Alcoa Shares on a Tear

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Alcoa (NYSE: AA), the largest producer of primary aluminum, fabricated aluminum and alumina, has had a nice bounce with shares up ~6.2% last Thursday after reporting tremendous earnings. Though 2011 was a slightly positive year for the S&P 500, which has since been on an upward streak from the beginning of this year, AA shares have actually declined down from over $17 in 2011 to $9.85 as of last Friday’s close. Finally, in the wake of surprisingly good earnings, the stock has had an uptick giving investors like Ron Gutfleish, Guru Ramakrishnan, Randall Smith, and Andrew Hall a break.

Earnings came in at $0.10 per share, beating the consensus estimate of a $0.04 EPS loss. Excluding some special items, AA generated net income of ~$105 million, well above street estimates, which was expected to be a loss. First quarter revenue of $6.01 billion and the EPS beat was mostly driven by improvement in the aerospace demand, higher realized aluminum prices, and major strides in productivity.

Below is a breakdown of results by division:

Alumina: AA reported 4.2 million tonnes of alumina production and third-party sales of $775 million.? AA’s source of income from alumina is its interest in the Alcoa World Alumina and Chemicals Joint Venture (AWAC JV). We expect less production from the Alumina segment for 2H 2012 given guidance from the company that production will be 100kmt (kmt refers to thousands of metric tons) lower next quarter. We would not be surprised by a further decline for the rest of FY 2012 as AA completes the 300kmt curtailment that it has announced. These curtailments are likely to come from US production. We note that alumina refining is electricity intensive and that instability in the power supply—see 2008—has serious ramifications on the business. The carbon tax that passed late last year in Australia will also have a negative impact on earnings, though that has probably been factored in by investors. On the call, AA did not commit to closing additional facilities but intends to reevaluate facilities that are in the upper end of the cost curve and to modernize old plants, which we view positively.

Primary metals: With adjusted EBITDA per tonne of $141, we expect enhanced performance by this division. The average selling price (ASP) far exceeded our ballpark range in the $80s, making us quite bullish for increased bottom line contribution from primary metals in the coming quarters.

Flat rolled products: The flat rolled products division was the star of the first quarter. The division generated $1.9 billion, with third party shipments of 452 kmt. An adjusted EBITDA margin of 11% blew our mid-single digit projection out of the water. This margin expansion drove much of the better-than-expected earnings this quarter. The trifecta of higher realized aluminum prices, increases in end market demand, and productivity gains helped the margin and overall profitability of the division. We expect the numerous tailwinds including recovery in aerospace and North American markets, increased shipments to China and Russia, and continued productivity gains to continue flat rolled products segment through the end of FY 2012. We did not anticipate such a quick recovery in the margins but now believe that if cost containment is continued, the strong performance will be reflected in higher sales in FY 2012.

Engineered products and solutions: The 19.2% EBITDA margin here also exceed the street’s estimate. With higher premiums, we think that the margins will continue to improve in the coming quarters. Improvements in pricing, volume, and process should more than offset cost increases including the Massena fire.

Management maintained its global demand projection of a 7% increase, which is more bullish than what we estimate in the low single digits. AA also made adjustments to the outlook for end market growth. In the first quarter, trends in major end markets i.e., aerospace, commercial transportation, and industrial products were up year-over-year, but again we are not quite as bullish as management is (see below table) given macroeconomic concerns. Upward revisions were made to 2012 growth estimates in aerospace, North American automotives, North American/European truck and airfoil markets. Downward revisions were made to European automotives and North American/European non-residential construction. We look favorably about the cost measures that management has implemented and will be closely monitoring the company’s ability to sustain those productivity gains.

From a valuation standpoint, AA trades at ~7.8x 2012 P/E compared to ~5.9x and ~4.8x for the broader metals & mining sector that includes competitors like Kaiser Aluminum (NASDAQ: KALU) and Noranda Aluminum (NYSE: NOR). KALU suffers from the same lack of lack of catalysts that we see in AA but has lower levels of risk given a higher dividend yield. KALU is likely to see strong volume growth this year, probably in the 6.0% to 7.0% range. Even if KALU addresses the debottlenecking projects in its Trentwood operations and sees margin gains from its general engineering division, we think there are better investment opportunities in the space like Freeport-McMoran Copper and Gold (NYSE: FCX). We view FCX as having been oversold even accounting for potential weakness in copper prices. With the Indonesian government’s announcement of its intent to decrease foreign ownership in mining projects, we think this concern has already been amply priced into the stock and actually anticipate a ramp-up in production. We also like NOR over AA as the overhang regarding Apollo’s sale has lifted, Apollo being a private equity firm that discussed in March its plan to sell ~25% of its stake.

Overall, with macroeconomic headwinds, particularly on the pricing front, we find there to be better opportunities in the market. Though AA’s results beat expectations, we see limited upside in AA shares to the tune of a few dollars to the price. Until we see meaningful improvement in its cash flow, we believe AA deserves a lower forward multiple than it has commanded in years past in spite of positive results from the downstream businesses this past quarter. 


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