Alcoa is the Dow's Best Value Play

By Spencer Knight - July 31, 2012 | Tickers: AA, BAC, F, HPQ | 0 Comments

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Alcoa (NYSE: AA) is an aluminum miner, manufacturer, and producer that, for lack of a better phrase, has been one of the worst blue chips since July of 2011. There are several reasons for Alcoa's year-long slide. The spark for this trend came from last summer's European and American debt issues that threatened to derail the modern economic cycle -- at least that is what bears wanted investors to think. Unfortunately, unlike most stocks, Alcoa failed to recover throughout the fourth quarter of 2011 and the first quarter of 2012.

Alcoa's earnings are weak

Alcoa's stock was unable to recover because weakening aluminum prices and five-year high aluminum stockpiles worried investors that Alcoa will be unable to provide impressive results in the future. Sure enough, as analysts and investors expected, Alcoa was unable to provide revenue and income that were supportive of a share price in the $18-$20 range. In fact, since the first half of 2011, Alcoa's sales have been unable to improve on a sequential and year-over-year basis.

Alcoa produced $377 million on $6.6 billion in revenue during the second quarter of 2011. Over the next four quarters, Alcoa alternated between profitable and unprofitable quarters to produce a profit of $142 million. The reason for the unpredictable and disappointing earnings results can be blamed on the volatile nature of aluminum prices

Aluminum is Alcoa's Achilles heel

Just as the classical hero Achilles was incredibly strong in Homer's Iliad and incredibly vulnerable in his Achilles heel in later Greek and Latin epics, Alcoa performs incredibly well during periods of rising aluminum prices and lower aluminum stockpiles. Unfortunately during periods of weak aluminum prices and rising stockpiles, Alcoa's share price sinks to the bottom of the Dow 30. In fact, Hewlett-Packard (NYSE: HPQ) is the only Dow stock that currently sits closer to its respective 52-week low.

Again though, this should not be surprising because Alcoa has suffered from decreasing -- or at least a lack of improving -- revenue for over a year now. On the other hand, just as Achilles was a fierce warrior of his time, Alcoa will come storming back to the top of the Dow in due time.

A corner is about to be turned

There are signs that Alcoa's share price is becoming a viable investment option. First and foremost the stock is currently at its lowest level since early 2009. In other words, Alcoa's share price is at the same level as it was after a dismal market crash. The difference is that in 2009 Alcoa's crash can be blamed on a systematic weakness in equities. This time around the only one to blame is Alcoa, and Alcoa can rightfully blame aluminum prices.

Luckily for Alcoa, aluminum prices may be ready to move higher. Aluminum's spot price is still trending lower, but the late June bounce indicates that aluminum will likely steady at its current level. The price of aluminum will also be helped by a six-month trend that has seen aluminum stockpiles shrink over 5%. As aluminum stockpiles continue to fall, the price of the metal will inevitably move higher, as this will indicate demand is picking up. Once investors receive a confirmation from aluminum prices then Alcoa's share price will begin to move higher as investors will be hopeful that Alcoa will produce strong earnings in the future.

What to watch out for

One important note to make is that Ford (NYSE: F) has announced that the firm will begin to use aluminum instead of steel for the F-150. While the implications of this change for Ford are important, it is even more important to note that Ford's usage of aluminum will help to deplete aluminum reserves, which will inevitably cause the price of the metal to move higher and eventually push Alcoa's share price higher. Of course, if Alcoa and other aluminum producers produce more aluminum then it will simply be a wash and Alcoa's share price will remain depressed.

Another aspect to pay close attention to is construction spending. Aluminum is a very important building material due to the combination of its strength and light weight. This allows for buildings to be constructed that are strong and relatively light. We have already seen signs that construction is slowing down, but unless the trend worsens then investors should not be concerned.

What to expect

Alcoa is currently the best value play in the Dow 30, because the share price is at relatively low levels and there are indications that the firm's business will begin to improve in the short term. Some may say that Alcoa's P/E (trailing 12 months) ratio near 100 indicates the stock is trading at inflated levels compared to a stock such as Bank of America (NYSE: BAC), which trades at about eight times the firm's trailing 12 months earnings. While these stats are in fact correct, the truth is Alcoa has been trading at high multiples for a very long time, thus comparing it to other Dow stocks that regularly trade at low P/E ratios is not useful. Keep in mind, this kind of valuation metric is often times relative to the particular stock or industry.

Alcoa's share price will not be heading higher overnight. We are looking at trends that need time to reverse course and subsequently confirm the reversal. However, I believe that Alcoa's share price is very close to a long-term low, and as aluminum prices begin to improve we will see the share price move higher. In a sense, Alcoa's Achilles heel has not been severed yet, and as the wound heals we will see the warrior bounce back to the top of the Dow.

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