Aloca: The Tallest Guy on A Sinking Ship?

Just like Helen Thomas got to ask the first question to start every White House press briefing, CNBC will not officially kickoff the earnings season until Alcoa made its earnings announcement.  Alcoa (NYSE: AA), the bellwether of cyclical companies, is the world’s leading producers of aluminum, alumina, and fabricated aluminum products.

We are not necessarily excited about its 4Q15 EPS of $0.04 beating the consensus of $0.02, but we are definitely alarmed by the magnitude drop from FY 2014 earnings $0.91 to 2016’s estimated $0.15.  In 2015, citing prolonged international aluminum price declines, Alcoa has threatened to shut down the smelting operations in Massena, Intalco, and Portland (Australia), to name a few.

Critics may argue that it is yet another one of Alcoa’s ploys to negotiate for government subsidies.  But, the fact remains that, after a long-term structural and systemic decline in the US aluminum industry, this may be the beginning of the end for one of the last few surviving basic metal industries in the U.S.

With softening demands and excess supply, aluminum prices have fallen 18% since 2014.  Over the same period, Alcoa’s revenue has decreased by at least 20%, earnings have dropped 75%, and the stock is nearly cut in half. The high correlation is a fact of life, as commodity stocks trade like the underlying commodity.

In an effort to reduce the correlation, Alcoa has announced that it will divide the company into an upstream (commodity-side) company and a downstream (value-add) company, including the aerospace, automotive, and technology business.  We believe it is a smart strategic move, since the separation effectively reduces the company’s exposure to underlying commodity price swings.

The downstream business, which has a higher profit margin, has seen significant growth since the recent $1.5 billion contract with GE, a new supply agreement with Boeing, and the acquisitions of RTI International Metals and Firth Rixson.  The growth totaled around $10 billion contracts in aerospace contracts since 2015.

We also believe that the upstream business should follow suit to scale back, instead, by cutting down its capacity in order to improve its cost structure.  The better efficiency of the upstream business will put Alcoa in a much better position to weather a drawn out decline in aluminum prices.  Although, even after the spinoff is executed (scheduled to be in the back half of 2016), Alcoa will still have over 40% exposure in the commodity.  This is a choice that Alcoa’s shareholders and management have made.

Ok, looks like the breakup makes strategic sense. But to AA shareholders, does it add value?   With $22.5 billion of revenue in 2015 ($9 vs. $13.5 billion between up & downstream), a market cap of $10.3 billion would suggest that AA shareholders pay 46 cents for every dollar Alcoa’s revenue.  In the meantime, with typical metal stocks trading about $0.85 on $1 revenue and aerospace stocks $1 for $1 revenue, the spinoff seems to be an inexpensive proposition to buy in.

The realistic expectation should be that, for such a major business model change, it will take time to see the intended effect.   However, for anyone older than 40 years, it is hard not to remember U.S. Steel, another U.S. major metal company, which has spun off its oil & gas business in 2001. Today, U.S. Steel produces less steel than it did in 1902.  Draw your own parallel if you wish.

One just cannot resist to draw another parallel between Saudi’s unwillingness to cut production in oil and China’s ramping up its dumping in aluminum.  Both contribute to the inevitable major commodity price plunges.  Even if the bullish outlook of the aluminum primary market prices comes to fruition in 2016, Alcoa and its stock may not bounce back overnight.

The real challenge is that after investment cash flow has been significantly curtailed in recent years, next 5-year operation cash inflow will be delayed too.  The same concern arises for any commodity company’s lack of the ability to generate positive cash flow in the near future after persistent, deep drops in prices.  Oh!  Moody’s has recently put Alcoa and other miners on ratings watch and warnings of a possible cut to its credit rating.

As U.S. Steel cannot escape its major downsize even with ‘United States’ in its name, Alcoa may not be able to alter its destiny with its cool ‘AA’ stock ticker.  At this point, we may say that Alcoa, at best, is the tallest guy on a sinking ship.



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