This Aluminum Producer Has Reached Its Bottom

Vladimir is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.

When the earnings season begins, all eyes will be on Alcoa (NYSE: AA). The company marks the unofficial start of the reporting season. This time, Alcoa is more than just the first company to report. Despite the drop in the aluminum prices, the company has gotten it right and is interesting for your portfolio. Here’s why.

Solid report

The company has announced its second quarter earnings of $0.07 per share, beating analysts’ estimates by $0.01. The reported revenue slightly missed the estimates. The main source of success was an increase in productivity. The company claims that it has gained $539 million in productivity across all business segments in the first half of the year.

Alcoa has generated $228 million in free cash flow. This has helped the company to keep $1.2 billion cash on hand despite $566 million in debt reduction in the quarter. Overall long-term debt stands at $7.7 billion, leading to a relatively high 0.53 debt-to-equity ratio.

Outlook

The future is always more interesting for market participants than the past. In the second quarter, aerospace and auto demand were strong. The company expects this trend to continue. Alcoa predicts that global aluminum demand would grow 7% in 2013. However, 46.5% of aluminum consumption comes from China -- a lot depends on this country. Lately, economic statistics from China signaled a slowdown. In addition, China struggles from overcapacity in the aluminum industry.

A recent report from Aluminum Corporation of China (NYSE: ACH) missed estimates and swung to a loss. The company cited that raw material costs were higher while aluminum prices were lower. The stock is under significant pressure, down 36% this year. The company expects to return to profitability in the second half of the year when the economy picks up. However, the upside in the world economy could be limited. In the meantime, with a 116 forward P/E and 1.34 debt-to-equity ratio, the shares are likely to remain under pressure.

The example of the Chinese aluminum producer shows that the situation in the industry is still fragile. Europe continues to be weak. Alcoa expects declines in the automotive, truck and construction industries in Europe.

Doubt over the situation in China and continued weakness in Europe would continue to put pressure on aluminum prices. The metal recently traded below the $1800 mark. Record prices of above $3000, seen before the credit crunch, are not likely to return in the foreseeable future. In this environment, the company’s execution becomes the focal point, and Alcoa delivers on this.

Valuation

Alcoa trades at 13.20 forward P/E. Given the trend in the company’s productivity and cost management, it is likely to meet expectations if aluminum prices meet the forecast. In comparison, another U.S. based aluminum producer, Century Aluminum (NASDAQ: CENX) is trading at 14.33 forward P/E. The stock has held well this year despite the drop in the aluminum prices, and is up 7%. Low debt-to-equity of 0.25 and attractive 0.84 P/B make this stock worth looking at. However, Alcoa is even cheaper, trading at 0.63 P/B.

Recently, it has become common for metals companies to trade below their book value. This cannot hold forever. Either the prices would go up, or the book value will have to go down, meaning write downs. I think that the first scenario is more plausible. On the income front, Alcoa yields 1.52%, which is not very impressive. Given that the company is focused on debt reduction, the dividend is unlikely to go up in the near term. Century Aluminum and Aluminum Corporation of China do not pay dividends.

Bottom line

Alcoa has been out of investors’ favor for too long. The company has made major improvements and proved that it can generate cash in difficult conditions. When the pricing situation improves, Alcoa would be a major beneficiary. At current prices, shares are attractive.

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Vladimir Zernov has no position in any stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. 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. Is this post wrong? Click here. Think you can do better? Join us and write your own!

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