After Earnings, Alcoa Is Fully Valued

Apr. 9.14 | About: Alcoa, Inc. (AA)

Summary

Alcoa earnings were roughly in line with a bottom line beat but top line miss.

The legacy commodity business continues to struggle thanks to depressed aluminum pricing.

Alcoa's value-add business reported solid results thanks to bull markets in aerospace and auto.

Negative free cash flow was seasonal and not surprising.

Fair value is $12-$13, and investors should wait for a dip before buying.

On Tuesday afternoon, Alcoa (NYSE:AA) unofficially kicked off the start of the earnings season. Last September, the aluminum maker was kicked out of the Dow, so many investors now look to JPMorgan Chase's (NYSE:JPM) report on Friday as the "official start" to the earnings season. Even if Alcoa has lost some of its luster, its report provides an important read on global growth and is obviously material for investors who own its shares. On the whole, it would be fair to describe this quarter as mixed or mildly positive, and shares are fairly valued in the $12.00-$13.00 range.

In the quarter, Alcoa generated $5.45 billion in revenue, which missed estimates by $100 million. Excluding restructuring and one-time charges, Alcoa earned $0.09 per share, which solidly beat expectations of $0.05 (all financial and operating data available here). Now, a recurring joke on Wall Street has been the size and frequency of Alcoa's non-recurring charges. In this quarter alone, they totaled $461 million. Over the past twelve months, one-time charges total $1.24 billion. Alcoa is shifting its business from a commodity-driven business to a value-add aluminum maker. While this strategy should prove profitable, especially given the relative weakness of aluminum pricing, it is certainly costly.

Revenue did fall 2% sequentially, but this is being driven by Alcoa's shift away from its legacy Primary Metals business. Capacity reductions, which have been the main culprit of Alcoa's one-time items, and an 8% decline in aluminum prices year-over-year led to a 6% year-over-year revenue decline. Thanks to cost-cutting efforts, Adjusted EBITDA per metric ton increased by $63 to $150. Still, after-tax operating income ("ATOI") was -$15 million. This legacy commodity unit will likely be a drag over the next 12-18 months.

When looking at Alcoa's value-add transformation, there are two units to focus on: engineered products and solutions, and global rolled products. Engineered products had an extremely strong quarter. ATOI was up 9% year-over-year to $189 million. Moreover, EBITDA margin expanded to 22.2% from 20.9%. This quarter was helped by strength from aerospace and commercial transportation. As investors in Boeing (NYSE:BA) know, we are in the midst of an aerospace super-cycle.

Thanks to consolidation, commercial airlines are once again solidly profitable and can afford to update their fleets. Further, planes like Boeing's 787 Dreamliner are delivering significant fuel efficiency gains, which make them very attractive for airlines. Boeing will take upwards of a decade to meet its current backlog, and planes require a significant amount of aluminum. Alcoa is one of the beneficiaries of this aerospace boom, and the company actually increased its 2014 aerospace growth target to 8%-9% from 7%-8%. Aerospace will help drive Alcoa's engineered products unit higher.

On the other hand, performance in global rolled products was a bit disappointing. ATOI came in at $59 million, which is down from $81 million last year. Adjusting for one-time items, this quarter's ATOI would have been $70 million, still down 13.6% from last year. On the positive side, auto sheet quarterly revenue was a record. Overall, EBITDA per ton was a bit disappointing at $342, which is a reason for this miss. Still, it is worth noting that EBITDA per ton at this value-add unit was more than twice the $150 EBITDA per ton its commodity unit generated. By making specialty products, Alcoa maintains far more pricing power even in a weak aluminum market.

Going forward, I expect this unit to perform better. We are seeing increasing use of aluminum in cars, with Ford (NYSE:F) releasing an all-aluminum F-150, and I expect GM to follow suit. Between a strong auto market and an increasing use of aluminum in autos, Alcoa should continue to generate more revenue and earnings at this moment. While ATOI was a shade disappointing this quarter, this unit has appreciable room for revenue growth over the next 24 months.

Finally, many investors focus on cash flow and Alcoa's balance sheet. It is important to recognize that the first quarter is seasonally weak from a cash flow perspective due to interest payment timing and seasonal working capital adjustments. In the quarter, cash on hand fell to $665 million from $1.437 billion last quarter. Net debt to capital came in at 33%, which is nowhere near a danger zone. Free cash flow was -$760 million, with operations consuming $551 million. This is an eye-popping number, but again, is cyclical. In fact, the working capital holding wasn't as large as last year. The company has 30 days of working capital, which is two days lower than the first quarter of 2013.

Overall, Alcoa reported some strength in engineered products, while global rolled products was not as strong as hoped. The commodity business continues to struggle and needs a higher price to break-even. There was a seasonal cash burn, but it was not particularly surprising. Alcoa remains on track to deliver some revenue growth this year and perhaps $1 billion in operating cash flow this year. With strong aerospace and auto demand, Alcoa should generate $1.00 in free cash flow per share in 2015. Given this, Alcoa is fairly valued in the $12-$13 range. After this quarter, investors should wait for a dip before buying.

Disclosure: I am long BA, F, GM. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.