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Using the Value Line Page: Are Alcoa’s Strong Earnings a Harbinger of Good Things - January 14, 2011
As the Business Description section of Value Line’s research report on Alcoa (AA – Free Value Line Research Report) highlights, the company is a global leader in the production of aluminum. It supplies the aerospace, automotive, building and construction, commercial transportation, and industrial markets. A truly global competitor, Alcoa has more than 300 operating and sales locations in over 35 countries.
Although sales of aluminum and alumina account for more than three-fourths of Alcoa’s total revenues, it also produces non-aluminum products, such as precision castings and fasteners for the aerospace and industrial markets. The company operations consist of four worldwide reportable segments: Alumina, Primary Metals, Flat-Rolled Products, and Engineered Products and Solutions.
One interesting thing to note about Alcoa is that it is one of the first large companies to report earnings each quarter. Moreover, since companies in many industries, including the aerospace, automotive, beverage, commercial construction, and gas sectors, use aluminum produced by Alcoa, demand for its products is a good gauge of the performance of companies in those businesses. As a result, a strong earnings performance by Alcoa is considered a bullish signal for the stock market overall. Thus, the company is an important bellwether for both earnings season and the broader economy.
In the just started fourth-quarter earnings season, which includes full-year results for calendar year companies, Alcoa reported upbeat earnings. Earnings per share for the December period were $0.24, compared with our estimate of $0.15 and the year-earlier loss of $0.27. The solid performance can be attributed, in part, to better pricing for aluminum, indicating, it seems, that economies around the world are on the road to recovery. The company also benefited from ongoing restructuring initiatives that have included divestitures of noncore assets. But a weaker U.S. dollar and escalating costs for raw materials and energy somewhat offset the aforementioned positives. Even so, share net for the year, as a whole, rose to $0.24, which marked a major turnaround from the 2009 deficit of $1.06. Notably, Alcoa generated free cash flow of $1.2 billion in 2010, which was its highest level since 2003—which was achieved well before the start of the recent recession (noted by the shaded area in the Graph).
Value Line analyst Frederick Harris believes that the momentum will continue this year. In his earnings update for the company (Alcoa Fourth Quarter Earnings Update), he highlights the fact that a number of the company's end markets have been strengthening, including aerospace and automotive. Ongoing streamlining efforts (which would include a sharp reduction in capital expenditures) should also help, he reasons. Unfortunately, Harris expects the costs for raw materials and energy will remain high. But despite those potential headwinds, he expects share net to climb to $0.90 in 2011.
The $0.90 estimate is an update of the $0.70 Harris had been expecting just prior to the earnings release. The old figure can be found in bold face in the 2011 column of the Statistical Array or in the “Full Year” column for 2011 in the Quarterly Earnings box. Value Line analysts update the full reports with supplementary reports anytime a newsworthy event takes place. These updates can be found daily online or, for those who prefer hard copy, a summary of the week’s important corporate specific news is included in the back of the Ratings & Reports section of the printed product.
Does this upward earnings revision make bellwether Alcoa a good buy?
For starters, Harris’ upbeat view to mid-decade, explained in more detail both in the Analyst Comment section of the recent research report and in the earnings update, remains intact. In short, he expects the expanding middle class in China, Brazil, India, and other developing countries to boost demand for companies that use Alcoa’s products in their manufacturing processes. Moreover, a decent balance sheet should allow the company to expand through acquisition.
Alcoa’s more than $9 billion of debt makes up about 40% of Alcoa’s capital structure (both figures can be found in the Capital Structure box). Although both figures would appear high when compared to industries such as technology, Alcoa’s business is capital intensive, which makes the 40% figure much more reasonable and allows ample room for bolt-on acquisitions.
Note, however, that the capital-intensive nature of the company’s business also results in a fair amount of leverage on the earnings front, which can be good and bad. In good times, the company’s earnings can rocket higher as a largely fixed-cost base is exploited. In difficult times, just covering costs can be a challenge—the recession led to such an earnings decline. Indeed, the Statistical Array clearly shows how earnings fell from $2.95 a share in 2007 to a loss of $1.06 a share in 2009. This variability is one of the important factors behind the company middling Financial Strength and Earnings Predictability scores, found in the Rating box at the bottom right of the page.
When looking comprehensively at the company, Harris believes the current stock quotation provides for worthwhile long-term recovery potential. Moreover, he expects the company to begin increasing the dividend in the next three to five years, boost the total return potential. The Statistical Array shows Harris’s three-to-five year dividend projection of $0.25 per share, which represents a-more-than 100% increase from the current level, in the far right column.
Harris’ earnings projection over the three- to five-year period of $1.60, also shown in the far right column of the Statistical Array, now rests at the low end of a range that could go as high as $1.80. However, Harris isn’t yet comfortable enough to materially increase the $1.60 number, as Alcoa’s earnings are highly sensitive to fluctuations in the price of aluminum. This fact is also what leads him to recommend Alcoa shares only for investors able to tolerate large price swings.
At the time of this article's writing, the author did not have positions in any of the companies mentioned.