Alcoa Stock Still Could Be a Value in Waiting

by Aaron Levitt | October 8, 2013 8:29 am

This year hasn’t been too kind to former economic bellwether[1] and aluminum producer Alcoa (AA[2]).

As the global economy continues to grapple with slowing growth, demand for aluminum[3] has plunged. That in turn has hampered the company’s earnings, which has led to soft prices for Alcoa stock. Lower share prices beget analyst downgrades, which weighs on share prices further, and … well, that’s how you have AA in the red amid a double-digit performance from the broader indices.

However, with Alcoa getting ready to kick off earnings season[4] for the first time as non-Dow Jones Industrial Average component for the first time since 1959, it’s still not a given that AA is dead money.

Booted From the Dow

Despite being a useless measure of stock market performance, the Dow Jones Industrial Average still holds plenty of significance for many investors. So when Alcoa was booted from the Dow[5], it was seen by many as a truly pivotal moment (for the worse) in AA stock history.

That “booting” comes after a horrendous period for the aluminum market. Slowing demand in key regions like China and Europe have caused warehouses to remain plenty stocked, putting the pinch on aluminum prices. All in all, aluminum has cratered since hitting post-recession highs back in 2011 and currently is trading around $1,789 per ton. Sure, that’s a slight improvement from previous months, but still close to the metal’s 52-week low.

Unsurprisingly, Alcoa’s earnings have reflected that drop in prices, and analysts have been quick to downgrade the firm’s chances.

The latest hit came from Morgan Stanley, which downgraded Alcoa stock to “equal weight” from “overweight” based on continued lower aluminum price forecasts. This echoes a reiterated “underperform” rating from RBC and a downgrade from Deutsche Bank — the latter believes AA is more than 30% overvalued at current prices.

Alcoa’s debt was even downgraded to “junk” status[6] by Moody’s back in July.

Anyone expecting relief might not get it when Alcoa reports third-quarter earnings, for which estimates are pretty dour. Aluminum prices took another dive during the most recent quarter and were significantly lower than they were during the second quarter of the year. That should have reduced the amount Alcoa could have charged for its production. As such, according to data provider FactSet, analysts expect AA to earn 6 cents per share[7].

With Wall Street essentially writing the former industrial titan off, Alcoa is nothing more than a relic of a former age, right?

Lower Prices Baked In

That would be a big, fat “no” — especially for those with a longer-term horizon.

Certainly, the cyclical downswing in aluminum demand is crushing Alcoa stock, which is sitting at fresh multiyear lows. But these lows might be a bargain hunter’s dream.

Despite not being Dow-worthy, Alcoa still holds respective 17% and 8% shares of the global alumina market and global primary aluminum output — it’s no slouch junior producer. Thus, a rebound in prices should be a significant tailwind for Alcoa stock.

Secondly, Alcoa continues to execute on its strategy of cutting costs and reducing its hefty debt load, both of which are helping with the aluminum producer’s cash situation. AA recorded $228 million in free cash flows last quarter, and sits on about $1.2 billion in cash. Most importantly, Alcoa stock remains profitable — unlike rivals Aluminum Corporation of China (ACH[8]) and Century Aluminum (CENX[9]).

Those are all big pluses in the investment department.

Finally (and for what it’s worth), Alcoa investors might have history on their side. According to a recent Wall Street Journal article[10], Dow components that are exiled from the bellwether index actually end up outperforming the index, with only a few exceptions. That’s because of the market’s general “value” bias. When most firms are kicked out of the index, they generally are considered out of favor with investors. Thus, they’re usually cheap when compared to the firms that are recently added to the index. During subsequent years, these true “Dogs of the Dow” could be the best bets for investors.

Alcoa currently trades at 18 times next year’s earnings, which isn’t rock-bottom cheap. However, given the potential for rising aluminum demand, AA shares still could be on the floor as we speak.

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

  1. former economic bellwether:
  2. AA:
  3. demand for aluminum:
  4. earnings season:
  5. Alcoa was booted from the Dow:
  6. Alcoa’s debt was even downgraded to “junk” status:
  7. analysts expect AA to earn 6 cents per share:
  8. ACH:
  9. CENX:
  10. recent Wall Street Journal article:

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