Alcoa Offers Little to Look Forward To

Gaurav is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.

It is definitely saddening to see a great company like the aluminum giant Alcoa (NYSE: AA) being reduced to a mere non-entity. The continued fall in the aluminum prices is taking a toll on its revenue and earnings and urging investors to focus on other stocks which promise better returns.

Kudos to the Alcoa management for its continued pursuit of more productivity and more cost cutting, but odds against it keep stacking up.

Excellent execution but missing a good catalyst

Alcoa produced a one-penny earnings beat in the second quarter, putting up adjusted earnings per share of $0.07, but this was mostly due to revised analyst expectations. Even a few weeks ahead of the release the analysts were expecting around $0.10 per share. Revenue was 2% lower than last year at $5.8 billion, in line with analyst expectations.

The company has made good progress in controlling its costs and achieving productivity gains. Between 2009 and 2012, Alcoa has achieved savings of $5.5 billion, and through the first half of the current fiscal it has added another $539 million to that number. Its target for the year is to achieve savings of $750 million.

Alcoa is doing a lot of restructuring and closing its high-cost smelters. The most recent in the line of closure is the Fusina smelter in Italy. This closure brings the company’s total smelting capacity to around 4.1 million metric tons of which around 13% is offline.

Alcoa also brought down its working capital needs to around 27 days from 50 days in the second quarter of 2009, and from 33 days in the second quarter of last year. It repaid $566 million debt while ending the quarter with $1.2 billion cash.

However, these impressive achievements are failing to excite investors as the falling prices of aluminum are a major overhang. This triggered Moody’s to cut the rating of the company’s bonds to junk in May. The stock is down almost 10% through the year and the only true catalyst for the stock would be a recovery in aluminum prices, which is nowhere in sight.

There is no respite from falling prices

At the start of the fiscal year Alcoa had factored in aluminum prices at around $2000/ton. But London Metal Exchange (LME) aluminum prices are already hovering around the $1800/ton level implying a 45% drop from July 2008. Alcoa is doing a fantastic job in countering the falling prices with cost cuts and productivity gains but the falling prices are significantly limiting its growth prospects.

Sequentially, Alcoa saw a 7% drop in realized aluminum prices which had a $150 million impact on the net income excluding special items. The company was able to offset majority of the impact with better operating performance but still could not avoid the $45 million drop.

The declining prices have weighed on analyst expectations for this year’s earnings per share. It currently stands at $0.32 per share, compared to $0.46 couple of months back. Analysts also expect a 2% revenue drop from last year to $23.2 billion.

Diversified miners are a better bet

Given the turbulence in the overall commodity sector it is a better option for investors to park their dollars with diversified miners. The world’s two largest mining companies – BHP Billiton (NYSE: BHP) and Rio Tinto (NYSE: RIO) can be good choices.

Both BHP and Rio are cheaper than Alcoa, while having higher operating margins and higher returns on assets. BHP has forward price-to-earnings ratio of 12.5 times and Rio 8.4 times vis-a-vis Alcoa’s 15.36 times. Their operating margins are 29.96% and 22.49% respectively paling the latter’s 3.5%. Similarly the returns on assets for the diversified duo are 9.74% and 6.04% while Alcoa’s is just 1.31%.

BHP Billiton and Rio have both announced record iron ore production from their mines in Australia and are currently looking to expand iron ore production. The two of them would add 11 million tonnes of incremental production over the coming six months. Although iron ore prices are a concern on account of slowing Chinese consumption but the weakness in Australian dollar has provided miners with a good cost advantage.

Meanwhile, Rio being the parent of aluminum producer Alcan may follow Alcoa’s footsteps and announce capacity cuts. But, its aluminum operations contributed just 10% to its earnings last year. Both BHP Billiton and Rio have been on the lookout for buyers for divesting their aluminum operations.

Net-net

Alcoa has been executing impressively and holding its ground against tough market conditions. But, unless aluminum prices do a u-turn, the company is unlikely to see any meaningful growth. Moreover, the stock is not cheap compared to other big mining companies. So, it is definitely not the time to buy Alcoa, but current investors may hold on to the stock for changes in the market dynamics.


Gaurav Basu has no position in any stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. Is this post wrong? Click here. Think you can do better? Join us and write your own!

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