American aluminum giant Alcoa (NYSE:AA) deserves credit for the internal operating improvements it has made in recent times. Unfortunately, the company is still in the business of selling aluminum and aluminum products, and that has long been one of the least attractive industrial metals for investors. While Alcoa does continue to look undervalued on the basis of historical valuation norms, this stock will probably be a value trap until and unless aluminum prices start picking up.
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A Decent End to the Year
Whether Alcoa really deserves to be seen as an economic bellwether is a topic for another day, but the reality is that it's the first major earnings release of every cycle. To that end, investors are likely to be reasonably pleased, albeit not thrilled, with what Alcoa reported.
Revenue fell 8% this quarter as production and shipment levels were fairly flattish in comparison to the third quarter. Unfortunately for Alcoa, aluminum prices have remained stubbornly unimpressive, with 2012 cash prices on the London Metal Exchange ending close to where they started.
Profits were quite a bit better, though. Gross margin improved almost four points, while operating income jumped 200%. EBITDA was up about one-third (and EBITDA margin improved more than three points) while segment ATOI more than doubled.
By segment, alumina ATOI was down two-thirds (on 3% shipment growth), but quite a bit better than expected. Alcoa's primary metals business was also stronger than expected, with the company reversing a year-ago loss despite lower realizations. Midstream and downstream operations posted record results, but came in weaker than analysts projected on a bigger seasonal slowdown.
Is China Still Calling the Tune for Aluminum
On management's call, Alcoa's CEO highlighted an outlook for a 7% aluminum demand growth in 2013, up from 6% in 2012. Importantly, demand from/in China is expected to contribute about half of that growth, so the state of the Chinese economy is important to aluminum companies beyond Chalco (NYSE:ACH).
Looking at major aluminum markets, management sees strong ongoing growth in aerospace as Boeing (NYSE:BA) and Airbus look to keep pace with their commercial backlogs. While the truck market is expected to recover, Alcoa is looking for a slowdown in autos relative to 2012.
It's Down to Prices Now
Alcoa has done a very good job over the past few years of taking costs out of the upstream businesses and shifting the midstream/downstream mix and processes towards better margins. While management is still targeting further benefits in the coming year, I think Alcoa has already pocketed the bulk of what it can do with these restructurings.
As a result, I think Alcoa's outlook is highly dependent upon aluminum prices. Prices are still below the $1.10 or so per pound that I think represents a "sweet spot" where Alcoa can post meaningfully better results. While most analysts and industry participants expect better prices in 2013 and 2014, time will tell.
In the meantime, it's worth asking if aluminum is a good place for investors to make their bets. As the Commercial Metals (NYSE:CMC) earnings release suggested, maybe the steel market is finally ready to recover. Likewise, iron prices have shot up again and Vale (NYSE:VALE) and Cliffs Natural Resources (NYSE:CLF) will prosper if those prices hold. Last and not least, an improvement in the global economy should also lift copper prices, and investors may want to consider names like Freeport McMoRan (NYSE:FCX) and Southern Copper (NYSE:SCCO).
The Bottom Line
Analysts have cut down their 2013 EBITDA forecasts on Alcoa by about 5% since the last quarter. Even at this lower level, though, the shares look pretty cheap on the basis of historical multiples. Using Alcoa's historical average EBITDA multiple (about eight) would point to a $17 fair value, while even a steeply discounted multiple (say on the order of 6.5 times) would suggest that Alcoa is underpriced.
It wouldn't surprise me if Alcoa enjoys a very good run if those aluminum prices pick up. What's more, I'm not sure how much downside is left in a stock trading at three-quarters of book value and only 20% above tangible book. So, although there's a very strong sense of deja vu here (and the risk of a value trap), I would still be interested in Alcoa at these prices.
At the time of writing, Stephen D. Simpson did not own any shares in any company mentioned in this article.
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