Alcoa (NYSE: AA)

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Alcoa (NYSE: AA)

Post  Max on Mon Sep 13, 2010 9:31 pm

I was recently asked to look into Alcoa, so here is the analysis.

Financial statements are very detailed, but do not give away much in terms of hints. Basically, the prospects of Alcoa are dependent entirely on the price (and more importantly the demand) for Aluminum. It is a dangerous time to be in manufacturing and even more so to be an such a narrowly defined business as this. The future is highly uncertain and a prolonged period of low Aluminum prices can be disastrous for this company. While I see some evidence of prudent hedging programs in place, it only makes prices more stable and reduces the chances of Alcoa participating in a sudden rise in Aluminum prices.

Income is negative, and has been for some time now. It really all depends on the price of Aluminum and a return to global growth and demand for materials. Alcoa has stopped factoring receivables, which can increase profits, but also exposes them to significant risk of default.

I worry particularly about China turning into a net exporter of Aluminum among many other goods and the permanent effect this will have on the perhaps less competitive US industry. The wave of consolidations in the industry are usually a sign that profits are running out, and companies are forced to buy growth rather than earn it organically. Also, the company is completing layoffs over the last three years that have terminated approx 10,000 employees. While this looks great on paper, it can cause loss of efficiency due to low morale and loss of skilled worker, and increased cost from severance packages.

So that sets the background long term picture, but its not all bad news for Alcoa. Looking at the book value, it shows approx $12 per share. Despite the need to adjust this significantly downwawrds since a lot of the value is property, plant and equipment, I think we could reasonably assume there is pretty good downside protection, especially since it has already fallen from around $40 to $11.50.

With 1 Billion shares out, it will take a lot of dilution to have an effect on the share price. A 100,000,0000 share issuance at $10 per share would dilute the stock only 10% and would raise $1 Billion. However, this same effect works against us in terms of profits. A $500 Million profit next year (vs. $50 Million loss so far this year) would still be a 20x PE multiple, which shows that the stock is certainly not cheap based on earnings alone.

Being an old and established company, pension liabilities are something to worry about. They may have some of the same issues as Manulife regarding low interest rates and how that would force them to increase their future liability provisions, since you need more money now to fund the pension if interest rates stay low.

Overall, I am neutral on the stock. It has a chance to jump up based on stock price alone, which could be driven by a swing to profit. While it does not look like the stock will decline too much further from here, there is little I can see in the fundamentals to justify owning it.

Short term speculation is a possibility, but you risk getting stuck in the stock for a very long time trying to get your money back.

Max
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