Alcoa Deserves A Bet
Federico is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.
Aluminum, which is used in everything from cans to cars or planes, has a growing global demand that increases hand in hand with the growth experienced by emerging markets like China and Brazil. As a matter of fact, Alcoa (NYSE: AA), the American aluminum champion that just reported earnings, expects global demand to grow by 7% in 2013 from 2012´s 6% (which has been the average growth rate for over the decade).
Still, even with demand growing fast, corporate results for producers have been poor. As a matter of fact, as seen in AA´s recently reported results, underlying earnings fell 67% from the previous year to $0.24 per share, with revenues down 5% to $23.7 billion. The reason for this is simple: supply has been growing faster than demand and prices have been falling for a while now. Aluminum its a commodity and the barriers to entry to this industry are nil, so capacity expansion just kept growing, killing high prices and bringing most producers into trouble. Hence, the corporate winners shall be the ones that can produce more efficiently. Prices are close to producing costs and there is almost no product differentiation. Buyers almost always buy the cheapest available item.
Aluminum efficiency depends on many factors but, above all, it depends on getting cheap energy for production. In a few words the main input cost when producing aluminum its just energy. The good news for all US producers, from Century Aluminum (NASDAQ: CENX) or Noranda (NYSE: NOR) to the much bigger AA, is that recently discovered land shale gas and oil resources assure a great advantage for US producers. US aluminum producers are going to be able to enjoy not only lower energy prices but also lower shipping costs to get their products to US based clients. This is the key reason to take a renewed look at American aluminum companies. Its important to stress that, even if shale oil/gas resorces are being untapped all over the world through the new fracking technologies, the US is - by far - the country with the biggest reserves along China and Argentina. Besides, and even more importantly, the US is the country which has developed the fracking technology further. This is the reason why US producers are going to be the ones that benefit in greater and faster way from this new way to recover fossil fuels.
When choosing which is the right bet within all US producers, its clear to me that AA is the way to go. Smaller producers trade at higher multiples and do not enjoy the scale efficiencies AA can deliver at the time of buying inputs for aluminum production (mainly energy and bauxite). That said, I need to recognize that those smaller producers do represent easier M&A targets going forward and that might make them deserve a valuation premium. Even so, given current prices for smaller aluminum companies (which I generally consider too high), I think AA its a cheaper and safer investment. For example, a company like CENX, which has an EV of only $920 million trades at the relatively rich multiples of 2013 12x EV/EBITDA and 20x P/OCF. Even a highly indebted company like NOR, which has an EV of $1 billion and net debt at over $500 million, trades at 2013 5.6x EV/EBITDA and 3.7x P/OCF. Meanwhile, AA, which enjoys a much better market position trades much more cheaply at 2013 3.5x EV/EBITDA and 3.1x P/OCF. The company is also reducing debt fast making it a safer investment (net debt now stands at 3.5x EBITDA). According to me, AA deserves a long bet meanwhile smaller producers like CENX and NOR should be ignored until valuations reach more reasonable levels. They represent too much risk for the extra upside that might offer compared to AA. NOR high debt level (NOR has a net debt of over 4x EBITDA) represents a high risk for debt holders but even a higher risk for equity holders. Historically hight debt levels to EBITDA are correlated to equity issuances. In the case of CENX debt should not be a problem (CENX debt stands at 1.6x EBITDA) but the company is not big enough to enjoy the distribution efficiencies that AA has (CENX revenues stand at $1.2 billion against the $26 billion that were sold in 2012 by AA). My recommendation is to go long on AA and simply ignore the rest.
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