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Alcoa - To Buy or Not to Buy?

November 10, 2013 | About:
One of the world’s leading aluminum producers Alcoa (AA) is forming a joint venture with Russia’s VSMPO-AVISMA Corporation, the biggest player of the titanium ingots and forged products market. The two companies will fulfill the ever-increasing demand of aluminum and high-end titanium from aircraft manufacturers. Last month, Alcoa reported its quarterly results for the first time after its exit from the Dow Jones Industrial Average. The company has been suffering due to the global economic slowdown and weakness in metal prices but the business has been working on improving its margins. The aluminum giant is also expecting some improvements from China. Alcoa has struggled due to the persistent weakness in the business environment, it has large levels of debt and its stock has performed poorly. But after the recent earnings beat and a relatively better performance at the NYSE in October, should you put your money in this company?

Earnings Beat

Last month, Alcoa reported its results for the third quarter in which it managed to beat both top and bottom line estimates. The company’s revenues dropped 1.17% from last year to $5.77 billion, which was above market’s expectations of $5.63 billion. Adjusted earnings came in at $120 million, or $0.11 per share, showing a significant increase from $32 million or $0.03 per share in the third quarter of 2012, easily beating the profit estimates of $0.05 per share.

The better than expected performance, despite the weakness in metal prices, can be attributed to its engineered products and solutions segments that posted an operating income of $192 million, up 22% from last year. Despite the lower metal prices, the global rolled products segment also managed to post an operating income of $71 million. Besides these factors, higher shipment volume to third parties also helped in offsetting the negative effects of lower aluminum prices.

Due to the Deutsche Bank’s downgrade of Alcoa’s shares to sell just a few days before the results, the market’s expectations were already very low. So it was relatively easier for the aluminum maker to beat the estimates.

Cost Savings

Alcoa has been restructuring its portfolio to lower its cost base. It has reduced, or in some cases closed, its high cost smelting capacities. Nearly 651,000 metric tons, or around 16%, of its smelting capacity is currently offline. In 2014, Alcoa’s joint venture with Ma’den , that has a capacity 740,000 metric tons, will become fully operational and this would reduce the company’s costs by 2 percentage points. The company’s target is to achieve a 10 percentage point reduction in the next two years. Investors should note that if the Ma’den plant comes fully online, then Alcoa could increase its offline smelting capacity to more than 16%.

So far, in the first nine months of the current year, Alcoa has achieved cost savings of $825 million, surpassing its annual target of $750 million.This is impressive as the management has been able to deliver on its promise, despite a very challenging business environment.

The China Factor

The demand from China plays a crucial role in determining the metal prices. The bad news is that Alcoa believes that the negative price trends in the country is not going to change in the near future, but, the good news is that it has increased its demand forecast from China from 11% to 12%. This improvement was a result of growth in manufacturing and an increase in production of semi aluminum products.

Excluding China, the global demand for aluminum is expected to grow by 4% in the current year. This is due to reduction in demand from Middle East and South Asia.

Should you invest?

Alcoa has been one of the worst performing metal stocks. The current earnings beat has given some respite to investors as the shares have been up 14.5% in October. However, in 2013, the stock has risen by just 4.4%, as opposed to the Dow Jones Industrial ETF (DIA) and the broader S&P 500 ETF (SPY), both of which are up more than 20% this year. Moreover, the aluminum prices in London Metal Exchange are expected to fall further which could create more problems for Alcoa’s shareholders. Meanwhile, JP Morgan has pointed out that despite what the management says, the weak aluminum prices will hurt the company’s cost reduction plans in upstream segments and the growth of its downstream operations. Other analysts believe that Alcoa has “more downside potential than upside”.

Investors should also note that Alcoa has been operating under massive debt. Its current long term debt-to-equity ratio is 59%, which is significantly above the industry’s average of 15%. Due to these reasons, I believe that unless the markets witness some stability in aluminum pricing, investors are better off staying on the sidelines at the moment.

Notes:

Alcoa Q3 2013 Earnings Press Release [Pdf File]

Alcoa Q3 2013 Earnings Conference Call Transcript

Disclosure: This article was written by Sarfaraz A. Khan, with valuable contribution from Gohar Yousuf, research assistant at Half Bridge Business Review. Neither Sarfaraz A. Khan, nor Gohar Yousuf have any positions in the stock(s) mentioned in this article.The article reflects opinions of the author(s) and does not constitute investment advice.

About the author:

Sarfaraz A. Khan
Sarfaraz A. Khan is a capital market analyst and finance writer. His specialty lies in energy stocks. He also covers consumer goods, services sector, technology stocks, emerging markets and ETFs. His work appears on TheStreet, Seeking Alpha, Motley Fool and GuruFocus.

Visit Sarfaraz A. Khan's Website


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