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Introduction

Alcoa (AA) is one of the largest integrated aluminum companies in the world, from mining bauxite to producing the final product such as fasteners and castings. AA operates in 31 countries and the company consists of four segments: Alumina, Primary Metals, Flat-Rolled Products, and Engineered Products and Solutions. The company derives almost ~80% of its sales from US and Europe. Aluminum and alumina represents around ~75% of its revenues, while finished products account for the rest. The company's fortunes are heavily dependent on the price of aluminum, which has been stuck in a low range since the last few years. The company has been affected by the massive overcapacity in China which has acted as a headwind for aluminum prices. The slowdown of the western economies has also acted as big dampener for Alcoa's growth. While the company has restructured its operations and cut costs post the Lehman crisis, the upside is still quite distant given the tepid outlook for aluminum prices and global economic growth.

Why Alcoa's future is problematic

  1. Chinese growth will slow down in the future - Most of the incremental growth in commodity demand over the last decade has come from China. However, we think that the Chinese economic growth will come down quite sharply over the next decade. Other economic powers like Japan, Europe and USA also face huge problems. This means that the expected demand growth is mostly a mirage. Alcoa thinks that the demand will double by 2020 from 2010, to reach 73.4 million tons with China making up for half of the demand. This 6.5% CAGR is an overestimate in our view and is difficult to achieve.
  2. Lack of Diversification - Alcoa does not have the diversification of major metal and mining MNCs like BHP Billiton (BHP), Rio Tinto (RIO), Freeport-McMoRan Copper & Gold (FCX) and Vale SA (VALE). The dependence on aluminum means that the company will continue to remain in a depressed state, unless the demand for aluminum grows dramatically. Given the current overcapacity, it is hard to see how that will happen.
  3. Cyclical industry which has probably seen a generational peak - AA operates in the cyclical mining industry which is marked by sharp peaks and troughs. The company faced losses during 2008 and 2009 as demand and prices plummeted. The company had to undergo painful cost cutting to return to profitability. However, the earnings are a fraction of the peak earnings seen during the boom years of 2006 and 2007.
  4. Chinese competition and supply overcapacity - China has built up a massive capacity in aluminum production which has acted as a growth dampener for aluminum prices. China due to its negative real interest rates has seen a massive investment boom. This has led to crazy overcapacity in some sectors like solar panels, wind turbines, shipbuilding, steel etc, which has led to crashing in the prices of these commodities and spelled doom for western manufacturers of these products. Even the domestic Chinese companies like Chinalco (ACH) have been hurt badly due to almost a hundred companies entering the sector.
  5. Dividends fall off a cliff - AA like other Dow constituents is generally looked upon as good investment because it has been paying high dividends for a long time. However, the 2008 Lehman crisis has taken a permanent toll on the company, which was forced to drastically prune its dividend. Annual dividend fell from 68c/share in 2008 to 12c/share in 2011. With the current earnings trajectory, it will take a long time for AA to return to its former dividend level.
  6. Margins and ROE has halved to low single digits - AA has recovered its revenues to ~$25 billion in 2011 which is almost the same as that in 2005. However, net margin has fallen to ~2% from ~5% in 2005.The ROE too has halved to ~4.5% in 2011 from ~9% earlier.

Alcoa Upside Risks

  1. Restructuring - Alcoa has become a leaner organization after pruning costs through a number of measures. The company has cut flab in a number of areas as it adjusts to a "new normal". The company has reduced working capital requirements and is using FCF to retire debt. The company has also increased its focus on higher growth and value added areas such as fasteners. In 2011, Alcoa bought aerospace fastener business of TransDigm Group Inc.
  2. Stock Performance - Alcoa has given ~18% loss over the last year, compared to ~11% return given by S&P 500. Over the last 5 years, AA has shed almost 3/4th of its value as competition from China has increased leading to decreased earnings. The stock has been trading in a range of ~$5 - $18 after the Leman crisis. The stock currently trades at ~$9, which is on the lower side of the range as earnings have decreased in 2012 from 2011.

Valuation - AA trades at almost the same multiples as the rest of the industry, with a P/S of 0.4x and P/B of 0.8x. The forward P/E of 8x is neither expensive nor cheap. The revenue and profit growth in the past three years have been flat. Dividend yield at ~1.3% is not too exciting either.

Recent Performance - The Company managed to beat analyst estimates in its most recent quarter; however its 2013 guidance failed to excite the investors. The management is projecting overall global growth of 7%, with the aerospace segment (9-10 percent) expected to grow at the strongest pace. The company gave a quarterly dividend of 3c/share which equates to a dividend yield of ~1.3%.

Summary

AA has probably seen its best days during 2007, when the commodity cycle reached a peak due to the global credit fueled demand growth. Though central banks have prevented a global deflation through zero interest rates, it looks unlikely that we will return to the strong economic growth anytime soon. AA's fortunes are closely tied up to economic growth as its performance depends on aluminum prices. With its major markets of USA and Europe stuck in a morass, it looks difficult how AA stock can return to its pre-Lehman glory. AA is well managed and has done a good job in restructuring operations. However, it's stuck in a bad industry and macro environment. Unless the global economy starts showing signs of a sustained recovery or China sheds a massive amount of its capacity, Alcoa stock will be stuck in a trading range.

Source: Alcoa - Dragon Hurting Both Demand And Supply