Alcoa Is A Bubble Cyclical Trading At 20+ Times Normalized Earnings

Jul.17.14 | About: Alcoa, Inc. (AA)


Alcoa is currently trading as if we'll never see another economic downturn again.

The most important component of the valuation process for Alcoa is estimating how its business performs at the mid-point of the cycle.

It's easy to get caught up in the excitement of Alcoa's results during economic upswings, but economic troughs--where both volume and pricing wane--are inevitable.

Investors are using Alcoa (NYSE:AA) to explain how frothy the stock market has become. The cyclical aluminum giant that is tied to volatile metals pricing reported excellent second-quarter results that revealed adjusted earnings per share of $0.18--a level that doubled sequentially and tripled on a year-over-year basis. The company credits the performance to its transformation efforts, but seasoned investors understand that the company's current strength has more to do with the economic cycle (and that we are nearing a peak) than anything else.

The most important component of valuation is the concept of normalized earnings. Many investors--and sometimes many money-managers--want to place a normalized earnings multiple on peak earnings to justify a purchase. Unfortunately, this is a recipe for disaster. We think this is what many investors are doing today with Alcoa.

If we were to annualize the company's excellent (and adjusted) second-quarter earnings, we'd arrive at a $0.72 earnings-per-share estimate for normalized earnings. At currently pricing levels, that means Alcoa is trading at ~23 times normalized earnings -- hardly a market multiple for this bellwether. Alcoa is currently trading as if we'll never see another economic downturn again. But savvy investors know that the next economic downturn is not a matter of 'if' but it is a matter of 'when.'

Alcoa has generated better performance than the annualized normalized measure (e.g. during 2007), and it has generated worse performance than this measure (every year since 2007). We show Alcoa's cyclical performance below to drive this point home:

Click to enlarge

Image Source: Alcoa

In valuing a cyclical stock such as Alcoa, it matters little what the firm does this year or next year or even in 2016, as it relates to earnings. The most important component of the valuation process for Alcoa is estimating how its business performs at the mid-point of the cycle. Intrinsic value is then derived from what we would describe to be these mid-cycle forecasts.

Said differently, placing a normalized multiple on normalized earnings is how investors (should) arrive at a fair value estimate. A fair value range is then assigned in order to leave oneself with an adequate margin of safety in the case of forecast error. Making estimates and forecasts is a fact of valuation -- it cannot be avoided because all value is based on the future. A margin of safety is simply par for the course, as well, because the future is inherently unpredictable.

Alcoa is a great example to use in how we differ from Warren Buffett's teachings. The Oracle of Omaha has famously said in the past: "You're neither right nor wrong because other people agree with you. You're right because your facts are right and your reasoning is right-and that's the only thing that makes you right. And if your facts and reasoning are right, you don't have to worry about anybody else."

The reality is that this statement is true if an investor is looking to buy the whole business. Said differently, if one's estimate of a company's future free cash flows are correct, it simply doesn't matter what others think the company is worth. In buying the business as a whole, the business can be valued and purchased (hopefully, at a nice discount). Market activity may provide the opportunity to buy the whole company on the cheap, but market activity is irrelevant to investors looking to buy entire companies. Their return, in this case, is embedded in the fundamentally-generated cash flows, which are independent of other investors.

However, for us stock market investors (those that can't buy multi-billion companies), we rely very heavily on what other people think. Other investors' buy and sell decisions are how a company's share price moves -- and by extension -- how firms converge to fair value estimates. So, even if we are correct in how we value Alcoa, the stock can still move higher. Stocks undershoot and overshoot intrinsic value all the time, and they can stay undervalued or overvalued for long periods of time -- and even become more undervalued or more overvalued. In the stock market, we not only care about what other people think, but it is other people that do make our stock calls right or wrong. This is the core of the Valuentum process. You can download the methodology report here (pdf).

We are very transparent, and we have many return readers. It is not a surprise that Alcoa has been trading above our intrinsic value estimate for much of 2014. In March, for example, we wrote an article where we walked through Alcoa's valuation, and we clearly stated that the firm wasn't attractively valued -- much like we're doing today. The stock has performed well since the publishing of that article, but while it may be convenient to point to Warren Buffett's quote as justification for why are (could still be) right, that is not how the Valuentum process works.

