Is Alcoa Really ‘Junk’?

by Aaron Levitt | June 4, 2013 8:48 am

Like much of the commodities complex, industrial metal aluminum has seen its fortune fade as the rising greenback[1], lower inflationary pressures and global growth concerns have taking the wind out of its sails. Add in overcapacity, and it’s easy to see why investors have fled the industrial metal in spades.

All in all, prices for aluminum have cratered since hitting post-recession highs back in 2011 amid all of these factors and is currently trading around 85 cents a pound — near the metal’s 52-week low.

Aluminum’s sustained and downward-drifting low price is finally beginning to have its way with the producers of the commodity as well, including industry stalwart Alcoa (AA[2]). After struggling during the past year or so, the blue chip and Dow Jones Industrial Average component received a critical debt downgrade to “junk” status.

Yet, the longer-term picture for Alcoa seems a bit rosier than Moody’s Investors Service would have you believe. So the question for investors remains: Is Alcoa really junk, or a value in the making?

Excess Supplies

It seems the world is currently flush with aluminum.

The WSJ reports that global London Mercantile Exchange-approved warehouses are filled to the brim with more than 5 million tons of aluminum. Already, producers have begun to move spill-over production to Shanghai Futures Exchange-based warehouses[3] — i.e. the market of last resort — to stockpile excess supply amid slack demand. The latest supply data from the World Bureau of Metal Statistics shows that the global aluminum market has a surplus of 317,100 tons in the first two months of the year.

That’s not sitting so pretty with producers like Noranda Aluminum (NOR[4]) or Alumina (AWC[5]). And it’s especially not tasting too sweet to Alcoa.

Those low prices and surpluses have caused AA shares to fall 16% during the past 12 months, including a 2.2% drop this year, and now are trading at the same levels as in April 2009.

Of course, a recent debt downgrade is hurting, too.

Amid the global oversupply, Moody’s downgraded the largest U.S. aluminum producer’s senior unsecured and corporate debt ratings to Ba1 from Baa3. While the ratings agency said Alcoa’s outlook was “stable,” that new credit rating firmly puts the company’s bonds squarely in the high-yield, or “junk,” category. That means the company that basically created the modern aluminum industry — back in 1888 as The Pittsburgh Reduction Company — has the same credit score bracket as unprofitable wireless broadband operator Clearwire (CLWR[6]) and troubled financial firm Royal Bank of Scotland (RBS[7]).

Overall, Moody’s pointed to challenging industry dynamics and the weakness in the aluminum industry as the reason for the downgrade and said key “debt metrics are likely to fall short of investment-grade standards through 2013 and 2014.”[8]

Still Plenty of Value

While the debt downgrade, low aluminum prices and falling stock do sting, there’s still hope for Alcoa. Perhaps even enough to make shares a potential buy.

First, the company has been serious about cost-cutting and getting its debt load under control. Alcoa’s total debt of $8.83 billion might seem high — and it is — but it’s the lowest amount of debt since 2008, when the firm’s IOU’s stood at $10.6 billion. Plus, AA is continuing to lessen the load. In July, Alcoa plans to pay off $422 million in notes and expects to change $575 million of 5.25% convertible bonds due March 2014. Those securities can be swapped for stock at about $6.43 per share.

At the same time, Alcoa also has done an excellent job reducing costs. Earlier in May, the company said it will shut two production lines at its Baie-Comeau smelter in Quebec and postpone a new line at the plant until 2019. Alcoa also is evaluating curtailing or permanently halt 460,000 metric tons (or nearly 11%) of its annual smelting capacity by the end of next year. This is on top of reducing smelting capacity by in 2012 with cutbacks in facilities located in Tennessee, Texas, Italy and Spain.

Also, more and more of Alcoa’s earnings have come from its engineered products business. This unit manufacturers wheels, aircraft parts and other lightweight yet strong goods, and has been more profitable than the company’s upstream aluminum business. AA has continued to tap this segment more and more, leaving some analysts speculating that Alcoa could offload raw material assets to help pay down debt faster.

Finally, Alcoa is cheap and still profitable. Back in April, the company reported a 59% increase in first-quarter net income. That beat analysts’ expectations and was driven by — ta-da! — both efficiency measures and gains in its engineering division. That earnings growth follows 2012’s fourth quarter year-over-year surge of 220%. Despite low aluminum prices, Alcoa continues to generate profits and cash flows — something that can’t be said for rivals like Aluminum Corporation of China (ACH[9]) or Chalco.

All in all, Alcoa can currently be had at just 12 times next year’s earnings thanks to a share price that’s hovering at 2009 levels. Meanwhile, the company’s longer-term outlook and debt loads are much better.

While AA does have plenty of work to do, for that cheap price[10], investors have a nice margin of safety. Considering the firm controls about 15% of global aluminum production, that’s a pretty good bet indeed.

As of this writing, Aaron Levitt did not hold a position in any of the aforementioned securities.

  1. rising greenback:
  2. AA:
  3. move spill-over production to Shanghai Futures Exchange-based warehouses:
  4. NOR:
  5. AWC:
  6. CLWR:
  7. RBS:
  8. “debt metrics are likely to fall short of investment-grade standards through 2013 and 2014.”:
  9. ACH:
  10. for that cheap price:

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