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Bullish on Alcoa for the medium-term

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Bullish on Alcoa for the medium-term

Introduction

This article was posted on Friday, 19:06, UTC.

On its official website, Alcoa claims to have invented the Aluminum industry in 1888. They are world leaders in Bauxite mining, alumina refining, and Aluminum smelting. The current company was separated from the erstwhile parent company ‘Alcoa Inc’ in November 2016, which was renamed as Arconic Inc.

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We dive deep into the factors that are in favor of Alcoa below.

High Aluminum prices that can rise even higher, low debt levels, a good buyout candidate, a great pedigree of 120 years and one of top 10 Aluminum producers in the world are some of the reasons that make Alcoa a good buy from a medium-term perspective.

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  • Aluminum prices are likely to rally higher towards $2000 per ton
  • LME aluminum stocks level is depleting quickly
  • China factor will influence Aluminum
  • Strong quarterly performance
  • Analysts are bullish on the company
  • A good buyout candidate

High Aluminum Prices

Aluminum prices have risen sharply from the lows in October 2015 and are consolidating near the highs since February of this year. A breakout of the 52-week highs will push prices above the $2000 per ton, which is a positive for Alcoa because alumina and aluminum are its major revenue sources.

Depleting LME Aluminum Stocks Level will Support Aluminum Prices

LME’s Aluminum stocks level has fallen sharply from 5500000 tons to less than 1500000 tons in the recent months. Though some reports point to abundant off-market stocks of Aluminum, the market is still tightening. One of the reasons for a tighter market is China.

The China Factor can Push Aluminum Prices Higher

China is one of the largest miner, refiner, and user of aluminum. Therefore, it’s growth and internal policies regarding aluminum will affect its prices globally.

Chinese Premier Li Keqiang while speaking at the World Economic Forum’s “Summer Davos” event in Dalian, China, from June 27-29, said that his country was committed to addressing the climate change issues.

Li also added:

China’s economy in the second-quarter maintained the first quarter’s steady and improving momentum. We are fully capable of achieving the main economic targets for the full year. Currently, China also faces many difficulties and challenges, but we are fully prepared, reports Reuters.

Both the above issues are positive for aluminum prices, which is already an outperformer compared to steel and copper in 2017.

In our view, this strong performance has reflected an increase in the potential for aluminum to be the next target of supply-side reform in China, a tightening ex-China balance, and rising costs of production,” wrote Goldman Sachs analysts. “Further, global political developments may also be supportive of capacity and production cuts, given the two leaders of the U.S. and China launched a 100-day (trade) plan on April 7. These developments support our existing view that aluminum is the next target for supply-side reform in China.

Therefore, the investment bank is bullish on Aluminum with a price target of $2000 per ton in six months and $2100 per ton in a year.

However, UBS analysts believe that aluminum prices are unlikely to see a bump up similar to coal. “While the audit on illegal capacity is quite substantial, it’s unclear whether that will lead to a large closure of excess capacity,” said says Daniel Morgan, senior commodities analyst at UBS, who recently returned from an investor trip to China, reports The Sydney Morning Herald.

Only time will tell which of the two forecasts will play out. However, China has few options if it wants to protect its citizens from the hazards of air pollution. Therefore, we expect the Goldman Sachs thesis to play out.

So, we have more or less established that aluminum prices will either stabilize or rally about 10% from the current levels. However, how does this make Alcoa a good investment bet? Let’s analyze.

How has Alcoa Performed in the First Quarter of This Year

Alcoa has benefitted from higher alumina and aluminum prices as seen in the Q1 2017 results. Revenues have increased 5% sequentially to $2.7 billion. On these revenues, the company’s earnings before interest, tax, depreciation, and amortization (EBITDA), excluding special items, grew 59% sequentially helping the company to report an adjusted net income of $117 million, or $0.63 per share.

Financial Health of Alcoa and its Projections for 2017

The company has achieved a free cash flow of $3 million compared to negative $445 million of free cash flow on a carve-out basis in the same quarter of 2016. Alcoa’s return on capital at 6.2% was a huge 4.7% increase over the previous financial year.

