Basic Materials And Alcoa: Some Good, Some Bad In Our Sector Overweight

 |  Includes: AA, BTUUQ, FCX, X
by: Brian Gilmartin, CFA


Basic Materials overweight is mixed, although Alcoa a big winner in 2014.

The sector is 3% of the S&P 500 by market cap.

We like the sector but don't own Chemical companies directly.

After the S&P 500's 32% return for 2013, we were looking around for undervalued companies that didn't participate in the 2013 rally, or if they did participate, still represented what we felt was good value for clients.

The Basic Materials sector fit the bill, or at least some of the industrial metal components of Basic Materials, since we felt that non-precious metals would benefit from a "return to global growth" scenario.

Here is how our primary Basic Material client holdings have performed: we have a 4%-5% weighting within client accounts.

Alcoa (NYSE:AA): Back from the dead, and what a star with the stock up 35% this year (excluding the dividend), the stock is benefiting from the increase in the local aluminum premia, and the continued shift to the use of aluminum within the auto and aerospace sectors.

This was a painful long for us for a few years, but patience paid off as Alcoa was ejected from the venerable Dow Jones 30 average at the same time it was trading below tangible book value.

I think it is transitioning now from a "deep value" stock that was widely hated in terms of investor sentiment to an improving "earnings growth" story.

Consensus earnings estimates from Thomson Reuters show that Alcoa's 2014, 2015 and 2016 consensus EPS estimates bottomed in December of 2013 and January 2014 and have improved steadily since that time.

2014's EPS consensus has improved 35% since January 31 '14, from $0.34 per share to the current $0.46 per share, which is a 35% boost in just the last 4 months.

2015 and 2016 are improving sharply as well: 2016's EPS consensus estimate is already close to doubling from $0.46 to the current $0.80 consensus estimate per share also for the first 5 months of 2014.

Alcoa will never be a momentum name, but earnings, revenue and cash-flow growth are critical for a high-fixed-cost business like AA.

Many investors don't realize that AA printed $3 per share in 2006 and traded as high as $48, before the 2008 Great Recession and beat-down inflicted great pain upon the company.

Morningstar carries a $15 perceived intrinsic value on AA, while our internal model is higher. However, from a technical perspective, I will wait and see if AA trades above the April 2011, $18.47 print.

That is our first major resistance level, and at that point we will evaluate AA based on absolute EPS, revenue and cash-flow valuation, and see how the trends look.

Here is our history of articles on Alcoa, including those when it was a deep value stock that was widely hated.

The biggest difference between today and the last three years for AA is that forward EPS estimates are starting to improve smartly.

We think the stock has more upside.

Peabody Energy (BTU): We just started buying BTU in the first quarter, and despite the EPA directive this week coming from the Obama Administration, BTU is still up 1% on the week.

The stock is down from a high over $80 in mid-2008, and then again a high near $73-$74 near 2011. This was our first buy of a coal name, but given the negative sentiment around the stock and the prospect for political change over the next few years, not to mention a hedge against higher natural gas prices, we decided to take a position in the stock.

Here is our first and only article on BTU on the Seeking Alpha site. As you can see, emotions run high around the name for a variety of reasons.

The free-cash-flow yield of 7% is particularly enticing for us. Morningstar has an intrinsic value price of $26, but even if that gets lowered as Morningstar sometimes does, investors would still have a decent discount to the perceived intrinsic value at current prices.

Our sell stop would be a trade below $15 on BTU on heavy volume, which would take out the March '14 lows.

Like many deep value names, BTU could wind up being like Alcoa, i.e. a test of fortitude and patience awaiting sizable gains.

Freeport-McMoran (NYSE:FCX): When FCX announced its acquisition of MMR and PXP, the deal was widely panned. $20 bl in debt was added to FCX's balance sheet taking the debt-to-capital ratio from 10% to 34% and return-on-invested capital for FCX was crushed like a bug under your shoe.

Even though copper and mining is still 75% of FCX's cash-flow and operating income, maybe FCX management was dumb as a fox. In the first quarter FCX Oil & Gas saw better-than-expected results, better volume and better returns.

In early May '14, FCX reported a $3.1 bl sale of Ford Eagle Shale property, part of the proceeds being used to pay down debt, and part were used for an acquisition of Gulf of Mexico's deep-water property.

Looking at the statement of cash-flows, I do worry about FCX, since the miner is generating less cash-flow-from-operations than its current capex requirement, so asset sales will be a big part of restoring that balance over the next two years, as the dividend will remain the same, and no shares will be repo'ed. (Hence no safety net is available to FCX.)

I think FCX's asset sales and realized prices for the sales are a key component of the next 18-24 months.

Given FCX's dependence on copper and mining still, what happens in China in terms of the economy and the supply and demand for copper is important going forward.

Morningstar's perceived intrinsic value is $28, while our internal model values FCX closer to $40. Average the two and FCX is pretty fairly valued currently.

Technically FCX is trading above its 200-day moving average, but we would get worried about our position if the stock traded below $30.

The stock could remain range-bound between $30-$40. A trade above $40 or the 200-week moving average would be a nice breakout.

The stock is down about 8% year-to-date (excluding the 3%-3.5% dividend).

Obviously stronger global and China growth and a higher copper price still matter.

US Steel (NYSE:X): We started buying X last summer and were pleasantly surprised as the q4 '13 rally took the stock from $18 to $30. (I learned a valuable lesson: X is really a 4th quarter stock in many regards. If readers would buy X in just the 4th quarter of every year, with the exception of 2008, the return would be nice, although I need to back-test that assumption. Just looking at the chart, that seems to be the case.)

We are still long X and bought more this week as the stock is down about 20% year-to-date in '14, although still higher than our cost basis from 2013's initial buy.

X also sports a 7% free-cash-flow yield although it is hamstrung competitively with its high-cost smelting operations.

The stock was killed with q2 '14 guidance as the q2 '14 EPS consensus estimate was slashed from $0.52 per share to just $0.01 per share. However, the forward estimates for 2015 and 2016 have been rising.

The one metric I'd like to see change after the July earnings report is the 2016 EPS consensus estimate: it is currently looking for flat growth from 2015's $2.39, so I'd like to see that 2016 estimate move higher.

I think X has one more decent run left in it, and it will probably happen in q4 '14. We will update our opinion on X sometime after the July earnings report, but we expect the stock will trade back to $30 from here before year-end.

A trade above the $30.56 current 200-week moving average and you will have a nice breakout. The late December, '13, early January '14 high for X was $30.47.

Our internal intrinsic value model puts a value on X (after discounting some assumptions) mid to high $30's, while Morningstar's intrinsic value estimate is currently $27.

If we ranked the above names in terms of discount-to-intrinsic value:

1.) Peabody 30% discount estimate

2.) US Steel 25% discount estimate

3.) Freeport - fairly valued

4.) Alcoa - fairly valued

If we ranked the above names by potential total return into 12/31/14:

1.) Alcoa - rising estimates and a lot going right;

2.) US Steel - 4th quarter trade shouldn't be ignored;

3.) Peabody - could depend on November election results. Sentiment around sector is horrible, for good reason.

4.) Freeport - so much depends on asset sales, etc.

Obviously, all this is an educated guess. Certainly the rankings give readers ideas in terms of how to position their own portfolios.

A lot can change this year.

The S&P 500 hasn't seen a 10% correction in some time.

Alcoa is presently our largest position (of the 4) within client accounts.

There is a lot going right there, finally.

As global growth continues to improve, these names should benefit, to some degree.

Disclosure: I am long AA, BTU, X, FCX. 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.