Monday, December 21, 2009

Alcoa (NYSE:AA): Upgrade to Overweight at Morgan Stanley; 50% upside to target

Morgan Stanley is upgrading Alcoa (NYSE:AA) to Overweight from Equal-Weight with a $22 price target (representing 50% upside from current levels).

The stock is trading at ~10x Morgan Stanley's estimate of earnings at spot ($1.00 per lb) aluminum, before factoring in improvements that they expect in alumina and downstream businesses. Firm has increased their earnings estimates by 50% for 2010 and 20% in 2011 to factor in better profitability in alumina and downstream; however, they continue to use their commodity team’s aluminum price of $0.84/lb in 2010 and $0.88/lb in 2011.

Drivers of the Upgrade

Driver 1: Potential increase in alumina pricing.

Morgan Stanley expects Alcoa to benefit from an increase in the alumina price relative to aluminum (the linkage rate). Alcoa’s realized linkage rates could exceed the 2006–08 average of 13% and stay above 15%, in line with recent market transactions. YTD 2009 average linkage has been above 15%, albeit at depressed base aluminum prices. AA’s cost competitiveness should improve with Juruti/Sao Luis ramp-up. The growth of smelting capacity in the bauxite-deficient regions could lead to tightness in this market and provide additional upside. Alumina accounts for ~45% of aluminum costs in China and ~35% world ex-China. They think Alcoa will more actively seek pricing power than in the past. Firm estimates the normalized earnings potential of Alcoa’s Bauxite & Alumina segment at $725 million at $46 ATOI/T.

Driver 2: Downstream better positioned.

They think Alcoa can earn more than the cost of capital in downstream segments. During the current downturn, Engineered Solutions quarterly ATOI bottomed at $65 million and Flat-Rolled was near breakeven, ex Russia/China losses. Restructuring of these segments in recent years, including sale of several underperforming businesses, will help increase earnings power through the cycle. Improvement in volumes in key end-markets, such as can sheet, aerospace and power generation, will help margins. Firm estimates the normalized earnings power of Flat-Rolled Products segment at $500 mn and Engineered Solutions at $600 mn at 9% and 12.8% RoA, respectively.

Some risk presented by a USD rebound. MSCO's FX strategists expect the USD to rally versus major currencies as rate and growth differentials shift in favor of the US. However, they expect EM growth to outpace G10 growth, and the USD to underperform EM currencies. This could result in some initial weakness, but the prospect of favorable EM and US growth, combined with aluminum’s still-tight link to the cost curve, leaves them relatively constructive.

Notablecalls: Well, this is the upgrade many have been waiting for in light of the Alumina price rally. The stock looks set to break out to new 52-week highs and as we are getting closer to year end, I don't really see anything standing in the way.

I suspect Alcoa will set up to be the perfect mark-up play.

Today, the stock will trade over the $15 level for sure with $15.10-15.25 my first targets for the name. I think that if the market plays ball we can see Alcoa up 6-8%, putting $15.45+ levels in play.

Let's see how it works out.

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