Earnings Kick Off - Can Alcoa Foil Its Skeptics?

Investors are anxiously awaiting kick-off of the second quarter earnings season and DJIA component Alcoa (AA) will set the tone with a conference call today at 5 p.m. There is much trepidation as to what second quarter earnings will look like with the strain of high energy costs and sluggish growth prospects for the economy as a whole. Much like the broad economy, Alcoa has been hampered by high energy prices as well as increased raw material costs. To make matters worse, the price of aluminum—Alcoa’s core product—which had enjoyed a nice run-up in the commodity boom, is showing signs of cooling off (link). The prognosis for Alcoa is not rosy in the short term, as it is expected to have earnings fall from last quarter’s results. Clearly, some of these concerns have already been priced into the stock as AA has dropped more than 20% from its recent high of nearly $45 on May 19^th. No doubt it has been an interesting beginning to Klaus Kleinfeld’s term as CEO; he took over at the helm on May 8^th.

Alcoa has been the beneficiary of the rising price of aluminum, which enabled the company to not be quite so concerned about input costs. However, if indeed the price of aluminum has stopped climbing, Alcoa will get squeezed.  Alcoa’s foreign rivals—UC Rusal and the aluminum subsidiary of Rio Tinto—have been more proactive in cutting costs and have made headway into finding cheaper energy solutions in Russia and China. Now, Alcoa appears to be behind the curve on reducing costs in the event that aluminum prices hit a lull, as we are starting to see now. All of this is to say that, although each of these companies will feel the added pressure of recent aluminum price declines, Alcoa faces a greater risk of earnings suppression than its competitors.

Now, to be fair, Alcoa shares do have fair appreciation potential over the long-term. The emerging markets of China, India, and Russia are all going to require vast amounts of aluminum and other materials to build infrastructure and, although there is significant weakness in the U.S. and European markets for aluminum, we expect demand to come around as building conditions improve. In addition, the stock is not overvalued; at this point it is trading at the lower range of its historically normal valuation metrics and is selling at less than 13 times earnings. So, using Ockham’s value investing methodology, we rate AA a Buy but that does not equate to a recommendation to buy—at least not at this time. We expect a rough earnings call this afternoon for the reasons listed above and it is reasonably likely that the company could miss the earnings guidance that it had already revised downward. Alcoa recently lowered earnings guidance by 2 cents, while many analysts are anticipating much worse than that. We expect the earnings to disappoint, maybe only slightly but further cautious guidance will be enough to sink the stock even more over the short-term.