Why Alcoa Inc. Stock Has Skyrocketed 57% in 2014

The aluminum giant's prospects are looking up, but conservative investors fear the stock has gotten ahead of the company's fundamentals.

Aug 30, 2014 at 12:00PM

Aa Rolled
Source: Alcoa.

In September 2013, Alcoa (NYSE:AA) suffered the indignity of being kicked out of the Dow Jones Industrials (DJINDICES:^DJI), capping a terrible period for the aluminum giant that had slashed its share price by more than 50% in just two and a half years. Yet after that painful eviction from the blue-chip index, Alcoa stock started climbing, and the shares have built on their modest gains at the end of last year to soar so far in 2014.

Investors are obviously much more upbeat about Alcoa's future prospects now, with some signs of a turnaround in the aluminum market and increasing confidence among shareholders about the company's particular strategic moves. Yet with shares having risen so far so fast, the main question investors have is whether Alcoa stock has room to run higher. Let's look at Alcoa more closely to see whether its gains to date this year could continue.

Stats on Alcoa

2014 YTD Return

56.9%

Expected 2014 Revenue Growth

(1.1%)

Expected 2014 EPS Growth

85%

Expected 5-Year Growth Rate

48%

Source: Yahoo! Finance.

What made Alcoa do so well?
To understand why Alcoa stock has produced such solid returns in 2014, it's important first to understand just how bad things were for the company in the recent past. For years, Alcoa has struggled with a glut of aluminum production worldwide, with major Chinese producers in particular flooding the market with cheap aluminum even as prices for the lightweight metal hit rock bottom. Even production cuts by Alcoa and other major global players in the industry weren't enough to bring supply and demand back into equilibrium, and falling prices led some aluminum producers to consider exiting the business entirely.

Given those long-term concerns, the first element of Alcoa's recovery came simply from the idea that the industry might have hit bottom. Over time, new sources of demand have emerged, and the sense among aluminum producers was that given enough time, the impact of supply curtailment would start pulling prices back to higher levels. That first stage of bullishness happened to coincide closely with Alcoa's exit from the Dow, which marked the low point for sentiment in the aluminum company's stock.

Aa Overview
Source: Alcoa.

Since then, Alcoa has started to see a payoff from its corporate strategy. Rather than relying on the ups and downs of the commodity aluminum market, Alcoa has shifted toward providing value-added manufactured aluminum products, putting a proprietary face on the components and materials that its most important customers need. Items such as aluminum wheels, aircraft components, and vehicle bodies fetch better prices that raw aluminum, and with many manufacturers struggling to meet customer demand of their own, being able to reach out to Alcoa to effectively outsource the production of key components has a lot of value at this stage in the business cycle. That was also a key component in Alcoa's acquisition of aerospace specialist Firth Rixson, potentially boosting its exposure to the fast-growing aircraft market.

At the same time, though, Alcoa sees value in maintaining its exposure to the commodity market. To compete more effectively, Alcoa knows it has to reduce costs in order to maximize profit margins, which is an ever-present challenge in raw aluminum products. Nevertheless, investors have greater confidence in the company's ability to meet its goals than they have in recent years, and that is helping to drive the stock higher.

What stands in Alcoa's way?
Bullish investors in Alcoa clearly have high hopes both for the company itself and for its customer partners. For now, the aerospace and automotive industries appear to be healthier than ever, with huge backlogs of aircraft orders almost guaranteeing ongoing demand for years to come, and with auto sales at extremely strong levels as well. But if broader economic conditions become less favorable, Alcoa might well have to adapt again to keep its recovery going.

Aa Factory
Alcoa factory facility. Source: Alcoa.

In addition, Alcoa's share-price valuation has already incorporated substantial growth projections. Trading at 19 times 2015 earnings estimates might not sound all that aggressive, but those projections assume that earnings will grow by more than 40% next year after an estimated 85% rise for 2014. That doesn't leave Alcoa much margin for error if it can't produce the growth investors demand.

The big picture for Alcoa
Alcoa's ascent from its depressed levels late last year makes sense given the fundamental improvement that the aluminum giant has seen thus far in 2014. To keep the stock moving higher, however, Alcoa will need to keep building momentum and assert its competitive edges against other players in the industry. Otherwise, enthusiasm among Alcoa investors might prove to be premature.

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Dan Caplinger 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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