Stay The Course: Alcoa's 1Q Results Support The Overweight Aerospace Position

| About: Alcoa, Inc. (AA)

Alcoa kicked off first-quarter earnings season with a solid report. Despite views that first-quarter earnings growth will be meager and almost negligible absent Apple (AAPL), we strongly disagree. We expect continued strong performance out of the cyclical aerospace sector coupled with improving earnings from the energy firms levered to oil. Alcoa, for example, posted $0.09 in earnings per share during the period versus consensus expectations of a $0.04 per share loss. But we had been expecting the earnings beat from the aluminum giant, and our fair value estimate for Alcoa remains unchanged following the report.

We view Alcoa's report more important for interpreting how certain end markets are performing than anything else. With that said, Alcoa reported year-over-year revenue growth in many of its major end markets, namely commercial transportation (up 32%), aerospace (up 15%), and automotive (up 7%). However, revenues declined 14% in its industrial products end market and fell 5% in its building and construction end market.

Importantly and pertinent to our overweight exposure to aerospace in our Best Ideas portfolio, Alcoa upped its 2012 global growth forecast for the aerospace market 3 percentage points and now expects that end market to see as much as 14% revenue expansion for the year. This is no surprise to us, and we view such a guidance increase as further support for our positions in Precision Castparts (PCP)--which competes indirectly with Alcoa--Astronics (ATRO), and micro-cap play EDAC Technologies (EDAC)--which remains heavily levered to industrial conglomerate United Technologies (UTX). Here's what Alcoa had to say on its conference call about the strength of aerospace:

Let's start with aerospace. I mean, we have increased our growth projection by 3 percentage points to 13% to 14% growth this year. This is mainly driven by a stronger performance of the segment of large commercial aircraft, which now has a combined backlog, Boeing and Airbus that is, of over 8,400 aircraft. So that's the equivalent of more than 8 years. But we also see, and that's new this quarter, that the business jet segment is coming back. We expect a growth of around 8%. However, this -- the growth from business jet was pretty much offset by the anticipated decline in the military output.

As it relates to other end markets, Alcoa expects global growth in the automotive segment to advance between 3% and 7%, commercial transportation segment to increase 1% to 5%, packaging to expand as much as 3%, building and construction to edge higher roughly 3.5% on the high end, and revenue in its industrial gas turbine markets to be roughly 1.5% higher than the year-ago period at the mid-point of its guidance range. We expect Alcoa to potentially raise its end market guidance for the automotive sector later this year based on sales trends from the automakers we've seen this year. In fact, it already did so in North America, upping its forecast 2 percentage points to the range of 7% to 12% expansion during 2012. The aluminum giant mentioned some weakness in the automotive sector in Europe and China, but here's what Alcoa had to say about North America on its conference call:

The year started strong, well, the first time since March 2008 that the seasonally adjusted selling rate topped 15 million vehicles in February. The run rate is not quite exactly there at the 14.5 million vehicles for the first 3 months. This is really still driven by the unusually high average fleet rate -- fleet age, 10.6 years today versus the 10-year average of 9.4 years.

Another positive sign, by the way, is that the vehicle incentives are down around 15% versus the first two months in 2011. And another (piece of) good news here that shows the strength in America will most likely continue is that inventories are below historic norms in March, 57 days. The historic norm is around 60 to 65 days. Good news.

For global aluminum demand, in general, Alcoa still expects 7% expansion during 2012 (slightly lower than the 10% pace achieved in 2011). On its call, the firm mentioned that it expects China and Asia to grow 1% lower than its previous expectations of 12%, but such double-digit growth (11%) for the region is still robust. Alcoa thinks a global aluminum supply deficit will persist during the year, though pricing continues to be a problem for the company even as it sheds alumina refining capacity. In its first quarter, for example, Alcoa experienced a 9% drop in the realized price of aluminum and a 13% fall in the realized price of alumina.

All things considered, Alcoa showed improved performance and indicated strength in the aerospace and automotive sectors. However, we prefer firms that have some pricing power and are less exposed to drastic swings in the economic cycle. Even though Alcoa boasts nice exposure to the aerospace sector, we think there are much better ways to play in that space, with Astronics and AAR Corp (AIR) currently undervalued. We could also see Precision Castparts rise to over $200 based on valuation and EDAC Tech reach the mid-teens. And as it relates to the auto sector, we like Ford (F) as one particular way to capitalize on the market's realization that pent-up demand for autos will be met.

With a large cash position in our Best Ideas portfolio, we're looking to capitalize on opportunities that Mr. Market presents during the ongoing pullback. Stay tuned.

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Valuentum Securities Inc. is an independent investment research provider, offering premium equity reports and dividend reports, as well as commentary across all sectors/companies, a Best Ideas Newsletter (spanning market caps, asset classes), a Dividend Growth Newsletter, business/investing book reviews pre-public release, modeling tools/products, and more. Independence and integrity remain our core, and we strive to be a champion of the investor. Valuentum is based in the Chicagoland area.


I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

Additional disclosure: Some of the firms included in this article may be included in our actively-managed portfolios.