In the March article, Alcoa received a Valuentum Buying Index rating of 6. This isn't a terrible score at all. The 6 reflected the firm's overpriced nature, but it also considered that its pricing and momentum dynamics were strong. Unlike traditional value investors that may sell or even short a stock because it is overpriced, we embrace the idea that stocks overshoot and undershoot intrinsic value all the time. As a result, Alcoa received a decent Valuentum Buying Index score at that time, and it has rallied. We didn't participate in the rally, but we benefited from other ideas that performed even better. We are the only firm that embraces these two intrinsically-important market dynamics together: value and momentum.

Stocks that are underpriced and have strong technical and momentum indicators score high on the Valuentum Buying Index (9 or 10), while firms with both poor value characteristics and poor momentum/technical characteristics score low on the index (1 or 2).

Furthering Your Understanding of the Stock Market

For those that may not be familiar with our boutique research firm, we think a comprehensive analysis of a firm's discounted cash flow valuation, relative valuation versus industry peers, as well as an assessment of technical and momentum indicators is the best way to identify the most attractive stocks at the best time to buy. We think stocks that are cheap (undervalued) and just starting to go up (momentum) are some of the best ones to evaluate for addition to the portfolios. These stocks have both strong valuation and pricing support. This process culminates in what we call our Valuentum Buying Index, which ranks stocks on a scale from 1 to 10, with 10 being the best.

Most stocks that are cheap and just starting to go up are also adored by value, growth, GARP, and momentum investors, all the same and across the board. Though we are purely fundamentally-based investors, we find that the stocks we like (underpriced stocks with strong momentum) are the ones that are soon to be liked by a large variety of money managers. We think this characteristic is partly responsible for the outperformance of our ideas -- as they are soon to experience heavy buying interest. Regardless of a money manager's focus, the Valuentum process covers the bases.

We liken stock selection to a modern-day beauty contest. In order to pick the winner of a beauty contest, one must know the preferences of the judges of a beauty contest. The contestant that is liked by the most judges will win, and in a similar respect, the stock that is liked by the most money managers will win. We may have our own views on which companies we like or which contestant we like, but it doesn't matter much if the money managers or judges disagree. That's why we focus on the DCF -- that's why we focus on relative value -- and that's why we use technical and momentum indicators. We think a comprehensive and systematic analysis applied across a coverage universe is the key to outperformance. We are tuned into what drives stocks higher and lower. Some investors know no other way to invest than the Valuentum process. They call this way of thinking common sense.

At the methodology's core, if a company is undervalued both on a discounted cash flow basis and on a relative valuation basis, and is showing improvement in technical and momentum indicators, it scores high on our scale. Alcoa continues to post a Valuentum Buying Index score of 6 on the index, though we note its future update may/will register a lower score, all else equal, as shares have breached the high end of the range (since we published this report on our website). Readers should stay up-to-date with current ratings on our website.

Alcoa's Investment Considerations

Investment Highlights

• Alcoa's average return on invested capital has trailed its cost of capital during the past few years, indicating weakness in business fundamentals and an inability to earn economic profits through the course of the economic cycle. We think there are better quality firms out there. The table at the top of this article revealed this dynamic very clearly.

• Alcoa is the world's leading producer of primary and fabricated aluminum, as well as the world's largest miner of bauxite and refiner of alumina. The company is diversified across a variety of end markets: aerospace, automotive, and packaging, to name a few.

• Alcoa's cash flow generation is about what we'd expect from an average company in our coverage universe. However, the firm's financial leverage is on the high side. If cash flows begin to falter, we'd grow more cautious on the firm's overall financial health. Though the firm remains focused on prudent cash management, it still retains a massive net debt position.

• Alcoa's fundamental performance is heavily tied to volatile and unpredictable aluminum prices. The LME price for aluminum has oscillated between $1,200 to $3,200 per metric ton during the past five years alone -- a huge range. Even as the firm builds out its value-add businesses, investors should be cognizant of this fundamental volatility.

• It's easy to get caught up in the excitement of Alcoa's results during economic upswings, but economic troughs--where both volume and pricing wane--are inevitable. The strength of its aerospace end market should cushion performance in tough times, however.

