Alcoa Inc: Transformation or Mean Reversion?

Alcoa, Inc (NYSE: AA  )  is on fire. The aluminum producer's stock is up a sizzling 54% year to date, making Alcoa one of the best performers in the S&P 500. According to pundits and analysts alike, Alcoa is a new and exciting value-added company with significant higher-margin growth ahead of it. 

But given Alcoa's pricey forward price to earnings ratio as well as analysts' history of adjusting their commentary to the latest trend, many investors understandably question whether the rally is sustainable. 

Is Alcoa really a new company, or is it the same company with margins reverting back to a normalized mean?

Signs of transformation
There are signs that Alcoa is legitimately transforming itself.  In its latest earnings report, the aluminum producer's value added divisions did grow significantly. Alcoa's engineered products and solutions division, for example, grew by 6% year over year and reported a quarterly record of $204 million in after tax operating income.

Given the healthy expected growth of Alcoa's value-added end markets such as aerospace and North American commercial transportation, one can make the argument that the value-added growth will continue for a while. If that growth continues, Alcoa margins will increase, and given the differentiated nature of the value added products, those margins will likely be more sustainable than Alcoa's current cut-throat commodity business. 

Moreover, Alcoa management is actively trying to speed up the process by acquiring value-added companies such as Firth Rixson, a maker of aerospace jet engine components.

With the rally of Alcoa's stock, the market itself is playing its part by giving management the mandate to do future value added acquisitions. Because of the mandate, Alcoa may do future value-added acquisitions as well. 

1 sign of mean reversion
Those things being said, there is a sign that Alcoa is just reverting to a normalized mean. Aluminum margins are, specifically, climbing as Chinese aluminum oversupply no longer haunts the marketplace. In Alcoa's second quarter earnings report, for example, Alcoa's primary metals unit reported an after-tax operating income of $97 million versus an after-tax operating income of negative $32 million last year. This vast improvement explains to a large degree why Alcoa turned a profit this quarter. 

With global aluminum demand expected to grow by 7% and a projected global deficit of aluminum this year, margins should be better for all companies in the aluminum industry. Indeed, other aluminum companies are also doing well. Century Aluminum  (NASDAQ: CENX  ) , for example, is up 68% year to date.

The bottom line
The reason for the puzzling rally is likely both that Alcoa's aluminum margins are reverting back to a normalized mean and that the company is legitimately transforming itself into a more value added company. And while mean reversion is not necessarily good news given that margins may trend lower as say when Chinese aluminum companies increase their production, the value added segment is likely to make a bigger and bigger part of Alcoa's profits moving forward.

Over time, the combination of organic value-added growth along with possible future acquisitions will transform Alcoa.  If Alcoa can achieve that transformation without overpaying for its future acquisitions while at the same time containing costs, Alcoa's rally will likely be sustainable and could continue. 

Top dividend stocks for the next decade
The smartest investors know that dividend stocks simply crush their non-dividend paying counterparts over the long term. That's beyond dispute. They also know that a well-constructed dividend portfolio creates wealth steadily, while still allowing you to sleep like a baby. Knowing how valuable such a portfolio might be, our top analysts put together a report on a group of high-yielding stocks that should be in any income investor's portfolio. To see our free report on these stocks, just click here now.


Read/Post Comments (0) | Recommend This Article (3)

Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

Be the first one to comment on this article.

Sponsored Links

Leaked: Apple's Next Smart Device
(Warning, it may shock you)
The secret is out... experts are predicting 458 million of these types of devices will be sold per year. 1 hyper-growth company stands to rake in maximum profit - and it's NOT Apple. Show me Apple's new smart gizmo!

DocumentId: 3034480, ~/Articles/ArticleHandler.aspx, 9/23/2014 12:30:26 PM

Report This Comment

Use this area to report a comment that you believe is in violation of the community guidelines. Our team will review the entry and take any appropriate action.

Sending report...


Advertisement