- Alcoa's fundamentals are deteriorating, yet the market reacted positively to its poor results.
- There are signs that investors are taking an increasingly speculative outlook on financially weak companies like Alcoa.
- If you think investors are underestimating risks in Europe and China, shorting Alcoa may be a good hedge.
The market's initial reaction to Alcoa's (NYSE:AA) quarterly results left me scratching my head. Negative GAAP earnings, sequential and year-over-year declines in revenue and a weakening in financial position does not strike me as "strong" performance, regardless of management's claims to the contrary. So why was the market's reaction so positive?
AA data by YCharts
It is easy to say that market participants have been duped into drinking the adjusted EBITDA kool-aid, focusing only on the press release rather than the underlying corporate reality. There are certainly a lot of "one-time" charges that seem to recur with frequency, and the $461M in restructuring charges just reported seems a continuation of the trend:
Moreover, AA's price appears to have diverged from industry fundamentals. Whereas the spot price of aluminum weakened in the last few quarters, the stock is up more than 50%:
AA data by YCharts
As performance deteriorated, so did the company's financial position. The Altman Z score is a metric designed to calculate the risk of a company becoming bankrupt in the next two years. This measure is approximate and there is not necessarily a clear cutoff between financially healthy and distressed companies, but a score of 3 or higher generally means the company is in decent financial shape and a score below 1.8 indicates potential trouble. Here's Alcoa's record on this metric:
AA Altman Z-Score (TTM) data by YCharts
Not good. Alcoa is in just about the worst financial shape in decades, almost as bad a during the financial crisis. In fact, last year, the company's debt was downgraded to junk. And while the company has not filed its current 10-Q as of this writing, the available information on the investor presentation suggests further financial fragility.
First, take a look at the red box. Working capital as defined by the company has steadily declined in the last few years. But the orange boxes raise additional questions: Alcoa has become increasingly dependent upon cashing out receivables by selling them to financial institutions, and in the last quarter changed their working capital calculation, using average working capital rather than the quarter end. What will this fancy financial statement footwork do to help the business? Something smells fishy.
So why aren't investors worried? Although I think the information presented above is enough to suggest that Alcoa is a questionable long-term investment, let's assume for a moment that longs are being rational and that I am missing something.
Equity investors have all sorts of reasons for their investments, but a common concern is capturing upside. In this respect they have more in common with buyers of call options than bondholders, who are typically more interested in protecting the downside. Like call option buyers, equity investors are willing to take on the risk of being wiped out in exchange for handsome returns if everything goes according to plan. In fact, because options are priced according to the expected volatility of the underlying going forward, an increase in uncertainty regarding the future may actually increase the price of call options. And past a certain point of financial weakness, common equity may begin to trade like out-of-the-money call options. So paradoxically, declines in operating performance and financial position do not necessarily mean that a company's common stock is less valuable, provided that the expected volatility of future performance rises.
So is there evidence of market participants increasingly viewing AA common as a leveraged, speculative play to the upside? On way to check is by looking at the ratio of puts to calls. In general, if there are more open positions on the call side, this suggests that investors are looking to capitalize on potential price appreciation, and if there are more positions on the put side, investors are looking to hedge or bet on the downside. In the front few months, Alcoa looks pretty balanced, but when we look at the June and July expirations, we see a massive imbalance. As of this writing, there are perhaps 20,000 outstanding near-the-money put contracts that expire in June, but call contracts number over 100,000. July is similarly unbalanced.
So what does this all mean? I think that there are a few conclusions to draw here. First, it appears that momentum investors are in control and speculation is trumping fundamentals right now. Recent articles here and here seem to confirm this viewpoint. So unless you think that you have an edge as a trader (most people don't, including myself), avoid Alcoa altogether. Second, avoid Alcoa preferred. It has a measly yield and limited upside, which is hardly compensation for the risk.
However, Alcoa is starting to look interesting as a short. Its growth story seems to hinge on markets with dubious prospects. Take a look at management's assessment of market conditions for 2014:
Perhaps these projections for North America are reasonable, but I'm skeptical about the green arrows for Europe and China. Given the flat incomes, high unemployment and possibility of deflation in the eurozone, I'm not sure how willing consumers will be to buy more cars or drinks. And while China sales seem likely to grow, the overall Alcoa growth story seems to hinge on the assumption that China's credit bubble will continue to inflate, holding up commodity prices. I cannot get into the minds of Communist Party leaders or handicap the ability of China's rickety financial system to further expand credit, but this seems like a speculative bet at best.
So if you are concerned that the U.S. market is increasingly speculative and worry that 1.) the eurozone crisis is not over, or 2.) China's massive credit expansion will end in tears, shorting Alcoa seems like a good way to hedge risk. I don't short stocks myself because it is not allowed in IRAs, but longer-dated puts on Alcoa are on my watch list.