Source: Alcoa.
Aluminum giant Alcoa (AA) has been one of the darlings of the stock market in 2014, with share prices having climbed by more than 50% since the beginning of the year. After terrible performance in past years due to low aluminum prices and dire predictions about the global economy, Alcoa has put into place a transformative strategy that involves making products that add value beyond what mere commodity producers can offer their customers. In Alcoa's most recent earnings report, investors saw some of the potential wins from that strategy. But value-focused investors worry that the stock might have gotten ahead of itself. Let's take a closer look at Alcoa's second-quarter financials to see what they say about the company's prospects in the current quarter as well as in the future.
Alcoa gets back to profitability
Alcoa's second-quarter earnings rewarded investors who had the nerve to stick out the tough times for the aluminum producer. The company reversed a year-ago loss by earning a $138 million profit, but what was particularly impressive is that Alcoa got help from all of its major segments. Engineered products and solutions have always carried the most potential for Alcoa, and the company has highlighted their importance to its overall success. But gains from the global-rolled products and other midstream production segment, as well as from primary metals and alumina production, came as somewhat more of a pleasant surprise.
Helping to support Alcoa's recovery is an improving supply and demand picture. Overall, Alcoa expects an even larger deficit in aluminum production now than it did in the previous quarter, and the company slashed its expected surplus in raw alumina by almost two-thirds. That has helped to support prices for the first time in a while, with Alcoa seeing a 2% gain in average realized aluminum prices compared to year-ago levels.
Recycled goods makes up an important part of Alcoa's business. Source: Alcoa.
The importance of major customers
Yet the long-term story for Alcoa remains its exposure to the red-hot aerospace and automotive industries. In aerospace, Boeing (BA -0.24%) has continued to see strong order demand for its newer aircraft models, and aluminum remains a key component in their manufacture, boding well for Alcoa's future. Alcoa sees further growth of 8% to 9%, and given that aerospace makes up almost a third of the company's overall exposure to value-add products, Alcoa stands to gain a lot as long as demand for new aircraft holds steady. Moreover, Alcoa's planned buyout of Firth Rixson will further add to its penetration of the aerospace market.
The automotive sector arguably has an even greater possibility to provide growth for Alcoa. Until recently, automakers tended to use the lightweight material for only limited purposes, favoring cheaper alternatives despite their added weight. But with the advent of the new aluminum-intensive F-150 pickup truck, the auto industry finds itself at a new crossroads as it considers ways to lighten vehicles and make them more fuel-efficient. If the F-150 proves successful, other automakers are likely to follow its lead, and that could bring huge amounts of business Alcoa's way.
What will it take to keep Alcoa moving higher?
Source: Alcoa.
The challenge for Alcoa, though, is that investors have high expectations for its immediate future. Shareholders want to see better than 60% improvement in earnings per share this quarter and a quadrupling of profits next quarter, all adding up to a near-doubling in EPS for the full year followed by greater than 40% earnings growth for 2015. If it can accomplish that monumental task, then the stock will boast an arguably reasonable forward earnings multiple of about 20.
Yet for Alcoa to reach its goal, it will need to squeeze as much profit as it can from its existing business lines. Investors don't expect huge gains in revenue in the near future, instead looking for Alcoa to keep making its operations more efficient and raising profit margins on existing sales. The transformation away from basic materials toward value-added manufactured products should go a long way toward helping Alcoa achieve its desired outcome, but longtime investors realize that there are still challenges Alcoa will have to overcome.
In a market environment in which old-economy growth stocks have become increasingly rare, Alcoa has the appeal of being a well-known name that has bounced sharply from its worst levels. But Alcoa needs to demonstrate its ability to follow through on its past success, and that will make next month's third-quarter results that much more important. Having demonstrated its ability to bounce back, the next question Alcoa has to answer is whether it can keep growing even past its initial recovery phase.
