Bearish Outlooks For Alcoa, Century Aluminum

 In an earlier article, I described the negative attitude surrounding aluminum and depicted the extent to which Alcoa (AA), a brand-name miner, will experience free cash flow burn. Since I first wrote the article, the stock has fall by 9.2% while the S&P rose by 3.4%. With a high beta of 2.1, low dividend yields, and high costs, this company is not for the risk-averse. I continue to find that both Alcoa and Century Aluminum (CENX) offer poor risk/reward at the present moment and holding out until macro headwinds dissipate is the recommended strategy.

 

From a multiples perspective, both basic materials firms appear cheap. Alcoa trades at a respective 10.3x and 9.9x past and forward earnings while Century trades at a respective 9.6x and 13.2x past and forward earnings. Input inflation continues to make its toll on the industry, as gross margins stand at only 18.3% for Alcoa and 9.6% for Century. The negative attitude surrounding aluminum, in my view, has set the bar too low and 2012 pricing is likely to be above expectations.

 

 

In addition, Aloca's CEO, Klaus Kleinfeld, was right to present an optimistic emerging market backdrop for context:

 

 

While you're seeing that the economy is slowing in some parts of the world, we also see strong growth in the emerging markets that basically offsets this impact…

 

 

So what you're seeing here is that we are forecasting a decline between the second half and the first half in basically 3 regions: Europe, North America and Brazil. As well as what you're seeing here is many of the emerging markets. They continue to grow very strongly. And we're predicting in China…, a year-on-year growth of 17%. In the previous quarter, we projected 15%, so we are upping our forecast on China on that. That equals this 10% additional growth in the second half over the first half.

 

 

The firm is investing $300M in the Davenport Works facility for automobiles, which I believe represents a bet of confidence on economic recovery. This is a viewpoint that I share (see here) and, hence, I see some upside to the firm. An anticipated CAGR of 6.5% for the next decade in aluminum demand is still overly aggressive and could result in inventories holding even greater surplus. Compounding issues at the most vulnerable time, "there's very offensive short selling going on by speculators", as Kleinfeld warned.

 

Consensus estimates for Alcoa's EPS are that it will grow by 53.7% to $0.83 and then by 16.9% and 22.7% more in the following two years. Assuming a multiple of 11x and a conservative 2012 EPS of $0.94, the rough intrinsic value of the stock is $10.34 for 10.6% upside. However, if the multiple were to decline to 8x and 2012 EPS turns out to be just 6.2% below the consensus at $0.91, the stock would decline by 22.1%. Accordingly, I find that risk overweighs reward here. The Street nevertheless rates shares a "buy" given a turnaround story in aluminum and shifts down the cost curve.

 

 

If Century is any indication, demand will likely remain short in the near-term. The firm's third quarter results were disappointing largely due to expenses in carbon pitch, calcine coke, etc. Although reduced fears about a recovery should merit a multiples increase, less diversification than Alcoa is containing value creation. I anticipate that ROIC could increase by as much as 400 basis points by 2013, including weakness in 2011.

 

 

Consensus estimates for Century's EPS are that it will decline by 70.6% to $0.32 in 2011 and then turnaround to grow by 140.6% and 51.9% in the following two years. Even if you assume that the multiple will expand to 11x and 2012 EPS will by $0.74, a conservative estimate, the stock still has 15.9% downside. The Street, accordingly, rates shares around a "sell".