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Victor Selva
Victor Selva
Articles (150) 

Alcoa: Profitability in an Unstable Market?

March 19, 2014 | About:

The aluminium industry is not easy to navigate, especially given the dependency on macroeconomic and global scenario. In fact, aluminium prices have been depressed for some time now, and it’s difficult to foresee when the volatility will stop. In such a scenario, Alcoa Inc. (NYSE:AA) has been relatively successful in maintaining certain stability in its balance sheet these past few years. Also, the company’s stock price experienced a boost after General Motors Company (NYSE:GM) announced that it would be manufacturing its 2018 pickup truck with Alcoa’s aluminium, which should likely increase the firm’s profits going forward.

However, the automotive segment only accounts for 5% of the company’s revenue, as it also operates in a variety of end markets, such as packaging, aircraft and construction. As a fully integrated alumina producer, Alcoa participates in the upstream segments of Alumina and Primary Metals (bauxite mining, refining and smelting), as well as the downstream areas of Engineered Products and Solutions. This secondary segment, traditionally less profitable, has become increasingly important in offsetting the price declines of aluminium.

Furthermore, the company recently invested in a Saudi Arabian aluminium production complex, in order to maintain its cost curve on the low end. By using a low-cost natural gas supply, the firm will able to significantly reduce its production costs. So, in the article below, I will analyze Alcoa's past profitability, capital and operating efficiency. In addition, I will take a look at which institutional investors bought the company’s shares in the last quarter and based on this information, we will get an understanding of the company´s revenues, operating metrics and quality of earnings.

Profitability Analysis

Profitability is a class of financial metric used to analyze a business’ ability to generate earnings compared with expenses and other relevant costs incurred during a specific period of time. In this section I will study several profitability metrics, such as return on assets, quality of earnings, cash flows and revenues. By analyzing these four metrics, we will be able to elucidate if the company is really making money.

ROA - Return On Assets = Net Income/Total Assets

ROA is an indicator of how profitable a company is relative to its total assets. It gives us an idea as to how efficient management is at using its assets to generate earnings. In simple terms, this metric tells you what earnings were generated from invested capital (assets).

I do not like the fact that Alcoa's ROA decreased substantially from 1.54% in 2010 to a current -6.02%, as I am always looking to invest in companies that generate increasing ROAs. Moreover, this decreasing ratio is evidence of the company generating less from its assets than it did in 2010, which is worrisome.

Quality of Earnings

Quality of earnings is the amount of earnings attributable to higher sales or lower costs, rather than artificial profits created by accounting anomalies, such as inflation of inventory. In order to assess Alcoa's quality of earnings we will compare the level of income with operating cash flows.

The company augmented its profits at a rate of -24%, but the growth of cash flows was higher, which is strong evidence of profits being created through augmented sales or cost reduction programs.

Working Capital

A company’s working capital measures its efficiency, as well as its short-term financial health. The ratio indicates whether a company has enough short term assets to cover its short term debt. Most believe that a ratio between 1.2 and 2.0 is sufficient, but anything below 1 indicates negative W/C and a ratio above 2 means that the company is not investing excess assets.

In order to appreciate a company's working capital structure, we need to analyze its current ratio growth. Alcoa's current ratio has decreased from 1.28 in 2010 to 1.14 in 2012. Although this means that the company´s balance sheet was stronger in the past, the ratio is still in an adequate range, as it hasn’t fallen below the 1x mark yet.

Gross Margin: Gross Income/Sales

The gross profit margin measures a company's manufacturing and distribution efficiency during the production process, but it also indicates what percentage of revenue/sales is left after subtracting the cost of goods sold. A company that boasts a higher gross profit margin than its competitors — and overall industry — is more efficient, meaning that investors will tend to pay more for said businesses.

Over the past three years, Alcoa’s gross margin has decreased slightly, falling from 17.9% in 2010 to 16.3% in 2012. The decreasing margin indicates that the firm has lost efficiency on a year-to-year basis.

Asset Turnover

Asset turnover measures a firm's efficiency in using its assets to generate sales or revenue — the higher the number the better. It also indicates pricing strategy: companies with low profit margins tend to have high asset turnover, while those with high profit margins have low asset turnover.

The fact that Alcoa’s assets growth (3%) outpaced its revenue growth indicates that the company is not making an optimal amount of money according to its asset base. I tend to invest in companies that generate more revenue growth than asset growth.

Institutional Sponsorship

It is important to check which hedge funds bought the stock in the last quarter and at what price they did so. I assume that if a prominent institutional investor put money into Alcoa, the stock will pass strict fundamental standards. Since investment gurus Steven Cohen (Trades, Portfolio) and Stanley Druckenmiller (Trades, Portfolio) bought the company’s shares in the past quarter, at an average price of $8.17, I feel confident that Alcoa will generate profits in the long run.

Analyst Outlook

Currently, many analysts have a good outlook for Alcoa. Analysts at MSN money are predicting that the firm will retrieve an increasing EPS of $0.59 for fiscal 2014, while Bloomberg is estimating revenue to grow slightly from 2013’s $23.05 billion to $24.39 billion for fiscal 2014. Furthermore, on Jan. 21, 2014, JPMorgan gave Alcoa a rating of "Overweight" with a target price of $9.97, signifying strong upside potential from this point.

Bottom Line

Although some aspects of Alcoa’s balance sheet have lost strength over the past few years, it’s important to point out that this is largely attributable to the unstable commodity prices. Looking forward, investors should expect earnings growth and margin expansion to increase substantially, as a consequence of General Motors' investment in the firm’s aluminium, and opening a joint venture with Saudi Arabian mining company Ma’aden. Also, management’s conservative capital allocation strategy is bound to loosen its reigns a little once the company enters another upcycle, so the average returns on capital of 1% can be expected to increase strongly over the next few years.

Disclosure: Victor Selva holds no position in any stocks mentioned.

Rating: 5.0/5 (2 votes)



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