Alcoa Prospering With Tight Aluminum Markets And Past Efficiency Efforts

 

I’ve liked Alcoa (AA) for a while, largely due to the company’s stringent self-improvement efforts, including shedding lower-return producing assets, selling non-core assets, and building up its green (or at least greener) production capabilities. I didn’t expect quite this level of aluminum price strength in 2021, though, and there are increasingly compelling arguments for a “higher for longer” scenario that could lead to significant free cash flow generation for Alcoa.

Over the long term, just about everybody gets their commodity price predictions wrong, but I think there’s a good argument for aluminum prices of $2,300/mt or higher through 2022. Using my typical multiple of 4.5x forward EBITDA supports a fair value of around $45 on my blended multiyear EBITDA estimate and just over $50 today on 12-month EBITDA.

As in the past, I will warn investors that this is a dangerous stock to consider as a long-term holding. While aluminum prices may well hold up higher for longer, I don’t believe this is a new permanent plateau.

 

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Alcoa Prospering With Tight Aluminum Markets And Past Efficiency Efforts

An Improving Market And Ongoing Self-Help Doing Wonders For Alcoa

Up more than 65% from my last update on the company, I can't reiterate the Rodney Dangerfield ("no respect") thesis anymore on Alcoa (AA). Instead, the market has recognized the improving end-market conditions in the aluminum market, as well as the progress the company has made on self-help efforts (streamlining the business and selling non-core assets).

I do still see upside to the mid-$20s for Alcoa, and a price close to $30 isn't out of the question if the demand/supply balance for aluminum gets even more favorable in 2021. It's hard to like any company like Alcoa for the long term, and I don't, but as a trade there could still be some upside left here and I won't totally dismiss the possibility that the company's ESG efforts could pay off in the form of higher premiums down the road.

 

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An Improving Market And Ongoing Self-Help Doing Wonders For Alcoa

Despite Rising Prices And Good Management Execution, Alcoa Can't Get Any Love

It’s fair to wonder what more Alcoa (AA) has to do, or can do, to change sentiment on the Street. Global overproduction of aluminum remains a real threat, but LME spot prices have improved 16% since the end of the second quarter and Alcoa’s EBITDA margin improved 340bp and the shares are down about 4% as of this writing from when I last wrote about the shares on July 16.

Management continues to improve the house, but the neighborhood remains one that investors don’t want to visit (let alone invest in), despite improving prices, shortages in areas like beverage cans, and improving trends in other end-markets like autos. I absolutely do not look at Alcoa has a long-term holding, but with a near-term fair value in the $17 range, it’s harder to ignore an attractive potential short-term trade.

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Despite Rising Prices And Good Management Execution, Alcoa Can't Get Any Love

Sentiment And Execution Boosting Alcoa's Share Price

When I wrote about Alcoa (AA) after the aluminum company’s first quarter earnings, I saw this as a risky, relatively low-quality name that nevertheless had upside to the mid-teens on prospects for a V-shaped recovery in multiple manufacturing end-markets. In the interim, investors have largely taken the bear-case scenarios for the pandemic-driven recession off the table, and initial data from China’s recovery have been generally positive, helping drive Alcoa shares toward that mid-teens target price and up about 90% from the time of that last piece.

Alcoca management has also helped its own cause, with solid ongoing execution and a continued willingness to make difficult decisions to improve margins and cash flows (like the restructuring at the high-cost San Ciprian facility in Spain). My primary concern on Alcoa shares now is whether a lot of the benefit of a V-shaped recovery is already in the stock. While Alcoa’s high financial leverage makes it quite sensitive to any changes in estimates (positive or negative), I still don’t like the fundamental outlook for the aluminum industry on a long-term basis, and I believe Alcoa is more of a trading opportunity on sentiment than a core buy-and-hold.

