Wall Street analysts are currently showing no love for three major aluminum miners. Given macro headwinds, cost pressures, and high volatility, the consensus is that the vulnerable fundamentals of Alcoa (AA), Norsk Hydro (OTC:NHYDY) and Century Aluminum (CENX) all warrant a "hold" rating. I agree with this sentiment and find that based on earnings potential and multiples expansion, the companies are more skewed towards risk than reward (see here).
From a multiples perspective, Hydro is the cheaper of the three, as it trades at only 6.5x past earnings. In addition, the company also hedges against risk due to having ideal exposure to emerging Asia, the highest dividend yield at 2.7%, and the lowest beta at 2. Century Aluminum and Alcoa, meanwhile, trade at a respective 8.6x and 10.1x past earnings.
At the third quarter earnings call, Hydro's CEO, Svein Brandtzaeg noted operational progress amidst a challenging environment:
"And the third quarter represented an additional important step towards the nameplate capacities. But we also are seeing the development in the macro economy has – now impacting the market beyond what is not only a seasonal weaker quarter. We also see that our customers are more cautious and the uncertainty is now gradually affecting the market situation.
Highlights from the third quarter is of course done that we have underlying habit of 1.646 million which is 260 million less than the second quarter and 700 million above the third quarter last year. Bauxite and alumina production increased with respectively 13% and 7% during the quarter, which adds to the improvement we did from the first to the second quarter this year".
As China becomes increasingly reliant on importation of raw materials, Hydro is in the best position of the three to benefit from improved pricing. Even still, the firm still has a limited ability to grow shareholder value. Consensus estimates for Hydro's EPS are that it will grow by 63.6% to $0.36 in 2011 and then hold flat the following year. Assuming the multiple soars to 11x and a conservative 2012 EPS of $0.34, the rough intrinsic value for the stock is $3.74, implying downside.
I am similarly pessimistic about Century, which faces considerable expenses in carbon pitch and calcine coke. Third quarter earnings were disappointing and the company is most exposed to macro headwinds due to its lack of diversification and losses. I find that of the three, Century Aluminum has the greatest downside.
Consensus estimates for Century Aluminum's EPS are that it will decline by 74.3% to $0.28 and then grow by 128.6% and 89.1% in the following two years. Even if the multiple rises to 11x and 2012 EPS turns out to be 15.6% above the consensus, the stock would still fall by 11%. Accordingly, I recommend holding out.
Alcoa is the safest, in my view, due to its brand and strategic efforts. While I anticipate volatile free cash flow and cash burn (see here), the company is doing its best to focus on long-term growth. The $300M investment in Davenport Works suggests confidence by management that it conditions will improve. Although Alcoa benefits from a foreign exchange effect, the company is not well hedged against inflationary input pressure. Fourth quarter aluminum price were weak, averaging $0.97 per pound for 15-day lag. I anticipate pricing improving to around $1.17 per pound in 2012. Alcoa is not sitting patiently to the whims of the market, however, and has streamlined its business to maximize returns. It is starting to exit underperforming businesses, mitigating the connection between LME aluminum and alumina prices, and focusing on downstream acquisitions to unlock synergistic value.
Consensus estimates for Alcoa's EPS are that it will grow by 42.6% to $0.77 and then by 14.3% and 28.4% more in the following two years. Of the 7 revisions to estimates, all have gone down for a net change of 7.5%. Assuming a multiple of 11x and a conservative 2012 EPS of $0.83, the rough intrinsic value of the stock is $9.13, implying 3.4% downside. If the multiple were to decline to 8.5x and 2012 EPS turns out to be 9.1% below consensus, the stock would fall by 28%.