospace and The Boeing (NYSE:BA) and Airbus have been seeing the beginning of another cyclical upswing. Keep in mind, though, that food packaging is just as large of a business as aerospace for aluminum producers, and commercial construction is a huge consumer, as well. What's the point? Just that it's not all about aerospace, as softness in construction markets in emerging markets would draw off a lot of that momentum. The Bottom Line Aloca often trades between 6x and 8x one-year forward EBITDA. Using the current average analyst EBITDA estimates for 2012 and a 7x estimate, that suggests that Alcoa shares should be trading for almost $15. Clearly, analysts are expecting a rebound in aluminum prices, but the Street isn't buying that right now. At this point, Alcoa looks like an interesting speculation. Companies like Freeport-McMoRan (NYSE:FCX) and Cliffs Natural Resources (NYSE:CLF) are likewise interesting and they're in similar boats. The market conditions of copper, iron and aluminum are indeed different, but it is hard to imagine that they aren't all basic trades on global growth in 2012. Investors feeling confident that emerging market growth will continue, may see a value in Alcoa, but aluminum prices have to move up if that's going to work. (For additional reading, check out 5 Must-Have Metrics For Value Investors.) By Stephen D. Simpson, CFA
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