Wednesday, May 26, 2010

Alcoa (NYSE:AA): Upgraded to Outperform, $18 target at Macquarie - Aluminum’s Not that Bad, Honest

Macquarie (USA) Equities Research is upgrading Alcoa (NYSE:AA) to Outperform from Neutral with a $18 price target (prev. $17), equating to 60% potential upside.

Macquarie believes the aluminum market is more healthy than most investors realize as physical premiums continue to move higher and demand growth is accelerating. US premia have risen 23% YTD while European premia are up 74%. The strong upward move in premiums reflects significant physical tightness in the market as excess warehouse inventory remains tied up in refinancing trades. Also, they note that ali prices hit $1.13/lb this year, above firm's price forecasts through ‘13.

The contango has remained favorable and they believe it is unlikely the significant amount of material tied up in these warehouse deals (~80% of LME inventory) will unwind in the medium term, keeping the physical market tight. Also, rising power costs in China coupled with the recent selloff in aluminum has put ~40% of Chinese capacity below breakeven, which should limit downside to prices here.

With Chinese efforts to eliminate discounted power tariffs to key energy intensive industries such as aluminium and global cost creep outside of China,the firm believes that aluminium prices have significant support near the $0.85-90/lb level and thus believe downside is very limited. With the price now at $2,000/tonne they estimate that 40–50% of all Chinese capacity is losing money and thus would expect production curtailments in China if the price were to remain at these levels, which would clearly be a positive catalyst for the aluminum price and Alcoa.

Alcoa’s Share Price has Performed Far Worse than the Aluminum Price
Aluminum prices have declined from their peak of $1.13/lb in March to reach $0.90/lb recently while Alcoa’s share price has performed much worse, falling 22% since March and 33% since the start of the year. Clearly, Alcoa’s weak earnings result in the first quarter led to increased concerns that AA wouldn’t be able to leverage the benefit of higher aluminum prices owing to rising energy input costs as well as unfavourable fx. Importantly, the firm believes that the recent decline in oil prices coupled with significant strengthening of the US dollar and still resilient LME aluminum prices should greatly increase AA’s leverage to a rising aluminum price environment going forward.

They believe that aluminium prices have reached a bottom in the short run and expect shares of AA to rally as Chinese macro concerns abate over the next few quarters and the European sovereign debt risks stabilize. FIrm believes aluminium prices have significant cash cost support at current levels given ~40–50% of Chinese capacity is now losing money and Chinese power prices continue to rise. Unlike the aluminium market we see that the coking coal, iron ore, and copper markets all trade at price levels significantly above marginal cost of production at current price levels, especially for the bulk materials.

Alcoa Valuation too Attractive to Ignore – See 60% Upside to Share Price
Macquarie commodity analysts forecast the long run aluminum price at $1.10/lb. However, under Macquarie's current forecasts they don’t see the aluminum price reaching this price level until 2014. To be conservative they used 2012 as their mid cycle earnings year for Alcoa, a point in time when they expect the downstream businesses to have recovered to 85–90% capacity utilization rates and much better margin performance to be realized in the Primary and Alumina segment as aluminum prices move gradually higher and LME alumia prices move higher on the heels of aluminum and higher linkage rates. Also, Alcoa’s cost reduction and restructuring efforts should be largely completed by 2012 as well, providing a better view on long-term earnings power of the company. Firm forecasts 2012 EPS for AA of $1.60 per share and total EBITDA of $4.7bn and their aluminum price assumption is $1.00/lb, which is not far off the current three-month forward price of $0.93/lb.

Over the cycle Alcoa has traded in a forward EBITDA valuation range of 6-8x with brief periods where the multiple exceeded these ranges as shown in the chart below. The historical average multiple for Alcoa is 7.4x forward EBITDA and thus the firm would argue that Alcoa should be worth at least 7x EBITDA on 2011 earnings expectations given the market usually awards a higher multiple on below average earnings years just as the market discounts earnings closer to the peak. The shares currently trade at 5.4x 2011E EBITDA and only 3.9x 2012E EBITDA, both levels which are well below historical averages and indicate the market has become overly pessimistic on Alcoa earnings and cash flow potential over the next several years in our view.

Macquarie's $18 price target assumes Alcoa trades at 7.4x 2011E EBITDA and only 5.4x their 2012E EBITDA forecast, which they believe represents mid cycle earnings for the company.

Notablecalls: The metals space had a nice run along with the general market yesterday & we may see some follow-through today.

Many of the names names like Alcoa are on the cheap side and could see nice gains in the n-t as the market retraces some of its recent losses.

As Macquarie highlights, Alcoa may actually have more upside leverage here as:

- Recent decline in oil price lowers the production costs

- Dollar's recent strength provides a tailwind (vs. the usual headwind)

I would not be surprised to see AA trade up 5%+ today putting $11.80-90 level in play.

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