Alcoa: The Worst May Be Behind

We have opened a position in Alcoa (NYSE:AA), a very non-consensus stock in today’s market. The cyclical Materials sector has suffered from the global growth slowdown and trade tensions. We explain below some pros and cons of the Alcoa trade today.

Alcoa: What’s Not Working

Since Alcoa’s restructuring in 2016, the new company stock rallied +150% into mid-2018 but has since lost over 65% of its value since the peak. The reasons for Alcoa’s poor stock performance have been the global economic slowdown (notably, in China, a large consumer of aluminum), the U.S.-China trade war, and contracting manufacturing activity in the global automotive sector.

Many investors had hoped that Alcoa’s U.S. smelting operations would benefit from U.S. sanctions on aluminum imports. This just has not happened. The 10% tariffs on China aluminum were a slap on the wrist not even felt in the aluminum market. The net result has been lower aluminum demand.

More broadly, Alcoa has struggled to compete in the global aluminum smelting industry. New, lower-cost capacity continues to come online in China and the Middle East. Alcoa has been slow to cut costs to better compete.

Alcoa: What Could Further Derail The Company

The biggest risk for Alcoa is further contraction in alumina prices and, therefore, margins. If aluminum prices move sharply lower into the future, this will weigh heavily on company-wide profitability. The company is highly leveraged to the prices of bauxite, alumina, and aluminum, which have proved to be highly volatile in recent years. And, of course, bauxite, alumina, and aluminum are determined by world demand for these products, especially in China. If readers are optimistic about the global economic outlook, and the ability of central bank policy makers to support the expansion, consumer demand would support commodity prices.

A more structural problem for Alcoa is found on the supply side. Overcapacity will remain a material headwind to aluminum price appreciation, driven largely by massive low-cost capacity additions in China. To some extent, Alcoa may be able to continue cutting costs to better compete (see below), but investors in Alcoa will need to count more on the demand side to pull commodity prices higher.

Alcoa: What Could Begin Working For The Company

Chinese demand for aluminum will be the key to Alcoa’s profitability and stock price. We are constructive on the Chinese economy turning up.

The China Manufacturing PMI took a leg down in 2018 as the trade war hit the economy. As the trade tensions fizzle out (Trump’s re-election depends on this) and China economic stimulus measures take effect, we can reasonably expect China’s demand for industrial commodities to pick up in 2020.

Alcoa’s outlook should improve as the global economy gradually recovers, as reflected by higher global GDP growth.

Cost reduction should also begin helping Alcoa’s profitability. Management reported that the company is likely to close some of its higher-cost smelting facilities in order to improve its cost-competitiveness. This week, we learned of a further push to cut costs. Management is looking to sell-off as much as $1 billion in assets, including a roughly 32,000-acre property in Rockdale, Texas.

In terms of fundamentals, Alcoa ranks near the top of peers within the Materials sector in terms of growth. Revenue is forecast to only increase modestly in 2020 but EPS growth is expected to jump as the company returns to profitability.

Alcoa also enjoys an attractive company valuation among Materials sector peers. Even as the stock’s P/E makes the company appear expensive at first blush, our valuation metric (Enterprise Value/EBITDA & Enterprise Value/sales) places Alcoa as the 9th cheapest company among the 287 Materials firms that we rank. Interestingly, by moving up in the income statement to look at operating earnings as opposed to bottom line earnings, our Market Value/EBITDA metric shows that Alcoa ranks in the top 10% within the sector. Alcoa’s core business is indeed profitable.

In terms of the balance sheet, the company is solid. Alcoa ranks in the top 33% of peers on our financial situation score and the Altman Z-score suggests no risk of financial troubles.

Finally, Alcoa ranks highly as an ESG-focused firm. This is important as more and more fund managers are running portfolios with an ESG mandate. Within the Materials sector, Alcoa is one of the most ESG-compliant firms.

In sum, Alcoa is a good litmus test of investor conviction. If readers believe that the economy is strong, recession risk is mild, and U.S.-China trade negotiations are advancing, then buying into an economically-sensitive, China-demand investment like Alcoa makes perfect sense. However, if readers don’t buy into a prolonged, Fed-supported economic expansion, then keep trading the momentum tech stocks until they bust.

Stock Price Technicals

One sign that pessimism may be fully saturated in the stock price was the market’s reaction to Alcoa’s Q3 earnings on October 16. Alcoa’s adjusted EPS came in at a loss of -$0.44 (worse than the expected loss of -$0.35) and down from a profit of $0.63 in the prior-year quarter. Sales were also down -24% in the quarter. Not much to rejoice in, yet the stock has jumped over 8%. Investors have perhaps begun anticipating better times ahead.

The stock price chart of Alcoa could be showing signs of an end, the slide which began in April 2018. While it may still take some work to get the price above the 200-day moving average (in yellow), once the stock turns, we see lots of upside potential for this former Dow stock.

As for risk management, we will trim back our position in Alcoa below the October swing low at roughly $18.00. Conversely, once the stock price busts above the 200-day moving average, we’ll begin adding to the winning position.

Conclusion

Alcoa is a contrarian play today. Many readers will disagree with our Buy recommendation. However, excess returns rarely accumulate to investors who always put money in the consensus stocks. While out of fashion for some time, the investing principle “buy low, wait, and sell high” should be applied with Alcoa.

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