Alcoa (NYSE:AA) is well positioned to thrive as its European rivals are forced to close their doors.
Meanwhile, investors are concerned that there is likely to be a near-term oversupply of aluminum a declining economic environment in the US and China.
That being said, Alcoa’s results appear to continue to shine. Now the key question is how Alcoa will fare over the next few quarters given this slowdown in economic demand.
And are investors adequately compensated for this risk? At 7x conservative free cash flow, I believe they are.
Revenue growth rates remain strong
Alcoa looks positively at its revenue growth rates as it beat analyst consensus to increase its revenue growth rates by 29% year over year.
Still, the stock has fallen significantly since the highs it reached a few months ago. This is completely discouraging. The reason for the stock’s sharp decline is that analysts continue to expect Alcoa’s revenue growth rates to ramp down rapidly in the second half of 2022, as they’ve been doing for several months.
Looking ahead to the next few quarters through mid-2023, analysts expect Alcoa’s revenue growth rates to turn negative.
Their estimates are based on the assumption that Alcoa’s strong revenue growth rates will fall in line with historical averages.
Nevertheless, it cannot be overlooked that aluminum prices on the spot market have sold off so sharply in recent months. This is clearly very bearish and should be factored into any investment thesis.
For all the commentary on low aluminum inventories, this does not appear to be reflected in aluminum spot market prices.
With that in mind, we will next discuss the bull and bear cases for investors to think about.
Alcoa’s near-term prospects
Everything there is to know about the Bull and Bear Falls is listed below.
On the supply side, there is an overwhelming concern that increased production from China could lead to an oversupply of aluminum in the near term. Meanwhile, the demand outlook is uncertain.
These two are the key bearish considerations on the supply and demand sides. These two are keeping investors at bay as the stock has sold off significantly over the past few days.
I would counter these considerations by arguing that exports from Russia not only face the sanctions against the country, but also the difficulty in paying Russian companies as their international banking system is taken offline, which will prevent excess aluminum from global markets are significantly restricted.
Then there are the other considerations at hand. Namely, the very high cost of energy input that puts a significant amount of capacity at risk.
As you can see above, Alcoa estimates that about 10% to 20% of China’s aluminum production is operating at negative cash margins.
I suspect that Europe has an even worse negative cash volume as Europe is suffering from a one-off energy crisis. This makes the production of aluminum unprofitable and uneconomical.
Capital Allocation Policy
As you can see below, Alcoa recently refinanced its mountain of debt so there is no longer any short-term debt maturities.
Alcoa has an insignificant amount of debt to pay off in 2022, and then the next batch won’t come until much later in 2027. That’s it!
For comparison, that puts net debt at $1.2 billion. For a company reporting more than $800 million in quarterly EBITDA, that debt is very manageable and irrelevant to the investment thesis.
Given this strong tax position, Alcoa believes it can return capital to shareholders after allocating capital to its top priority of growing its business.
Here’s what Alcoa said during the earnings call:
We trust in the strength of the company. And that’s how we delivered returns for shareholders in the second quarter because our cash balance was strong. Our cash generation has been strong and we are confident in the company’s future ability to weather cyclical storms.
And that’s why we provided it. We just announced an additional buyback of $500 million. We have $150 million remaining for prior buyback authorization.
During the second quarter of 2022, Alcoa repurchased $275 million of stock, or 3.3% of its market cap, returned to shareholders during the second quarter, for an annualized rate of 13.3%.
In addition, Alcoa now announces that it has increased its buyback authorization to $500 million. This is a perpetual buyback program.
That brings the total authorized buyback program to $650 million, or 7.8% of its market cap. Realistically, note that just because a company has announced a stock authorization program doesn’t mean that the company will necessarily exhaust its authorization.
Aside from returning capital to shareholders, it’s important to remember that Alcoa has very strong returns on equity.
As you can see above, Alcoa’s ROE would dwarf the profitability profiles of many so-called “asset light” cloud companies right now.
Alcoa is reporting very strong ROE numbers, supported by strong cash flows and returning capital to shareholders.
AA Share Rating – Priced at 8x Free Cash Flow
For the first half of 2022, Alcoa’s EBITDA was $2 billion. However, this high EBITDA has not translated into an equal and proportional level of free cash flow. For illustration, free cash flow for the first half of 2022 was $390 million as the majority of EBITDA profitability is driven by working capital.
Keep in mind, however, that Alcoa said back in the first quarter of 2022 that its very large negative working capital utilization would reverse throughout 2022.
And that’s what you see in the red and green boxes above, from Q1 to Q2 free cash flow improved significantly given the improvement in working capital.
Looking ahead to the remainder of 2022, Alcoa continues to claim, as it did last quarter, that it will see an improvement in working capital in the second half of 2022.
That could mean that Alcoa’s free cash flow would likely hit $1 billion in 2022.
Meanwhile, analysts, for their part, continue to expect free cash flow of around $1.4 billion from Alcoa in 2022. While I think that estimate is overestimated, I believe if Alcoa could offer further free cash flow potential, it would this obviously continue to support share price.
Using my estimate of $1 billion in free cash flow for 2022, Alcoa would cost 8 times this year’s free cash flow.
The final result
Alcoa is a natural resources company exposed to highly volatile demand stemming from both a global economic slowdown and China’s Covid lockdown policy. Despite much pessimism, the business appears to be performing strongly and generating very strong free cash flows. I believe paying 8x free cash flow for this deal is cheap and an attractive multiple.
I’ll leave the final words to the Alcoa management team. In a recent conference call, Alcoa said:
So we had lower metal prices, slightly higher raw material costs, higher energy costs in Lista. And we’ve had some operational issues in Western Australia and I think that’s going to cost us about $50 million in the third quarter. So, like I said, the third quarter is shaping up to be a tough one.
That’s what I think the market is thinking about right now, the challenging Q3 quarter. However, I’m looking beyond the next six months and trying to prepare for what’s next after this challenging period.
In summary, the best time to buy into a cyclical stock is during these negative outlook periods. When nobody else wants to join. And the sale time will be in about six to nine months as the outlook begins to improve.