Alcoa: This Time Is Different

Summary

• Commodities are very cheap and have positive momentum.
• Alcoa is a pure commodity play after the break-up with Arconic.
• Due to cost cutting Alcoa is in good shape to profit from rising commodity prices.

Time for value?

I'm not telling something new when I say that the US stock market is not cheap. The numbers in Exhibit 1 speak for themselves.

Exhibit 1: Worldwide valuations

This leaves US equity-investors two options:

1. Invest in foreign stocks and/or
2. Invest in US value stocks.

According to Franklin Templeton there's a strong historical relationship between value and non-US equities. Over the past two decades, non-US stocks have tended to outperform US stocks when value starts to work. Based on a positive outlook for commodities in general and aluminium in particular, Alcoa (NYSE: NYSE:AA) is trading at a forward PE of less than 10.

Commodities: at the start of a bull market

The most interesting investments are those that are at the same time undervalued and trending up. Do commodities fit into this category?

Let's first take a look at valuation. As we can see in exhibit 2, commodities are at a multi-year low compared to equities. The last time commodities were this cheap, was at the height of the dotcom-bubble.

Exhibit 2: Commodity cheapness

In the years after 2000 the Goldman Sachs Commodity Index quintupled...

When we look at the price chart of PowerShares DB Commodity Index Tracking ETF (DBC) we can clearly see that after the lows at the end of 2016, commodities are slowly but firmly trending higher.

Exhibit 3: Commodity uptrend

The investment clock

Is it a coincidence that commodities started trending up at the end of 2016, the moment the FED raised the rates a first time?

Exhibit 4: US Fed Funds Rate

According to the investment clock-theory, commodities are the best asset class in the overheat-phase. In this phase of the economic cycle, inflation picks up and central banks start raising rates.

Exhibit 5: The Investment Clock

Aluminium: the only way is up?

One commodity that is certainly on the rise, is aluminium.

Exhibit 6: Aluminium Price Chart

Exhibit 6 doesn't only show that momentum is positive for aluminium, it also makes clear that recessions are bad!

When we look at James Picerno's Recession Probability Estimate, we can only conclude that a recession is not around the corner.

Exhibit 7: Recession Probability Estimate

To the contrary, the global economic growth is very strong for the moment.

Exhibit 8: Global economic growth

The major regions in the developed markets have PMI's above 50 which indicates their economies are in expansion.

Exhibit 9: Developed world PMI

In the emerging markets, the picture is a bit mixed, with China and Russia in expansionary territory while the PMI's in Brazil and India are below 50, but improving.

Exhibit 10: Emerging market PMI

According to Alcoa, the aluminium-market is in balance (as is the case for bauxite and alumina). This supply/demand balance coupled with strong global economic growth leads to inventories coming down and prices going up.

Exhibit 11: Aluminium Inventories

For aluminium-players like Alcoa, the picture would be perfect if the premiums for physical delivery also start rising. And they are at least already ticking up a bit.

Exhibit 12: Aluminium Premiums for physical delivery

Exhibit 13: Alcoa's Regional Premiums Allocation

When we look at aluminum's production process, bauxite is refined to alumina. Then, the alumina is processed into aluminum.

Exhibit 14: Alcoa's value chain

Because Alcoa is selling part of its Alumina-production to third parties, rising alumina-prices are good news for Alcoa. And this is indeed the case!

Exhibit 15: Alumina Price Chart

China: pollution production cuts

China plans to curtail some of its aluminum capacity to mitigate the country's rising pollution levels, especially during the winter months. According to Reuters, the prospect of significant aluminum production capacity being closed by Chinese policy-makers is "an unprecedented supply side shock for aluminum". This will be even more so if these measures would remain in place until the Winter Olympics of 2022, which are held in … Beijing, China.

Alcoa: this time is different

This time is different. The most dangerous four words in finance. And still we are using them because we believe that Alcoa has never been in a better position and in better shape to profit from rising commodity prices.

One year ago the old Alcoa was broken up in two parts: Arconic (NYSE: ARNC) and Alcoa. While the former included all the fast-growing, high margin value added business, the latter kept the slow-growth, cyclical aluminum business. This means that Alcoa is now a pure commodity play with full exposure to the vagaries of the aluminium-market.

On top of that has Alcoa been restructuring and reducing costs. In the alumina global cost curve Alcoa went from the 30th percentile in 2010 to 12th now. In aluminum, it shifted from the 51st percentile to the 37th now. This means Alcoa has never been in better shape to profit from a rising commodity-market!

Exhibit 16: Alcoa's global cost curve positions

Valuation and price target

We expect Alcoa to have earnings per share of $3.25 and $4.95 for this and next year. This means Alcoa trades currently at a forward PE of only 9.6 versus 21.1 for the S&P 500. We expect Alcoa to generate free cash flows of $958 and $1,327 million for this and next year.

Exhibit 17: Free cash flow projections

We do not expect a recession anytime soon, but this doesn't mean we think there will not be one in the coming years. That's why we factor in a serious dip in our free cash flow forecast in 2022. Why 2022? Your guess is as good as mine, but…

The best cure for rising commodity prices are rising commodity prices. Adding capacity leads to increased supply and lower prices. But remember: this time is different. We expect that China will not add capacity before the Winter Olympics of 2022…

Based on our above free cash flow projections, an expected equity market return of 4.08%, a beta of 1.86 and a WACC of 5.60%, we arrive at a price target of $60, which gives an upside potential of 26% and implies a forward PE of (only) 12.

Bonus-card: Trump!

And then we haven't talked about Trump and his (announced) policy measures. First of all there are his plans for increased infrastructure spending, which off course would be good news for Alcoa.

Trump is also taking a tougher stance regarding alleged dumping on the American market. Only a few days ago, the U.S. Commerce Department announced a preliminary finding that China dumped aluminum foil on the U.S. market, and it imposed duties of 97%-162%. Again good news for Alcoa.

And last but not least: Trump's tax reform. On November 2, 2017, the House Ways and Means Committee released its tax reform plan. It's based on the Trump administration plan released on September 27, 2017. The plan would reduce the corporate tax rate from 35% to 20%. This would certainly be good news for Alcoa, given its current tax rate of … 39%. If we would lower Alcoa's tax rate in our DCF-calculation to 35% our target price would rise to 65!

Price momentum

On the price of both iPath Dow Jones-UBS Aluminum Total Return Sub-Index ETN (JJU) and Alcoa (NYSE: AA) we can see that the momentum is clearly positive.

Exhibit 18: JJU Price Chart

Exhibit 19: Alcoa Price Chart

Conclusion

The combination of:

• Cheap commodity markets with positive momentum,
• Global economic growth,
• Favorable supply/demand conditions in the aluminium-market and
• Alcoa being a pure and cost-efficient commodity play

should reward investors: buy Alcoa!

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This article provides opinions and information, but does not contain recommendations or personal investment advice to any specific person for any particular purpose. The information provided is for educational purposes only and does not constitute a recommendation of the suitability of any investment strategy for a particular investor.

Analyst’s Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.