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Alcoa Kicks Off The Earnings Season

Posted: Jan 11, 2008 11:18 AM by Ryan Barnes

Tickers in this Article: AA, BHP, RTP

Maybe this year's party won't be so bad after all. Aluminum conglomerate Alcoa (NYSE:AA) is traditionally the first of the Dow Jones industrials to report fourth quarter earnings. Many expected 2008 to be a depressing affair, but this year the party started with a bang.

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Dressed to impress, Alcoa beat analyst estimates, and reported revenue increases that many assumed impossible given the high cost of raw materials and fuel. This confirmed what I see as a favorable valuation in light of global aluminum demand and the company's large share repurchase program currently in process. (To get started on your New Year's valuations, see Strategies For Quarterly Earnings Season.)

Earnings Figures
Alcoa earned $311 million, or 37 cents per share, in the fourth quarter, excluding one-time gains from the sale of some downstream businesses last quarter. This was down from the 41 cents per share it earned in the same quarter last year, but it beat the consensus estimate of 33 cents per share. Revenue came in at $7.39 billion, down from last year's $7.84 billion but well ahead of the consensus estimate of $6.92 billion. (If these numbers put you into a fog, check out Understanding The Income Statement.)

Several Drags on Profit Still Exist
There are several ongoing concerns affecting net margins, mainly rising energy and raw materials costs. Cost of goods sold was up a full 330 basis points in the last quarter, an alarming jump intensified by aluminum spot prices that are flat to down in the global market.

Revenue is also being affected by Alcoa's exposure to the domestic auto industry, where production at the Big Three auto makers fell by 4% year-over-year and the heavy trucking market, where truck inventories are high and shipping is down on rising fuel costs. Meanwhile the weak U.S. dollar led to currency conversion losses of over $50 million in the fourth quarter.

Geographical Demand Mix
As expected, weak housing and construction markets kept growth in the United States minimal at best. Growth in this region was only 6% for all of 2007, and even less in Europe where construction growth was only 3% for the year.

China, the Middle East, and Latin America continue to save the day, as double-digit growth (including 35%+ in China) is propping up global demand figures. Alcoa expects to see worldwide growth in aluminum consumption of 10% in 2008, and management feels that spot prices will stabilize during the year to push gross margins higher.

Balance Sheet Strength in a Tough Market
I've been quite attracted to Alcoa's efforts to clean up the balance sheet during a tough 2007. Investment and segment sales have flushed the company with cash to complete share buybacks, and over $3 billion was put towards capital expenditures during 2007 without increasing debt. In fact, debt restructuring has been so successful that the average maturity date has been doubled while keeping interest costs, and debt/equity ratios the same. (For the basics of debt ratio analysis, see Debt Reckoning.)

Making the Equity Case
When I crunch the numbers on Alcoa shares, I can't help thinking the risk-reward balance is very favorable right now. With a trailing P/E just over 12, the stock is trading at an earnings multiple just barely above the 10% worldwide growth that management is predicting for aluminum consumption. While there's no guarantee that Alcoa will participate in all of that global growth, its capital investments should lead to lower production costs and higher volumes.

And let's not forget about share buybacks - any shares bought back in 2008 will provide another free bump for shareholders by increasing their proportional stake of future earnings, and when that effect is combined with the healthy 2.2% dividend yield, and I can begin to see a path to solid shareholder returns in 2008.

Parting Thoughts
Investors interested in Alcoa should be keeping a watchful eye on aluminum spot prices and the domestic construction markets during the next few quarters, but Alcoa's stable earnings and cash flow make the stock compelling in today's uncertain market. With the improvement in the balance sheet, the company has also made itself more marketable to possible buyers like mining giants Rio Tinto Alcan (NYSE:RTP) and BHP Billiton (NYSE:BHP).

By Ryan Barnes

Ryan Barnes has over 10 years experience in portfolio management and investment research, covering equities, fixed income and derivative products. Barnes has worked with Merrill Lynch, Charles Schwab, Morgan Stanley and many others as an institutional trader, and maintained AIMR compliant performance for a diverse set of high-net-worth investors.

Barnes is currently working as a writer and financial modeling consultant specializing in capital appreciation and hedging strategies, and is the editor of EpiphanyInvesting, a website devoted to finding long-term success in the stock market.

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