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Near a 2-Year Low, Is Alcoa a Buy?

By Maxx Chatsko – Dec 8, 2018 at 9:03AM

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Alcoa stock hasn't traded under $33 per share for this long since the first half of 2017. Is Wall Street overlooking the business's momentum?

On the one hand, shares of the new Alcoa (AA) have managed to beat the S&P 500 since launching in late 2016. On the other hand, shareholders have helplessly watched those market-beating gains evaporate in the second half of 2018. The ongoing stock slide has put the share price at levels not seen in almost two years.

The company knew it would take time to clean up its balance sheet, begin tackling its massive pension deficit, and double down on efficient operations. It even received a solid boost from positive developments in the global aluminum industry, which helped to increase selling prices for the three major components of the aluminum supply chain. But then Uncle Sam decided to rip up several decades-old rules on trade. The resulting uncertainty has proven difficult for management to overcome.

Is Wall Street right to be pessimistic on the aluminum leader, or should long-term investors consider Alcoa stock a buy?

A man looking through binoculars and smiling.

Image source: Getty Images.

The bull case

There are several noteworthy positives for Alcoa. In the first nine months of 2018, the business posted just over $10 billion in revenue, representing a year-over-year increase of 19%. Earnings before income taxes (EBIT) jumped 30% in the comparison period, while EBIT margin improved from 11.1% to 12.2%. 

That allowed the aluminum leader to begin making progress on its massively underfunded pension and postretirement obligations. At the end of 2017, the company reported a deficit of $3.5 billion relating to its obligations to retirees, but managed to nudge that down to a deficit of "only" $2.1 billion by the end of September 2018 through a combination of contributions and offloading part of its annuities to a capital management firm. Closing the gap on pension and postretirement obligations is a step in the right direction for retirees and shareholders, as it reduces long-term liabilities.

Continued strength in the global aluminum value chain -- which includes bauxite, alumina, and aluminum -- should help Alcoa continue making progress on its underfunded pension obligations while expanding its bottom line. On the third-quarter 2018 conference call management projected that demand would outstrip supply in both alumina and aluminum markets for the year, while bauxite would be in surplus. Two out of three ain't bad, and that bodes well for strong selling prices heading into 2019.

A hand pounding the table next to a tablet displaying a falling stock price.

Image source: Getty Images.

The bear case

Investors are hoping that increased operating efficiency and improving market conditions can create enough positive momentum to offset headwinds from other sources. That may prove difficult, as many important factors remain outside of the company's control.

For instance, although Alcoa expects a global aluminum deficit between 1 million and 1.4 million metric tons in 2018, the previous estimate called for a deficit between 1.1 million and 1.5 million metric tons. That's not a huge difference, but the new guidance was paired with reduced expectations for global demand growth. Slowing Chinese consumption is now expected to squeeze worldwide aluminum growth to around 4.25% for the year, down from the 4.75% previously expected. 

In other words, while American tariffs on aluminum imports are actually helping the business, slowing global growth could end up offsetting those benefits. It would help if the United States and Canada could agree to remove the tariffs each has placed on the other, but that won't occur until the new NAFTA trade deal becomes law -- and that will require some big concessions from Canada.

While many things remain out of the company's control, investors may scoff at one questionable initiative management has decided to pull the trigger on: a $200 million share-repurchase program. Stock buybacks might be the worst use of capital at this point in time. It would be better to use that cash to pay down debt (Alcoa ended the third quarter of 2018 with $1.8 billion in debt), invest in research and development (the new zero-emission aluminum joint venture could revolutionize the industry), or fund its pensions -- all of which would have a sustainable positive impact on the share price.

Aluminum ingots stacked.

Image source: Getty Images.

Alcoa's risks can't be discounted

Whenever a business is involved in commodity markets, especially those heavily influenced by China, its fortunes can change rather quickly. Although Alcoa is making progress against its strategic priorities, there's no telling where the stock price will be this time next year, let alone in five years.

That said, the North American aluminum industry should be able to set aside its differences within the next two or three years, which could translate into higher global market share that more than offsets most other headwinds. Given that strong possibility, and in light of its market cap of $6.2 billion and the fact it trades at just 7.7 times future earnings, I think the positives outweigh the negatives for long-term investors: Alcoa stock is a buy.

Maxx Chatsko has no position in any of the stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. The Motley Fool has a disclosure policy.

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