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Sentiment And Execution Boosting Alcoa's Share Price

Alcoa: A Battleground Between Sound Management And Unsound Markets

I've always liked Warren Buffett's quote about how in a "battle" between good management and a bad industry, the industry's reputation will almost always remain intact. I think Alcoa (NYSE:AA) has a good management team (and that may be understating it) doing the right things. But I also think that the aluminum business is a fundamentally lousy business, and it's exceptionally difficult for any player to make real money on a sustained basis - long-term FCF margins for this industry have been close to zero.

Unless you believe something is going to change on a deep fundamental basis in the aluminum industry, it's challenging to make a long-term DCF argument for Alcoa. An EV/EBITDA approach is much more favorable, and Alcoa could benefit from more V-shaped recoveries in markets like autos and some industrial markets, but this is a tough, tough stock to love as more than a speculative trade.

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Alcoa: A Battleground Between Sound Management And Unsound Markets

Alcoa May Be Bottoming Out, But Management Still Has A Lot To Do To Improve Costs

Despite liking management’s portfolio transformation plan, I wasn’t very bullish on Alcoa (AA) in late October, and my primary concerns – that the company is too high up on the cost curve and can do nothing about global overproduction – have come home to roost again, with management forecasting a “balanced” market for alumina in 2020, but an oversupplied aluminum market.

These shares still look undervalued relative to my expectations, but even after a 15% or so drop from that last article, I’m still not keen to own the shares. My basic approach on commodities is that you find the better opportunities in situations where there is a supply bottleneck that will take time to work out and/or where the supplier has a cost advantage. Neither really applies to Alcoa, and while I think further capacity curtailments, closures, and/or sales can improve the long-term viability of the business, I’m just not keen on trying to wring performance out of this name.

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Alcoa May Be Bottoming Out, But Management Still Has A Lot To Do To Improve Costs

Further Restructuring At Alcoa Is Welcome, But Macro Pressures Are Still In Play

All you might really need to know about how things have been going at Alcoa (AA) is that sell-side expectations for 2019 EBITDA were around $2.4 billion in January and the average estimate is now around $1.6 billion. With demand hurt by weak global auto production and slowing economies around the world, and exacerbated by the U.S.-China trade tensions, alumina and aluminum prices have disappointed relative to initial expectations, and Alcoa hasn’t been able to do nearly enough on the cost side to offset that pressure.

I feel a little bad about being hard on Alcoa, given that I think management’s recently-announced portfolio review and restructuring plans are a sound move. The problem is that this is still an overleveraged commodity company that is too far up the price curve and too much at risk to Chinese production volumes. The shares do look too cheap to me at around 4x-5x 2020 EBITDA (including pension liabilities), but too much is riding on a successful restructuring for my comfort.

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Further Restructuring At Alcoa Is Welcome, But Macro Pressures Are Still In Play

Alcoa Looks Undervalued, But With Some Significant Asterisks

There are some investors who simply refuse to consider highly cyclical stocks like Steel Dynamics (STLD) or Alcoa (AA), and a quick look at the recent chart outlines some of the reasons why. With Alcoa’s high sensitivity to alumina and alumina prices (a roughly 5% change in aluminum prices can move EBITDA by close to 10%), and the ongoing volatility of the commodity markets, it’s a tough company to model accurately beyond a few quarters. Making matters worse, the valuation norms for the shares seem to have broken down over the least year or so, making it even more challenging to come up with a good sense of where the shares should trade.

When all else fails, I come back to free cash flow, and I do believe Alcoa is undervalued here. Current aluminum prices don’t appear to be sustainable, and Alcoa should see more capacity leave the market in response … though the timing there is of course uncertain. I believe the shares are undervalued below the mid-$30’s, but I’d never consider this as more than a trade.

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Alcoa Looks Undervalued, But With Some Significant Asterisks

Supply Issues Creating A Windfall For Alcoa

While I liked Alcoa (AA) three months ago, and thought that the company could benefit from some supply curtailments, I didn’t expect the significant market disruptions that have pushed spot aluminum prices on the LME to over $2,528/mt (versus less than $2,100 in December). Now, though, the market is dealing with section 232 limitations, problems with the Alunorte facility, and U.S. sanctions against Russian producers, pushing the markets into more substantial supply deficits.