The company has a total debt of $1.45 billion. However, with $804 million in cash, its net debt drops to $0.65 billion, which is very comfortable.

In 2017, Alcoa expects both Bauxite and Alumina to remain in a relative balance, however, it expects the demand growth for Aluminum to increase from its earlier forecast of 4% to a higher range of 4.5-5%.

It expects to earn an EBITDA of $2.1 billion to $2.3 billion in the current year with a targeted $50 million net performance improvement.

The company has also targeted a 200-basis point increase in its return on capital from a 2016 baseline to end-2019, normalized for market conditions and has targeted to match or better the returns of the S&P 500 index. Both these have been linked to the executive compensation.

Other Factors that can Cause Bullish Surprises

The analyst community is very bullish on Alcoa. There are 10 buy ratings and four hold ratings with an average price target of $41.1. The median P/E on current year’s estimate is 11.85, which is not high considering the S&P P/E which is above 21.

Recently, Gabelli analyst Justin Bergner reiterated his “Buy” on Alcoa with a target price of $50. Similarly, Goldman Sachs also has an aggressive target of $52 on the stock.

Meanwhile, rumors have been floating that rival companies are looking to buy Alcoa. If any company announces its intent to buy out Alcoa, it will offer a handsome return from the current levels.

What does the Chart Forecast for Alcoa?

Alcoa saw a nice run up from its lows to the highs of $40, reached in mid-February of this year. Price has been falling in a channel, which is a normal correction. A breakout of the channel will resume the uptrend in the stock opening up a possibility of a retest of the highs at $40, whereas, a fall can take it to the lower end of the channel at $28, which is a significant support.

We shall wait for a dip towards the $30-$31 levels to initiate a mid to long-term position on the stock. We shall keep a stop loss of $27 and expect the stock to reach its highs of $40.

Conclusion

We are in no hurry to chase Alcoa higher. We expect the S&P 500 to dip and Alcoa also to dip close to $30 levels, where we believe that it becomes a good buy. We want to hold this company for the medium to long-term as the future of Aluminum looks bright and Alcoa is a leaner and better company after its split from its parent.

Featured image from Shutterstock

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Rakesh Upadhyay

Rakesh Upadhyay

Rakesh Upadhyay is a Technical Analyst and Portfolio Consultant for The Summit Group. He has more than a decade of experience as a private trader. His philosophy is to use technical analysis for momentum trading and fundamental analysis for long-term positions. Rakesh likes to keep himself fit by lifting weights and considers himself to be a spiritual person.

Comments
  • user

    AUTHOR ishturman

    Posted on 2:42 pm July 9, 2017.

    What timeframe is medium term? When you is good to buy and how many months. Is mrdium term?

  • user

    AUTHOR Rakesh Upadhyay

    Posted on 3:10 pm July 9, 2017.

    Hello ishturman…

    I expect a correction in the S&P 500 to 2320 levels soon. At that time, I expect Alcoa to drop to about $31 or so. That should be a decent entry point as far as a good risk-reward is concerned. However, if the S&P 500 breaks 2320 levels, the purchase should be put on hold.

    As far as holding Alcoa is concerned, we expect Aluminum prices to increase in the second-half of this year into first-half of the next. Therefore, Alcoa should be held for anywhere between 1-2 years.

    Anything less than a year, I consider it as a short-term investment. 1-2 years is a medium-term play and anything more than 3 years is a long-term investment.

    Thank you

  • user

    AUTHOR felix

    Posted on 11:23 am August 3, 2017.

    Hi Rakest,

    any update?

    Thanks

    • user

      AUTHOR Rakesh Upadhyay

      Posted on 12:35 pm August 3, 2017.

      Hello Felix,

      Alcoa never fell to our buy levels. The markets did not correct as I was expecting them to. At the current levels, Alcoa is very close to its overhead resistance of $40. I will prefer to wait.

      With warm regards
      Rakesh Upadhyay

  • View Comments (4) ...
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