1 Aluminum Producer To NOT Buy, 1 To Moderately Buy
David is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.
Given how volatile basic materials are, investors should look to the macroeconomy for guidance. If you believe that the economy will hit full employment quicker than what the market forecasts (like I do), consider buying now. If you believe that the economy will be worse than forecasts, consider selling. In the former case, while diversification is always good - there are some stocks that are simply too risky for the limited reward. Below, I review aluminum producers Alcoa (NYSE: AA) and Alumina (NYSE: AWC).
Alcoa is expected to recover very well from a challenging environment. While EPS over the twelve trailing months was $0.06, EPS of $0.74 is expected for next year and 11.6% annual growth thereafter in the near-term. Analysts are on the fence - rating the stock a "hold". It has more than double the volatility of the broader market, so you want to make sure that you either (1) truly love the stock's fundamentals or (2) find the upside outweighs downside.
The median target price is $10.68, which implies more than 25% upside. The average PE multiple for the firm has gone up and down with shaky volatility. There is thus really no reasonable exit multiple to gauge valuation after properly risk discounting. Free cash flow trends are similarly shaky with $560M generated for the TTM ending 2Q12 versus $828M in 2Q11, $650M in 2Q10, and -$2.2B in 2Q09. As you can see, however, the firm has nicely recovered from challenging environments.
I would recommend buying only a small stake in Alcoa as a bet on the macroeconomy. Truth is, a 25% discount to the intrinsic price just meets the threshold of what I consider to be a "value play". Alcoa is very much an up and down roller coaster, not for the faint of heart, and viewed indifferently on the Street.
Alumina trades at a respective 42.3x and 29.6x past and forward earnings - far too high to justify an entry point. Yes, the earnings base is volatile, but the buying market will still be on the fence with multiples this high. And part of the reason why the stock's multiples are so elevated right now is due to expectations for solid returns.
The Australian aluminum producer currently offers a dividend yield of 8.1% and is forecasted to grow earnings at 35.1% annually over the next 5 years. By contrast, Alcoa is only expected to grow earnings by 11.6%. In my view, both companies are more or less equally exposed to the same market, so more than 3x greater growth forecasts sets the bar very high. For an industry as uncertain as alumina, adding a high bar on top of the volatility makes risk outweigh reward.
On the positive side, Alumina is well diversified. It is invalid in aluminum smelting, alumina refining, and bauxite mining. The firm's geographical operations extend to the US, Suriname, Guinea, Jamaica, Spain, and Brazil. Volatility is more than double that of the current market and warrants, when all things are considered, holding out until visibility improves.
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