Alcoa Running Hard To Go Nowhere

By Stephen D. Simpson, CFA | July 09, 2013 AAA

Another quarter is in the books at Alcoa (NYSE:AA), and although I think management continues to do a good job with its downstream operations and rationalizing its upstream cost structure, all of it matters little in the face of persistent price weakness in aluminum. As has been the case for a while now, Aloca looks undervalued on both an EV/EBITDA and NAV basis, but the relentless erosion in aluminum prices makes it difficult to have much faith in those metrics.

Better Than Expected Results For Q2
Alcoa delivered better results than the Street expected for the second quarter, as the company managed to eke out a bit of positive performance in the face of ongoing aluminum price erosion.

Revenue fell 2% for the quarter, with third-party alumina sales up 10%, third-party primary aluminum sales down 10%, rolled product sales down 2%, and engineered product sales up 3%. Gross margin improved more than two points from the year-ago period, but fell more than a point sequentially. Operating income was up 65% from last year, but down almost one-quarter from the first quarter, and EBITDA was likewise stronger on a year-over-year basis (up 19%) and weaker sequentially (down 11%).

SEE: A Clear Look At EBITDA

All things considered, the company's downstream businesses are doing pretty well. Even the upstream operations aren't terrible – although realized prices in the primary metals business fell by $0.07/lb sequentially, smelting costs fell $0.06/lb. With that, Alcoa shares have actually performed the year-to-date performance in alumina, but that's still pretty cold comfort for shareholders.

Do Ratings Cuts And Alcoa's Size Mean Ejection From The Dow Jones Is Coming?
At the end of May, Moody's downgraded Alcoa's unsecured debt to junk. Given the maturities and structure of Alcoa's debt, this move isn't going to have a dramatic near-term impact on the company. That said, it's only the second time that a Dow stock has been given such a rating. Furthermore, Alcoa is far and away the smallest company in the Dow Jones Industrial Average (though it's a price-weighted index and not cap-weighted). That leads me to wonder if another shuffling of the deck could be on the way, with Alcoa finding itself booted out.

SEE: 5 Earnings Season Tips

How Much Cutting And Restructuring Can Alcoa Do?
Alcoa management has not been afraid to look for ways to cut costs to get through this slump in the aluminum market. About 13% of the company's smelting capacity is idle, and another 11% or so is under review for idling (either temporary or permanent). It's a familiar problem for Alcoa – they are operating responsibly, as are large rivals like Rio Tinto (NYSE:RIO) and BHP Billiton (NYSE:BHP), but Chinese smelters get sweetheart financing from state-run banks that allows them to continuing operating at loss-making aluminum prices.

At some point, though, Alcoa reaches a point where further capacity cuts start to cut into the company's muscle and its long-term future. I don't think there's much argument that the company's downstream operations are more attractive than the upstream, but I don't know that they can be separated without sacrificing meaningful operational/integration synergies. As a result, I'm not sure Alcoa can really transition into a company more like Allegheny (NYSE:ATI) or Carpenter (NYSE:CRS) without paying a big long-term price.

The Bottom Line
Valuing Alcoa feels like chasing an anchor that's sinking. The stock continually looks cheap relative to twelve-month EBITDA targets and net asset value, but the metal price assumptions that underpin those estimates keep eroding. As a result, sticking with my 6.5x EBITDA estimate suggests a fair value around $9.50 and a NAV analysis suggests a fair value around $9, but both have to be taken with large grains of salt. It's also worth noting that if you fully load Alcoa's post-retirement/pension liabilities into the EBITDA analysis, the resulting fair value is only about $4.

If you have a firm conviction that aluminum prices are going to bottom out and rebound, these shares would be a good way to play that thesis. I don't have that conviction, though, and so while I applaud Alcoa management for doing what they can in difficult circumstances, I just don't see why I should own these shares when other commodity/resource companies are also undervalued and facing better pricing environments.

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