Avoid These 2 Risky Stocks, Buy This Breakup Play
David is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.
Basic materials can be highly unpredictable. Prices rise and fall overnight. Companies collapse to pressure. Others are cornered out of the market. And some manage to generate attractive returns to shareholders through appropriately managing production to optimally meet demand. In the end, the tail of basic materials is largely a tail of managing risks. Below, I review three aluminum producers to consider buying.
Alcoa (NYSE: AA): End The Risk By Executing a Split!
Given all of the uncertainty surrounding basic materials, it should not be surprising that the stock is more than 100% volatile than the broader market. This risk has highly discounted shares to 12.7x forward earnings, but analysts still rate the stock closer to a "sell" than a "buy." Although the company has helped mitigate internal risks to attract back investors, operational underperformance overcloud the story.
First, the company decided to settle a civil racketeering suit in a US court from a Bahrain smelting facility by paying $85 million in cash. Even still, third quarter performance was terrible with analysts dropping EPS estimates to $0.01 - a dramatic decline from $0.15 one year ago.
The good news is that some analyst views imply that the company can unlock 63% in value from splitting. Alcoa was badly hit by declines in aluminum prices, and it is now at a lower multiple to book value than nearly all of its competitors are. Separating specialized products from commodity-driven mining & smelting will enable investors to better allocate risk towards the optimal source. Commodities are proving to be ultimately a huge deterrent for investors interested in the, say, aerospace studs market.
While Alcoa does a strong job of controlling costs, it is not enough for investors to view the specialized products business as safe given all of the commodity volatility that it comes packaged with. Going forward, I expect Alcoa to listen to shareholder and either sell off some of its riskier commodity assets or execute a spinoff or split.
While analysts rate Century closer to a "sell" than a "buy," Alumina is around a "hold." The former is forecasted for 7% annual EPS growth over the next 5 years versus 35.1% for the latter. Given how low the bar has been set, if you are confident about a turnaround at Century, strong risk-adjusted upside lies ahead to attract an investment.
However, the reward does not seem to justify taking the signs of growing headwinds. After encouraging unsustainably high prices, Century recently filed a notice that it was closing its power contract in Hawesville, Ky. While costs have come down and operating leverage has improved concurrent to production increases, results have been less than pleasing. Earnings were weak with a $0.16 per share loss in 2Q12 being 6.7% worse than analyst forecasts. This followed several quarters of weak performance. Chinese growth of only 8% was also disappointing in light of management's conservative outlook on future curtailments.
On the positive side, the company is geographically well positioned across the US, Jamaica, Latin America, and, of course, Australia. And the company trades at 0.9x book value, so it is a potential takeover target for a private equity firm betting on the future of aluminum. With that said, the current ratio of 0.7x puts pressure on the firm's ability to pay debt and expand into new growth opportunities. Accordingly, I believe the sidelines are the best place to be.
TakeoverAnalyst has no positions in the stocks mentioned above. The Motley Fool has no positions in the stocks mentioned above. 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.If you have questions about this post or the Fool’s blog network, click here for information.