Alcoa: The Assets You Need for an Economy to Grow (NYSE: AA)
Alcoa (NYSE: AA) is well positioned to thrive as its European counterparts are forced to close.
Meanwhile, investors are concerned that there is likely to be an oversupply of aluminum in the near term caused by a slowing economic environment in the United States and China.
That being said, Alcoa’s results seem to continue to shine. Now the main question is how Alcoa will fare over the next two quarters given this slowdown in economic demand.
And are investors sufficiently compensated for this risk? At 7x a conservative multiple of free cash flow, I believe they are.
Revenue growth rates remain high
Alcoa is seeing its revenue growth rates impress positively as it beats analyst consensus to increase its revenue growth rates by 29% y/y.
Nonetheless, the stock is down sharply from the highs reached just a few months ago. It’s completely disheartening. The reason the stock has fallen so significantly is that analysts continue to expect, as they have for a few months now, that Alcoa’s revenue growth rates will quickly return to decline in the second semester 2022.
Looking ahead to the next few quarters to mid-2023, analysts expect Alcoa’s revenue growth rates to slip into negative territory.
Their estimates are based on the assumption that Alcoa’s strong revenue growth rates will once again fall below historical averages.
Nevertheless, one cannot ignore the fact that aluminum prices on the spot market have fallen sharply in recent months. This is clearly very bearish and should be considered in any investment thesis.
Despite all the comments about low aluminum inventories, this doesn’t seem to be reflected in spot market aluminum prices.
Along the same lines, we will then discuss bullish and bearish cases that investors should think about.
Alcoa short-term outlook
Everything you need to know about bullish and bearish cases is noted below.
On the supply side, there are overwhelming fears that increased production from China will lead to an oversupply of aluminum in the near term. In the meantime, the demand outlook is uncertain.
These two elements are the main bearish considerations on the supply and demand side. These two are keeping investors at bay, with stocks selling off significantly in recent days.
I would counter these considerations by arguing that Russia’s exports are significantly reduced given not only the sanctions against the country, but also the difficulty in paying Russian companies whose international banking system is taken offline, which will prevent the excess aluminum from reaching global markets.
Then there are the other considerations at hand. Namely, very high energy input costs that put a significant amount of capacity at risk.
As you can see above, Alcoa estimates that around 10-20% of Chinese aluminum production operates at negative margins.
I suspect Europe has even worse negative cash volumes, as Europe is suffering from a once-in-a-lifetime energy crisis. This makes aluminum production unprofitable and uneconomical.
Capital allocation policy
As you can see below, Alcoa recently refinanced its debt pile so that it had no short-term maturities.
Alcoa has an insignificant amount of debt to pay in 2022, and then the next pile won’t arrive until much later in 2027. That’s it!
For context, that puts his net debt at $1.2 billion. For a company that reports over $800 million in EBITDA in a quarter, this level of leverage is very manageable and not material to the investment thesis.
Given this strong financial position, Alcoa believes that having used capital for its number one priority, which is growing its business, it can return capital to shareholders.
That’s what Alcoa said on the earnings call,
We have confidence in the solidity of the company. And so we delivered shareholder returns in the second quarter because our cash balance was strong. Our cash generation has been strong and we are confident in the company’s future ability to weather cyclical storms.
And that’s why we provided it. We just announced an additional buyout of $500 million. We still have $150 million left on the pre-purchase authorization.
During the second quarter of 2022, Alcoa repurchased $275 million of stock, or 3.3% of its market capitalization returned to shareholders during the second quarter, which annualized at 13.3%.
Additionally, Alcoa is now announcing that it has increased its buyout authorization to $500 million. This is an open-ended buyback program.
This brings its total authorized buyback program to $650 million, or 7.8% of its market capitalization. Note that realistically, just because a company has announced a stock authorization program does not mean that the company will necessarily exhaust its authorization.
That being said, besides the return of capital to shareholders, it is important to keep in mind that Alcoa has very high returns on equity.
As you can see above, Alcoa’s ROE today would put many profitability profiles of so-called “asset light” cloud companies to shame.
Alcoa is reporting very strong ROE figures, supported by strong cash flow and return of capital to shareholders.
Valuation of AA shares – At a price of 8x free cash flow
For the first half of 2022, Alcoa’s EBITDA was $2 billion. That said, this high level of EBITDA has not translated into an equal and commensurate level of free cash flow. To illustrate, free cash flow for the first half of 2022 was $390 million, with the vast majority of EBITDA profitability being absorbed by working capital.
However, keep in mind that in the first quarter of 2022, Alcoa said at the time that its very large negative use of working capital would reverse throughout 2022.
And that’s exactly what you see above in the red and green boxes above, from the first to the second quarter, free cash flow has improved significantly given the improvement in working capital.
Looking ahead to the remainder of 2022, Alcoa continues to argue, as it did last quarter, that it would see improved working capital in the second half of 2022.
This could mean that Alcoa’s free cash flow would likely reach $1 billion in 2022.
Meanwhile, analysts, for their part, continue to expect around $1.4 billion in free cash flow from Alcoa in 2022. While I think that estimate is too high, I think if Alcoa could provide additional free cash flow potential, this would obviously further support its share price.
Using my $1 billion free cash flow estimate for 2022, that would price Alcoa at 8 times that year’s free cash flow.
Alcoa is a commodities company that is experiencing highly volatile demand, both due to a global economic slowdown and China’s lockdown policy due to Covid. Despite a lot of pessimism, the company seems to be performing well and generating very strong free cash flow. I believe paying 8x free cash flow for this business is cheap and an attractive multiple.
I will leave the final word to Alcoa’s management team. In a recent conference call, Alcoa said:
So we had lower metal prices, higher raw material costs, higher energy costs at Lista. And we had operational issues in Western Australia and that, I think, is going to cost us about $50 million in the third quarter. So, as I said, the third quarter is going to be tough.
I think that’s what the market is thinking about right now, the tough quarter of the third quarter. However, I am looking beyond the next six months and trying to position myself for what comes after this difficult time.
In summary, the best time to buy a cyclical stock is during these periods of negative outlook. When no one else wants to get involved. And the time to sell will be around six to nine months when the outlook starts to slowly improve.