Although Alcoa has had a good run over these last three months, and I don’t view it as a long-term holding, there may still be some worthwhile upside left at these levels.

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Supply Issues Creating A Windfall For Alcoa

Lackluster Earnings And Guidance Create An Opportunity In Alcoa

Alcoa (AA) is not the easiest stock to follow or own. While Alcoa enjoys a solid position on the cost curve for both bauxite and alumina and has made progress with its aluminum costs, there are a lot of moving parts to the model that management has little or no control over, including the hard-to-predict behavior of the Chinese government toward its smelters. Longer term, I'd like to see Alcoa pursue an upstream merger to further consolidate the industry and create more cost-cutting opportunities, but in the meantime, the outlook for aluminum in 2018 should some upside.

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Lackluster Earnings And Guidance Create An Opportunity In Alcoa

Seeking Alpha: Today's Performance And Valuation Understate Carpenter's Potential

Seven months ago, I had some concerns about the near-term outlook for Carpenter Technology (NYSE:CRS), as I thought near-term weakness in oil/gas demand and recent trend of uninspiring quarterly performance would outweigh a generally positive view of improving aerospace market fundamentals. The shares are about 3% lower today than when I last wrote about Carpenter - basically matching the S&P 500 and significantly outperforming Allegheny Technologies (NYSE:ATI), Alcoa (NYSE:AA), and Universal Stainless & Alloy (NASDAQ:USAP).

The near-term outlook is still dicey. Expectations for fiscal 2016 earnings have come down a few times, but the outlook for fiscal 2017 seems to be getting better (at least from a sell-side perspective). The next few quarters are likely to see revenue contraction due to weakness in energy and industrial demand, but I believe Carpenter can still leverage its specialty alloy expertise to generate long-term revenue growth in the mid-single digits. Given the prospects for growth in aerospace and an eventual recovery in energy, coupled with some scarcity value, I think the company is looking more interesting for investors who can afford to be early to the story.

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Today's Performance And Valuation Understate Carpenter's Potential

Seeking Alpha: Alcoa Trying To Find The Path To A Better Neighborhood

What do you do when your neighbors are committed arsonists who know that they don't have to face the full costs and consequences of their actions? That may be rather extreme and hyperbolic, but it's how I've started to think about Alcoa (NYSE:AA). I really like Alcoa's progress in reducing its cost structure , shutting down higher-cost capacity, and leveraging itself more toward downstream higher value-add applications, but a lot of the progress the company has made has been undone by Chinese producers willing to produce at uneconomic standalone prices due to input cost supports from the Chinese governments.

I think there's an argument to be made that Alcoa ought to trade closer to $16 to $17 today, but just a few minor model adjustments can drop the fair value down to $10 or lower. Alcoa is well-positioned to play a more prominent role in the aerospace cycle, but the company's balance sheet likely restricts the amount (or at least the pace) of transformation from this point and other drivers like increased use of aluminum in auto production aren't certain.

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Alcoa Trying To Find The Path To A Better Neighborhood

Seeking Alpha: Carpenter Technology Feeling The Pain Before The Gain

Specialty alloy producers haven't had a great run over the last year, with Carpenter Technology (NYSE:CRS) down about 30%, Universal Stainless & Alloy (NASDAQ:USAP) and Precision Castparts (NYSE:PCP) down more than 20%, and Allegheny Technologies (NYSE:ATI) up 3% (but still lagging the S&P 500). Inventory destocking of higher-value components has played a role, but so have concerns about the near-term future of oil/gas spending and nickel prices.

Carpenter has committed some unforced errors along the way, including unplanned outages and higher than expected costs at the new Athens facility, and those have been exacerbated by what sometimes feels like "death by a thousand papercuts" serial downward guidance revisions. On a more positive note, the Athens facility still holds the potential to significantly improve the company's premium alloy capacity and its peak margins and aircraft/aircraft engine manufacturers ought to be busy for many years delivering on their orders books.

