Basic Material Stocks: 2 'Strong Buys', 1 'Hold'

Includes: AA, ABX, WPM
by: Takeover Analyst

Given the inflationary results of unrestrained government spending, basic materials have strong positive secular trends. This is particularly true for gold, which is viewed as the natural hedge against inflation. However, price is only one piece to the revenue function. Quantity is the other piece - and it is ready to take off with several leading producers getting ready to launch various operations. In this article, I provide three different basic material companies with various degrees of upside. They cover a variety of industries: aluminum, silver, and gold. In my view, Alcoa and Barrick are "strong buys" while Silver Wheaton is a "hold".

Alcoa (NYSE:AA)

Alcoa trades at a respective 24.9x and 9.2x past and forward earnings with a dividend yield of 1.4%. To value Alcoa, I make several assumptions: (1) per annum growth trending from 13.1% to 11% over the next half decade or so, (2) operating metrics stay at historical levels, (3) a perpetual growth rate of 2.5%, and (4) a discount rate of 10%. Based on these assumptions, I find that the fair value of the stock is $12.30, implying double-digit upside.

This aluminum producer trades at only 6.7x my 2015 free cash flow estimate. With a beta of 2.1, Alcoa is also well positioned to soar when the global economy hits full employment. Given the wide spread between past and forward multiples, Alcoa also has plenty of room to appreciate even if earnings are slightly below expections.

Silver Wheaton (SLW)

Silver Wheaton trades at a respective 15x and 9.5x past and forward earnings. Consensus estimates for Silver Wheaton's EPS forecast that it will grow by 29% to $2 in 2012, grow by 27% in 2013, and then fall by 7.5% in 2014. If the company merits a multiple of 11 times and produces EPS of $2.48, the stock would fall by the double-digits. This multiple is still at a meaningful premium to its peers. In light of this premium, I would steer away from an investment for now.

While I am generally bullish on basic materials, I am more reserved on silver. Silver Wheaton is around 50% more volatile than the broader market and its dividend yield of 1.6% doesn't exactly hedge against the added risk.

Barrick Gold (NYSE:ABX)

Barrick trades at a respective 7.8x and 6x past and forward earnings with a dividend yield of 2.3%. Consensus estimates for Barrick's EPS forecast that it will grow by 3.6% to $4.84 in 2012, grow by 23.6% in 2013, and then fall by 6.4% in 2014. Assuming a multiple of 10x and a conservative 2013 EPS of $5.94, the stock would hit $59.40.

At the same time, Barrick is also incredibly safe. It is less than 60% volatile than the broader market and management has recently increased the dividend yield by an impressive 33%. There are several projects that will also catalyze free cash flow: Pueblo Viejo, Pascua-Lama, and Jabal Sayid. The first two projects are expected to contribute $2.5B annually to EBITDA over the next five years. Accordingly, I rate the stock a "strong buy".

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