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Shares of Alcoa (NYSE:AA) saw a modest uptick in after-hours trading on Tuesday after the aluminum company beat on low expectations for the third quarter.

Investors are cautiously optimistic as benefits from productivity enhancements outweigh lower aluminum prices. Despite these improvements I remain very hesitant to invest on the back of the high debt position, and structural nature of restructuring costs, both taking a toll on earnings.

Third Quarter Results

Alcoa generated third-quarter revenues of $5.76 billion, down 1.2% on the year, and down 1.4% compared to the second quarter. Consensus estimates for revenues stood at $5.63 billion.

On a GAAP basis, Alcoa reported net earnings of $24 million, or $0.02 per share. Non-GAAP earnings came in at $120 million, or $0.11 per share, ahead of consensus estimates at $0.05 per share.

Last year, Alcoa reported adjusted earnings of $0.07 per share, despite higher aluminum prices at the time.

CEO and Chairman Klaus Kleinfeld commented on the performance over the past quarter, "Our performance this quarter shows our repositioning of the Company is on the right path. We continued to build our value-add businesses, capturing demand for innovative material solutions across multiple markets. Our commodity business delivered better performance in a tougher market environment, and we continued to reshape the portfolio to lower the cost base."

Looking Into The Results

Revenues fell some 1.4% compared to the second quarter, which seems weak at first sight. Note that Alcoa saw a $57 per metric ton drop in aluminum prices, with prices down 3% over the past three months.

While revenues were falling, both on a quarterly and annual basis, Alcoa is making some progress on gross margins. Gross margins came in at 16.8% over the past quarter, up 110 basis points compared to the second quarter. Last year, gross margins were just 9.7%.

The company took $151 million in restructuring and other charges, including $96 million in special items to optimize its upstream portfolio. All these, and past productivity efforts, have resulted in year-to-date productivity gains of $825 million, ahead of Alcoa's $750 million annual target.

On the back of the gross margin improvements, earnings came in at $24 million. This compares to second-quarter GAAP losses of $119 million and a $143 million loss in the third quarter of last year.

Valuation

Alcoa ended the quarter with $1.02 billion in cash and equivalents. Total debt stood at $8.34 billion, for a net debt position of $7.3 billion. Note that this excludes nearly $6 billion in pension and post-retirement benefits.

Revenues for the first nine months of the year came in at $17.45 billion, down 2.0% on the year before. Alcoa reported a GAAP net income of $54 million for the period, compared to a $51 million loss last year.

At this pace annual revenues are seen around $23.5 billion, while GAAP net income is likely to be negligible.

Trading around $8 per share, the market values Alcoa at some $8.5 billion, or 0.35 times annual revenues and a non-meaningful earnings multiple.

The quarterly dividend of $0.03 per hare, results in a 1.5% dividend yield at these levels.

Some Historical Perspective

As I wrote in an article published just last week, Alcoa has been a terrible long-term investment as shares and operations fell off a cliff during the 2008 recession.

After shares were trading as high as $25-$45 per share between 2004 and 2008, they never managed to recover from the losses of 2009. The company continues to struggle despite the global economic recovery.

Between 2009 and 2013, revenues are expected to rise by a cumulative 27% to around $23.5 billion. After reporting losses of over a billion back in 2009, Alcoa returned to profitability, although it has reported very modest profits since 2010.

Investment Thesis

The good thing is that Alcoa saw some strength in both the upstream and downstream business over the past quarter.

Engineered products, where Alcoa supplies to aerospace companies like Boeing (BA) and Airbus continues to do well, resulting in a 22% increase in after tax operating income to $192 million. The primary metals business earned $8 million compared to a $14 million loss last year. The performance of the latter business is very impressive given the lower aluminum prices.

The downstream business, which makes specialized aluminum products is the major profit driver behind Alcoa, as it has a huge backlog for future deliveries. Note that during the conference call, Alcoa issued some cautious comments about shipments to aircraft manufactures into the final quarter because of an inventory built up at manufacturers.

The continued improvements in the production platform resulted in some hefty charges. Alcoa took $109 million in charges related to the close of the Soderberg potlines at the Baie-Comeau smelter in Quebec, taking 105,000 metric tons of capacity offline. The Ma'den-Alcoa joint venture with 740,000 metric tons capacity should come fully online in 2014. This would allow Alcoa to achieve a 2 percent point cost reduction, thereby achieving a portion of its 10% point cost reduction target by 2015.

Note that Alcoa currently has some 651,000 metric tons of smelting capacity offline, equivalent to 16% of its total capacity. With the Ma'den project coming online this might be even more. While the opening offers Alcoa flexibility to switch around with production to lower production costs, so much idle capacity is not a good thing.

Just last week, when Deutsche Bank cut Alcoa to a sell, I took a look at the company's prospects. I thought the downgrade would not spell much good for the results, but Alcoa managed to beat on low expectations. I continue to be very cautious given the high debt position, and the sub-optimal profitability despite a reasonably solid world economy.

I must say that I am positively surprised by just how much productivity gains offset poor pricing, but in traditional Alcoa style GAAP earnings were really poor, driven by many "one-off " items.

I reiterate my conclusion and stay on the sidelines. I do see solid operating leverage if aluminum prices stabilize or slightly rise, combined with productivity improvements and lower cost smelters. That being said, Alcoa needs structural higher earnings to justify even this low valuation given the huge net-debt position and the high pension liabilities.

Source: Alcoa Kicks Off Earnings Season With A Cautious Beat