Alcoa: Why This Stock Is Undervalued

| About: Alcoa, Inc. (AA)

Alcoa (AA) is the third largest aluminum producer in the world and the biggest based in the United States. Recently, it reported a surprise net income for the first quarter of $0.09 per share versus an expected loss by its stock followers. Alcoa shares rose 6% on the news but I believe that the stock should go up even more in the next couple of years. The main reason is that Alcoa is reducing its capacity and is also undergoing a cost restructuring program which should reduce its aluminum producing costs by 10% through 2015 and the company also has a number of segments which are more profitable than its main aluminum segment. Second, the shares are trading below their price to earnings range and earnings should improve substantially in the next couple of years which should drive the share price up after a 44% decline in 2011 and a rise of around 7% year-to-date.

Alcoa is the largest domestic aluminum producer with a market capitalization of $10.5 billion, enterprise value of $18 billion, a price to earnings ratio of 18 and an annualized dividend yield of 1.2%. The company is trading near its 52-week low of $8.45 and has a 5 year trading range between $5 and $48 per share. Historically, Alcoa stock has been trading at an average of between 16 and 23 and its current price to earnings ratio is at the lower end of this range at around 18. I believe that due to efficiencies, increased demand due to higher economic activities, and a rising price of aluminum, Alcoa will earn $0.60 this year and $0.95 per share next year. Assuming the aluminum price increases by 25% from the current price of about $2,000 per tone, to $2,500 per tone, which is roughly the average price for the past five years, Alcoa should be able to earn $1 per share in 2013 and its current price implies a price to earnings ratio for 2013 of 10 or two times lower than the average price to earnings ratio of 20 which the company has been able to maintain in the past decade.

While there is no guarantee, investors should be encouraged by this double benefit that the price to earnings ratio will likely expand and the company's earnings per share will rise in the next few years. For a comparison, two other publicly trading aluminum producers are trading significantly higher compared to Alcoa. Aluminum Corporation of China (ACH) trades at a price to earnings of 163 and Alumina (AWC) at a more reasonable level of 23.5.

The reason for this undervaluation in my opinion is that Alcoa is currently undergoing a cost restructuring which will bear fruit later in the year and in 2013. In addition we are witnessing an economic recovery which has been below expectations. There are already signs that the demand for Alcoa products is increasing and I believe aluminum prices will follow as the aluminum production now is cornered by a few large producers and prices are easier to adjust based on demand. According to the World Bureau of metal statistics (registration required), the Americas account for 22% of aluminum usage and I believe this will go up as the economy continues to recover here and as Latin America's emerging economies continue to grow. Alcoa is well positioned to service these two major markets. Recently, President Obama visited Columbia where he promoted closer economic ties between the U.S. and South American countries which should benefit Alcoa directly in the coming years.

In 2011, the company reported revenues of $25 billion and net income of $611 million which compares favorably to RUSAL, a major competitor traded on the Hong Kong exchange, which reported revenue of $12.3 billion and net income of $237 million for the same period and to Rio Tinto's (RIO) aluminum segment which reported revenues of $12.2 billion and underlying earnings of $442 million.

For the first quarter of 2012, Alcoa was able to achieve profitability while many investors expected a loss and also the company disclosed that it expects continued supply deficit and aluminum demand growth of about 7% in 2012. The positive results were driven by productivity growth and achieved despite a rise in input costs. Segment by segment earnings are as follows: the alumina segment reported after-tax operating income (ATOI) of $35 million, primary metals $10 million, global rolled products was a record $96 million for a first quarter, and engineered products and solutions ATOI was $155 million.

Looking ahead, I think that all four segments will show significant improvements in the quarters to come because of rising demand, improving volume and pricing, continued productivity improvement and a stabilization in energy prices. More specifically, the company expects the aluminum and primary metals divisions to benefit from additional gains in productivity and curtailments in production with the primary metals being negatively affected by the Massena fire and other outages. Productivity gains are also expected to continue in rolled products and engineered products and solutions with rolled products benefiting from improvements in Russia and China and engineered building and construction hurt by European slow-down but helped by share gains from innovation across all sectors. The company should also benefit by improvement of the auto industry in the U.S. and beverage can packaging in Europe and China.

In conclusion, I believe Alcoa shares are a good buy at the current price level as there are a number of catalysts to drive the price up including multiples expansion, rise in economic activity and demand for aluminum, productivity and efficiency improvements and reduction in capacity. In addition, the company is building an integrated aluminum facility in Saudi Arabia which should come on line in 2013 and be completed in 2014. This is an example of how Alcoa is able to provide solutions to its customers regardless of their location and at the same time rewarding shareholders. All this makes Alcoa stock a steal under $10 per share.

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