Alcoa (AA) reports on Tuesday with the usual dismal outlook that has halved the shares over the last two years. Investors have waited patiently for weakness in aluminum prices to moderate and may not have too much longer to wait. Despite industry weakness, the shares have bottomed and the company is still able to generate free cash flow. Investors able to wait out cyclical weakness should be rewarded over the next couple of years.
Expectations have bottomed
The company is expected to post earnings of $0.05 per share on revenue of $5.66 billion this quarter. This represents a 67% growth in quarterly earnings against a 3.0% decrease in sales. Alcoa posted a decline of -1.9% in revenue last quarter over the prior year and has seen revenue decline by an average 3.9% over each of the last four quarters.
The company beat expectations for earnings last quarter by 16.7%, posting $0.07 per share on revenue of $5.85 billion. The shares have fallen an average of 1.9% over the week following the last four earnings reports, though they rose 3.2% in the week after the most recent report.
Estimates have been slashed from $0.09 over the last 90 days with J.P. Morgan (JPM) cutting their estimate by more than half on Friday on weak aluminum prices. Despite continued weakness in prices, the bank maintained its $9 price target for the shares.
The pessimism on the company has built to a crescendo with the removal of the company from the Dow Jones Industrial Average after 54 years in the index. Seeking Alpha contributor Douglas Ehrman recently questioned the how well the Dow index now represents the overall economy without Alcoa.
Those able to hold on will be rewarded
Despite the massive cyclical drop in aluminum prices, the company is still able to produce free cash flow. Over the trailing twelve months, free cash flow has increased with $1.64 billion in operational cash flow and $1.22 billion in capital expenditures. Besides the positive free cash flow, Alcoa also has $1.2 billion in cash on its balance sheet even after an aggressive debt reduction program.
The company controls 8% of global primary aluminum output and 17% of the global alumina market, and this market leadership should help the company when prices rebound. In a recent investors' presentation, Alcoa reported 7% growth in global aluminum demand with stabilizing inventory.
Revenue has plummeted 23% since the 2007 high of $30.7 billion on a 16% drop in the price of aluminum. By management's estimate, earnings decrease by approximately $240 million for every $100 per metric ton decline in aluminum prices on the London Metal Exchange. While the company is not the lowest-cost producer, its new Saudi Arabian operation has helped lower smelting costs and this may help support earnings through any continuing price weakness.
Production curtailments across the industry are finally weighing on inventory and the market may be tightening this year. Days of consumption in inventories has come down from a high of 108 days in 2009 to just 77 days this year.
Along with a stabilization in inventory, prices may get an economic tailwind over the next several quarters. The third quarter should be the last to see significant weakness in Europe as the region moves out of six consecutive quarters of declining GDP. An economic rebound in the Eurozone and China could provide an upside surprise to demand over the next year and strong demand from the automotive and construction sectors continues to support U.S. operations.
My own estimate is for sales to decline 4% in 2014 but to pick up to $22.8 billion in 2015 and $2.7 billion in EBITDA. On an enterprise-to-EBITDA value of 8.0 times and debt of about $7.0 billion, the stock could rebound to $14.34 per share.
Shares of the $8.5 billion integrated aluminum producer have bottomed around $8 over the last year. Cyclical weakness and over supply of aluminum looks to be working itself out and prices may soon start an uptrend. Alcoa has the financial strength and scale to weather the tough years and should come out stronger over the longer-term horizon.