Alcoa Inc: Transformation or Mean Reversion?

Is Alcoa's head-scratching rally sustainable?

Jul 18, 2014 at 11:00AM

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. 

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Jay Yao has no position in any stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

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