By Joseph Hogue, CFA
Looking at the chart for Alcoa (NYSE:AA) and understanding the extreme cyclicality of the company’s line of business, I fully expected to come out of research with a buy recommendation. After a deeper look at fundamentals, while the stock does look attractive from a valuation basis, there are others within the sector that are more favorable investments.
World Leader in Aluminum
Alcoa is the world leader in production of aluminum and a top supplier of alumina. The company is engaged in the mining, refining, fabricating, and recycling of the metals and has operations in 31 countries. The sector is extremely cyclical and closely tied to growth in construction and transportation. Principal users of aluminum are food packagers, construction, and transportation. Automakers have been increasing their usage in the last few years to comply with energy-efficiency standards given the metal’s lighter weight than steel.
The sector benefited greatly from the run-up in construction during the boom and has been one of the laggards since the bust. Alcoa shares hit an all-time high of $47.35 in July of 2007, fell to $5.22 by March of 2009, and have only made it as high as $18 since the recovery. Recent weakness in global markets have driven the shares back to $9.80 per share. Despite the tough scenario over the last few years, Alcoa managed to increase sales by 21% in the third quarter of this year versus the year prior and maintain a global market share of 14.8%. As is common in a recession, the company cut production and implemented cost-cutting measures over the last few years.
Global consumption of aluminum grew at a compound average growth rate of 6.0% over the last decade. Demand should increase incrementally if global growth meets expectations for 3.1% in 2012. Alcoa projects aluminum demand will grow 12% in 2011 and Standard & Poor’s forecasts prices at $1.20 in 2012 against $1.11 in 2011. Though the metal has benefited from the economic growth in China, it has not performed as well as other metals. China became a net exporter of aluminum in 2002 and has periodically contributed to the excess global supply. Prices are somewhat tied to copper prices given substitution in the production process.
The company is almost seven times larger than the average in the industry with a market capitalization of $10.5 billion. The company trades at a price-to-earnings of 10.3 times trailing twelve-months earnings, relatively expensive compared to peers, but price-to-book looks more favorable at just 0.64 times book value.
The company is more heavily leveraged than peers with a debt-to-equity ratio of .6 times. Despite this, it still underperforms the industry average in return-on-equity. Due to its size and market share, Alcoa will have less trouble raising debt capital so it is understandable that it would be more highly levered but the lower performance ratios speak to a problem in execution.
Despite being in a fairly mature industry, the company only pays a dividend yield of 1.3% versus the industry average of 4.3%. A lower dividend yield would be acceptable if the company were able to use the cash for growth.
The stock surged 6.1% on Monday given optimism in the U.S. markets and rumors out of Europe. Any developments in the outlook for global growth will drive movements in the shares, given extreme cyclicality. The company recently expanded its Almar refinery in northern Brazil to double capacity to 3.6 million tons of alumina and has been increasing production in factories dormant throughout the recession.
Short interest is at approximately 5.1% of shares outstanding, higher than the market average and considerable given the company’s size. The overall short interest is not particularly high though and institutional holding only amounts to 59.6% of outstanding, so there is little likelihood of a short squeeze.
Standard & Poor’s has a price target of $13.00 and a buy recommendation based on P/E multiple expansion to 13.5 while earnings per share are only expected to grow to $0.96 from $0.95 in 2011. The average estimate of 18 analysts surveyed by Yahoo Finance for the next four quarters is $1.02 per share. This would put the share price at about $9.50 given current price multiples or $13.77 with multiple expansion to 13.5 times earnings. Given global economic growth and continued uncertainty in Europe, a price multiple somewhere in-between (11.5x) is probably more appropriate bringing the shares close to $11.73 per share.
Strategies for Investment
Given valuation on a price-to-book basis and the possibility for higher aluminum prices in the year ahead, a case could be made for investment. On a relative basis, there are more attractive companies within the sector which would also benefit from higher metals prices.
Noranda Aluminum Holding (NOR) has a trailing p/e of just 3.5 times and a return-on-equity of 57.9%. The company’s operating margin is also higher than Alcoa’s at 14.7% versus 6.7% and there has been significant insider purchases in the past month. Over 97% of the shares are held by institutions with 4.9% of the float sold short. This sets the stock up for a short squeeze in the event of an upside catalyst. An investment in Noranda could be hedged against a short in Alcoa to reduce the risk of further weakness in aluminum. Those still squeamish about shorting stocks should read an earlier article showing how individual investors have the advantage in the short market.
For those still bullish on Alcoa, options strategies provide a risk-adjusted entry point. Investors long in the stock can sell call options for the January 2013 strike of $10 for a premium of $2.00 per share. The strategy lowers the investor’s price in the shares from $9.80 to approximately $7.80 per share, a discount of 20.4% from the current price. At this price, and forecasted earnings, the price multiple is more in-line with the industry average. Upside gain is limited to 32.5% at $10 per share.
A put-write strategy also allows current income against a possible investment. An investor would sell a put option at the January 2013 expiration and the strike of $10.00 per share. The investor collects $2.20 per share and promises to buy the shares for at $10.00 on expiration if they have fallen below the strike. Shares would have to fall below $8.00 to reach the breakeven point, a decline of 18.4% from the current price. If shares trade above the $10 strike price at expiration, the investor keeps the premium and no further investment is necessary.
Return depends on the amount deposited in the margin account to cover possible losses. A lowered risk strategy would involve selling the puts with a strike of $7.50 at a premium of $1.04, lowering the break-even price to $6.46 per share. The cash-secured put strategy is also a favorite of mine for cheaper entry into a stock.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.