Alcoa (NYSE:AA) is a business that is highly susceptible to global economic conditions. Declines in aluminum demand led to a fall in spot prices in Q4 2011. Consequently, the market has been quite harsh on the company’s stock, pushing it down into single digits. We have taken these factors into account in revising our price estimate for Alcoa’s stock from $16 to $14, which is still approximately 40% ahead of the current market price.
Alcoa still stands behind on its earlier forecast of aluminum consumption doubling by 2020, which translates into a 6.5 percent annual growth over the next 9 years. Global economic uncertainty may not allow aluminum to recover during the next six months, but we believe that Alcoa’s restructuring efforts and initiatives to develop high-end engineered products, as well as its focus on the automotive sector will help drive sales and allow for better operating margins going forward. Alcoa is the world leader in the production and management of primary aluminum, fabricated aluminum and alumina, and competes globally with other mining giants like Rio Tinto (NYSE:RIO) and BHP Billiton (NYSE:BHP).
Revised Estimates Reflect Alcoa’s Realigned Strategy
Alcoa is increasing its focus on its midstream flat-rolled products and its downstream engineered products, eying the huge demand potential of automotive manufacturers. Globally, there is a shift toward the use of aluminum in automobiles to reduce vehicle weights in order to achieve better fuel efficiency. Alcoa is investing significantly in research and development in order to produce better technologies and materials for vehicles. Alcoa’s joint venture with China Power Investment Corporation (CPI) to manufacture high quality engineered products also points towards the company’s shift of focus to higher margin businesses. However in the near-term the input costs here are significant.
With the rising input costs, we have lowered our forecast for EBITDA margin on alumina sales to around 11 percent over the Trefis forecast period. Consequently, the decline in the market prices will affect the Primary metal margins as well. We estimate the figure at around 8.5 percent. Flat rolled products were in demand in 2011 as well, with their average realized annual price jumping approximately 14 percent. We estimate them to hold strong going forward as well. As per our revised estimate, engineered products will witness a robust growth in of approximately 10 percent and EBITDA margins above 15 percent.
According to Trefis estimates, the primary aluminum business accounts for 29 percent of Alcoa’s value. Although the engineered products division accounts for a small percentage of company’s revenues, better profitability and increased research and development will increase its contribution to overall profits going forward. We estimate that the business accounts for 28 percent of the company’s stock value, about equal to the company’s alumina business.
Strong Long-Term Outlook
Alcoa has maintained its outlook for the next ten years, stating that global aluminum demand will double by 2020, which implies a 6.5 percent compound annual growth rate. The company posted an operating loss of $193 million in Q4 2011, but we believe that strong fundamentals and robust outlook will help Alcoa’s revenues going forward. Aluminum prices are largely driven by global economic conditions, so as the global economy eventually improves the company should post better earnings.