Alcoa Earnings Open Room for Downside

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Earnings season traditionally opens up with Alcoa's (NYSE: AA  )  report. This quarter Alcoa negatively surprised investors, reporting an adjusted net income of $0.04 per share, 33% below analysts' expectations. The company's shares have had a spectacular run that began in October, but I think the future of this trend is now in danger.

Low prices continue to pressure profitability
Aluminum prices continued their decline in the fourth quarter of 2013. Alcoa is responding to this trend by expanding the role of its value-add businesses, which brought 57% of revenue in the fourth quarter. Alcoa also stated that it gained $1.1 billion in productivity improvements in 2013. However, lower prices mostly erased those gains.

Alcoa expects a 7% growth in global aluminum demand in 2014. It's worth noting that last year's demand growth was also 7%, but it didn't help prices. Some market players like Vale (NYSE: VALE  ) seem not to believe in the price rebound in the near future. Vale recently sold all of its shares in Norwegian aluminum producer Norsk Hydro.

Alcoa also stated that it sees 2% surplus supply at the alumina market. The company also mentioned that several new factories will begin production in 2014. However, some factories are leaving the market at the same time. A month ago, Rio Tinto (NYSE: RIO  ) announced the suspension of alumina production at its Gove refinery in Australia. All in all, it doesn't look like market conditions are going to meaningfully improve in 2014.

All eyes on the value-add businesses
In such an environment, Alcoa must extract growth from its value-add products. The company is very optimistic about the auto industry shift to lightweight vehicles, which will increase the percentage of aluminum parts used in them.

However, this opportunity is yet to turn into increased earnings numbers. As of now, the company's revenue fell for two consecutive quarters. What's more, Alcoa had to make a $1.7 billion goodwill impairment related to legacy smelting acquisitions and to take a $243 million charge in connection with the resolution of the U.S. government investigations.

On the positive side, the company delivered a healthy growth in free cash flow. Alcoa will remain modest on growth spending in 2014, targeting to spend $500 million. On the growth side, Alcoa's Saudi Arabia joint venture performance presents interest for investors. The smelter is expected to operate at full capacity this year, while the first alumina from refinery will come in the fourth quarter.

Bottom line
In my opinion, the biggest risk is that Alcoa's shares have rallied too far too fast, opening the room for a possible downside. The projected growth is muted. Also, Alcoa's dividend is unlikely to attract income hunters. What's more, this dividend is unlikely to be increased in the near future, given the tough market conditions.

Alcoa's shares trade at more than 25 times trailing earnings after the recent run. At such multiples, the company must have a clear path to deliver good growth. I think that Alcoa needs better aluminum prices to continue its growth. Yes, the company targets another $850 million in productivity improvements in 2014. However, tweaks here and there are unlikely to result in great earnings growth should the downside in prices persist.

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Vladimir Zernov

Vladimir Zernov believes that fundamental analysis works best with energy and materials stocks and covers them on Motley Fool.

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