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Shares of Alcoa (NYSE:AA) started the final trading week of November on a strong note following optimism from analysts at Goldman Sachs. With shares approaching the $10 mark, they are trading at the highest levels since 2012.

While I note that the company has great potential for operating leverage, amidst productivity improvements and a recovery in aluminum prices, I remain a bit more cautious.

High explicit and implicit (debt) obligations make actual leverage being employed very high, which remains a worry according to me, especially with so much capacity sitting idle.

While I share the optimism in Goldman's story, I believe downside risks are being ignored to some extent by the bank, especially in relation to the poor track record of the company. I remain on the sidelines.

Goldman Is Upbeat

Analysts at Goldman Sachs (NYSE:GS) raises Alcoa from "Neutral" to "Buy." The price target was hiked by three dollar to $11 per share, suggesting some 19% upside from Friday's levels.

Analyst Sal Tharani believes that the market is not fully appreciating Alcoa's strong position in high margin aluminum products for aerospace and automotive industries.

He sees Alcoa adding more than $2 billion in revenues and some $525 million in EBITDA in the mid- and downstream business in the coming three years. Market growth and a growth in market share should be the driver behind these increases.

The downstream business, notably the "Engineered Products" business is less price sensitive and there is upside in the cautious outlook for the supply-demand fundamentals. Positive free cash flow should start next year, given the continued high cost capacity closures, asset portfolio management and the low-cost Ma'den joint venture.

Third Quarter Review

About six weeks ago, Alcoa reported its third quarter results. The company reported a 1.2% fall in quarterly revenues, coming in at $5.76 billion. Revenues were on the fall on the back of poor pricing, with prices being down $57 per metric ton.

GAAP earnings came in at $24 million, or $0.02 per share. Earnings on a non-GAAP basis came in at $120 million, or at $0.11 per share. The company is making progress to boost earnings, notably through productivity improvements. The company took $151 million in restructuring charges during the quarter to further optimize the upstream portfolio.

Valuation

Alcoa ended its third quarter with $1.02 billion in cash and equivalents. Debt stood at $8.34 billion, resulting in a net debt position of around $7.3 billion. On top of this came some $6 billion in pension and post-retirement benefits obligations.

Revenues for the first nine months of 2013 came in at $17.5 billion, down 2.0% from the year earlier. Earnings on a GAAP-basis came in at $54 million, while the company reported a similar loss last year.

At this pace, revenues of $23.5 billion are attainable while GAAP earnings for the full year are negligible.

Trading around $9.50 per share, the market values Alcoa at $10.2 billion. This values operating assets at 0.4 times annual revenues and a non-meaningful earnings multiple.

Alcoa currently pays a quarterly dividend of $0.03 per share, for an annual dividend yield of 1.3%.

Some Historical Perspective

Despite a recent recovery, Alcoa has been a terrible long-term investment. Shares and operations fell off a cliff during the 2008 recession, with shares trading between $30-$50 in 2007 and 2008.

Shares fell to lows of $5 at the start of 2009 to peak around $15-$20 in 2011, to fall back again. So far in 2013, shares have traded in a $7-$10 trading range, with shares now trading at the high end of this trading range.

Between 2009 and 2013, annual revenues are expected to rise by little over a quarter to an expected $23.5 billion. The company reported large losses in 2009, followed by very modest earnings since 2010.

Investment Thesis

Following the release of its third quarter results, I took a look at Alcoa's prospects. I concluded that the company kicked off the earnings season with a modest beat.

I noted that Alcoa is seeing some strength in both the upstream and downstream business in recent times, notably in its engineered products business in which it is a huge supplier to Boeing (NYSE:BA). This unit is very profitable, it remains notably the primary metals business which is Alcoa's troubled child.

Note that downstream profits seem solid, given the huge order backlog within the aerospace industry. Despite this, Alcoa warned for a modest inventory built up in the aerospace industry.

The trouble with Alcoa are the large legacy assets and obligations which come with that. The company continues to take charges related to closures and clean-ups of operational sites. Yet these steps are necessary to reduce operating costs going forwards, such is the Ma'den joint venture, which should cut costs by some 2%.

That being said, the addition of capacity of Ma'den might be unlucky timing as Alcoa has already taken 650,000 tons of smelting capacity offline, about a sixth of total production.

I reiterate my stance from October, and remain cautious. The high debt, other legacy obligations and the sub-optimal current earnings are a worry amidst a reasonably solid world economy. While I am pleasantly surprised with productivity gains and the extent of those gains, the poor pricing and many one-time charges keep depressing earnings.

That being said, Alcoa does have the opportunity to show decent operating leverage once prices stabilize or increase. Yet I believe that Alcoa needs many more structural improvements to justify even this historical low valuation given the high leverage and many other obligations.

Source: Alcoa - On The Verge Of Trading Above $10 Following Goldman's Bullish Notes