Have Declining Aluminum Prices Foiled Alcoa?

The past few years have been turbulent for Alcoa (NYSE:AA) and its shareholders. Amid a volatile stock price and declining aluminum prices, can the company achieve stability in the near term? Let's use our Cheat Sheet investing framework to decide whether Alcoa is an OUTPERFORM, WAIT AND SEE, or STAY AWAY.

C = Catalysts for the Stock's Movement

As one of the world's largest aluminum producers, Alcoa's profitability is largely determined by the price of metal it sells. Aluminum has declined in price for two straight years due to oversupply and a reversal of the decade-long bull market in commodities. A three-month buyer of aluminum pays around $1764, roughly 30 percent less than what the metal traded at two years ago. As a result, Alcoa has struggled to achieve stable profitability. Still, the company's-first quarter earnings were impressive and beat estimates in the first quarter.

CEO Klaus Kleinfeld shut down operations at many of the company's mines and refineries in 2012, hoping that an estimated 12 percent reduction in the company's output would reduce aluminum supply and bolster prices. While Alcoa is one of the top three aluminum producers in the world, it is unclear if this strategy will be effective in producing a sustainable impact on its price. To help hedge itself against depressed aluminum prices, Alcoa has invested in higher-performing operations, such as refining alumina, the oxide that creates aluminum, and Bauxite mining. Specifically, the company has expanded its Bauxite mining operation to Brazil and Russia, where it enjoys higher operating margins due to lower energy costs.

Alcoa has focused on growing its engineered products and solutions division as the global aerospace industry continues to thrive. Sales from the this division increased 24 percent, netting $173 million in revenues and operating at a record quarterly EBITDA margin of 20.9 percent. This division should remain profitable for Alcoa as lightweight aluminum parts are in demand for new automobiles and aircraft; but due to slowing economic growth in China, investors should not expect the division to repeat its record-breaking performance next quarter.

D = Debt-to-Equity Ratio is Moderately High

Alcoa currently has a debt-to-equity ratio of 0.665. While Alcoa has reduced its leverage by some 25 percent since 2009, the company still utilizes too much debt in its capital structure compared to the basic materials industry average. Moreover, Moody's recently downgraded Alcoa's credit rating to Ba1 on May 29. While the company still has a strong cash balance of $1.9 billion, new debt issuance will be more expensive as a result of the downgrade. Alcoa should use cash flows in the future to reduce some of its debt, as higher leverage increases the company's exposure to fluctuations in the price of aluminum.

T = Technicals are Weak

Alcoa is currently trading at around $7.85, below both its 50-day moving average of $8.35 and its 200-day moving average of $8.57. The stock has been volatile in the past year, and it has recently experienced a downtrend as indicated by its trading below its key moving average. From the graph, we can see that $8 has been a support level for the stock. For the past year, the stock has trended back up after hitting this price. Recently, though, the stock has broken through its $8 support level and could trend lower unless it corrects back to this price again.

T = Trends Support the Industry in Which the Company Operates 

The future looks bright for aluminum demand. Emerging aerospace industries in China and India are consuming components produced by Alcoa's engineered products and solutions division. Additionally, automakers are incorporating more aluminum into their vehicles, as the metal is more lightweight and energy-efficient than steel. Slowing economic growth in China, however, may reduce demand from the Chinese construction industry.

Conclusion

Alcoa's profitability in the short term will continue to hurt from the sub-$1,800 aluminum price. Management has mitigated its exposure to aluminum price fluctuations somewhat by focusing on producing high-value parts for the booming aerospace growth in China and India. With most of the global aluminum business operating at a loss, production will decrease, helping restore supply to the equilibrium. When the downtrend in aluminum prices does reverse, Alcoa is positioned well — its operating margins are much better than Chinese competitors like Aluminum Corporation of China (NYSE:ACH).