The extent to which Carpenter looks like a good investment idea today really rests with your conviction that the company will start participating in the commercial aerospace ramp over the next few years and that this process will restore the company's margins and asset efficiency to prior levels. I'm more bullish on Universal Stainless, but I think stocks like Carpenter Technology and Alcoa (NYSE:AA) will be higher in a few years' time on the back of commercial aviation and an eventual oil/gas recovery.

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Carpenter Technology Feeling The Pain Before The Gain

Seeking Alpha: The New And Improved Alcoa Showing Its Mettle

"I guess what I'm trying to say is, if I can change, and you can change, everybody can change." Rocky IV

That is probably the first time I've quoted Rocky Balboa in an investment article, but in the case of Alcoa (NYSE:AA) it fits. A year and a half ago, you wouldn't have found many analysts who gave Alcoa much of a chance to meaningfully restructure and improve its business, even though management was already well underway with cost and productivity initiatives.

And yet here we are - Alcoa's shares are about 60% over the past year, 80% over the past two years. While 2014 revenue was only about 14% higher than the 2010 level, total segment ATOI was more than 40% higher, as the company has made real strides with cost reduction and a mix shift toward higher-value products.

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The New And Improved Alcoa Showing Its Mettle

Investopedia: Alcoa Running Hard To Go Nowhere

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.

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Investopedia: For Alcoa, It Can Still Get Worse Before It Gets Better

Alcoa (NYSE: AA) management must feel like they're running on a treadmill or swimming in a flume. No matter the progress that the company makes with productivity or improved downstream operations, it feels as though ongoing global supply growth strips away the advantageous. So, although Alcoa continues to look underpriced, the brutal competition in this market makes it a hard stock to recommend to investors

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Seeking Alpha: Strong Share And Management Discipline Bode Well For Koppers

Famed investor Peter Lynch liked to advocate for investing in companies that do things that nobody really ever thinks about, or even better, does things that are unpleasant in some fashion. Koppers (KOP) arguably fits both of this criteria, as I don't think many investors spend much time contemplating the markets for carbon pitch or creosote, and distillation of coal tar (and its byproducts) are not what I'd call particularly pleasant.

That's not what I find interesting about Koppers. More relevant to me are the company's strong market shares across multiple markets and a management team that seems keenly focused on economic value creation. Although Koppers stock is just off its 52-week high and about 10% off its all-time high, these shares could still offer some upside from today's level.

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Strong Share And Management Discipline Bode Well For Koppers

Investopedia: Rio Tinto Looks To Make A Fresh Start

Apparently there's only so much even a generally passive board of directors can take before it feels the need to do something. Rio Tinto (NYSE:RIO) has announced a large impairment charge for 2012 and the replacement of its CEO - both largely tied to unsuccessful and wasteful expansion /capital allocation strategies. Now it is up to new management to chart a new path and improve returns in a more uncertain commodity climate.

Change at the Top
While the phrasing of the press release from Rio Tinto was sanitized and generic, I don't believe it is a stretch to suggest that Rio Tinto chose to fire Tom Albanese, its CEO of nearly six years. Certainly, Albanese's performance during his tenure gave cause to make a move.

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Investopedia: Alcoa Has Improved, But It's Still In The Aluminum Business

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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Investopedia: Precision Castparts Goes For A Bold And Eminently Logical Deal

When it comes to specialty metal components manufacturer Precision Castparts (NYSE:PCP), it's really never a question as to whether management will do another deal. Rather, it's just a question of who the company will buy, how much it will pay and how successful it will ultimately prove to be.

Last week, though, management announced a real doozy - a $2.9 billion bid for titanium producer Titanium Metals (NYSE:TIE) (aka "Timet"). Although a large and expensive deal would be a significant risk for most companies, Precision Castparts is not like most companies, and I expect this deal will prove to be quite worthwhile for shareholders over time.

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