Business Quality

Economic Profit Analysis

The best measure of a firm's ability to create value for shareholders is expressed by comparing its return on invested capital with its weighted average cost of capital. The gap or difference between ROIC and WACC is called the firm's economic profit spread. Alcoa's 3-year historical return on invested capital (without goodwill) is 7.2%, which is below the estimate of its cost of capital of 8.6%. As such, we assign the firm a ValueCreation™ rating of POOR. In the chart below, we show the probable path of ROIC in the years ahead based on the estimated volatility of key drivers behind the measure. The solid grey line reflects the most likely outcome, in our opinion, and represents the scenario that results in our fair value estimate.

Cash Flow Analysis

Firms that generate a free cash flow margin (free cash flow divided by total revenue) above 5% are usually considered cash cows. Alcoa's free cash flow margin has averaged about 2.1% during the past 3 years. As such, we think the firm's cash flow generation is relatively MEDIUM. The free cash flow measure shown above is derived by taking cash flow from operations less capital expenditures and differs from enterprise free cash flow (FCFF), which we use in deriving our fair value estimate for the company. For more information on the differences between these two measures, please visit our website at At Alcoa, cash flow from operations decreased about 28% from levels registered two years ago, while capital expenditures fell about 7% over the same time period.

Valuation Analysis

Our discounted cash flow model indicates that Alcoa's shares are worth between $9-$15 each. Shares continue to trade above the high end of this range. The margin of safety around our fair value estimate is driven by the firm's MEDIUM ValueRisk™ rating, which is derived from the historical volatility of key valuation drivers.

Our valuation model reflects a compound annual revenue growth rate of 3% during the next five years, a pace that is roughly in-line with the firm's 3-year historical compound annual growth rate of 3.1%. Our fair value estimate reflects a 5-year projected average operating margin of 7.3%, which is above Alcoa's trailing 3-year average. We're building in some nice revenue and earnings growth.

Beyond year 5, we assume free cash flow will grow at an annual rate of 2.2% for the next 15 years and 3% in perpetuity. For Alcoa, we use a 8.6% weighted average cost of capital to discount future free cash flows. An argument can be made that Alcoa's discount rate is too low, which if increased, would further lower our estimate of the company's intrinsic value.

Margin of Safety Analysis

Our discounted cash flow process values each firm on the basis of the present value of all future free cash flows. Although we estimate the firm's fair value at about $12 per share, every company has a range of probable fair values that's created by the uncertainty of key valuation drivers (like future revenue or earnings, for example). After all, if the future was known with certainty, we wouldn't see much volatility in the markets as stocks would trade precisely at their known fair values. Our ValueRisk™ rating sets the margin of safety or the fair value range we assign to each stock. In the graph below, we show this probable range of fair values for Alcoa. We think the firm is attractive below $9 per share (the green line), but quite expensive above $15 per share (the red line). The prices that fall along the yellow line, which includes our fair value estimate, represent a reasonable valuation for the firm, in our opinion.

Future Path of Fair Value

We estimate Alcoa's fair value at this point in time to be about $12 per share. As time passes, however, companies generate cash flow and pay out cash to shareholders in the form of dividends. The chart below compares the firm's current share price with the path of Alcoa's expected equity value per share over the next three years, assuming our long-term projections prove accurate. The range between the resulting downside fair value and upside fair value in Year 3 represents our best estimate of the value of the firm's shares three years hence. This range of potential outcomes is also subject to change over time, should our views on the firm's future cash flow potential change. The expected fair value of $16 per share in Year 3 represents our existing fair value per share of $12 increased at an annual rate of the firm's cost of equity less its dividend yield. Said differently, Alcoa could stay flat for three years, and we wouldn't think anything of it. The upside and downside ranges are derived in the same way, but from the upper and lower bounds of our fair value estimate range.

Pro Forma Financial Statements

Click to enlarge

Click to enlarge

Click to enlarge

In the spirit of transparency, we show how the performance of the Valuentum Buying Index has stacked up per underlying score as it relates to firms in the Best Ideas portfolio. Past results are not a guarantee of future performance.

Disclosure: The author has no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.