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Alcoa (NYSE: AA ) was among three companies ejected from the Dow Jones Industrial Average last September. While being booted from America's premier stock index would typically depress a company's stock, the opposite occurred here: Alcoa's stock has rallied 18% year to date and 51% over a one-year span.
Fellow aluminum producer Century Aluminum (NASDAQ: CENX ) also rallied 24% year to date and 72% over the past year. The rally in aluminum producers, which were pressured by Chinese aluminum overproduction, confounded pundits and doubters alike.
It turns out improving fundamentals may have something to do with Alcoa's rally.
While revenue was down 2% sequentially and 6% year over year, Alcoa collected adjusted earnings (which exclude one-time items) of $0.09 per share versus $0.04 per share in the fourth quarter of 2013.
Alcoa's adjusted earnings increased due to several trends working in the company's favor.
First, Alcoa's higher-margin, value-add business, which includes its engineered products and solutions and global rolled product divisions, is growing at a robust clip thanks to strong demand from automotive and aerospace manufacturers. That strong aerospace demand should continue, as experts forecast total aircraft sales to grow at a 7.5% annual rate in the near future. Strong demand from the automotive manufacturers should also continue as car makers increasingly use aluminum in the place of steel to meet stricter federal mile per gallon standards. Alcoa predicts, for example, auto sheet revenue to grow from $229 million last year to $330 million in 2014 and $580 million in 2015.
Second, global aluminium oversupply may be a thing of the past. Alcoa believes that, for the first time in years, global aluminum demand will be greater than global aluminum supply in 2014.If demand does outstrip supply, Alcoa should realize greater revenue per ton from its production.
Third, Alcoa is improving productivity. With $250 million in productivity gains this quarter, the company is on track to achieve $850 million in productivity gains this year. With those productivity gains, the company predicts that it will be in the 38th percentile of the aluminum cost curve by 2018 versus the 43rd percentile last year. By boosting productivity and being on the lower end of the cost curve, Alcoa should realize higher margins and be more competitive in the future.
The bottom line
Despite the many positives, I don't think that Alcoa can continue to rally like it has over the past year.
At the end of the day, Alcoa is very dependent on the health of the U.S economy, which accounts for roughly half of its revenue. This is because a significant percentage of Alcoa's demand comes from big-ticket capital manufacturers that are very sensitive to macro conditions. Given that the U.S. economy has yet to reach escape velocity, if the economy turns, those capital manufacturers will see lower demand and Alcoa will see lower profit. With a forward P/E ratio of 22 versus the S&P's forward P/E of 15.6, Alcoa's valuation doesn't give it much room for error.
That being said, I don't think the Alcoa has much downside, either. The shorts, which originally made up 12% of Alcoa's float, have covered nearly 44 million shares in recent months.
Alcoa's fundamentals have definitely improved, but the broader economy needs to be healthier before higher valuations make sense.
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