Alcoa (NYSE: AA) has been a tough stock to own for the last year or so. It got even tougher this week following its Monday earnings report.
Alcoa is always one of the first companies to report quarterly earnings and generally sets the tone for earnings season. While it managed to beat analyst earnings expectations, shares tumbled 9% on the news. Shares are already down nearly 20% year-to-date and are down 50% over the last 12 months.
The big overhang for Alcoa is its exposure to commodities, as everything commodity-related is taking it on the chin right now. Alcoa’s exposure to falling aluminum and alumina prices is overshadowing the growth in its aerospace business. Its recent acquisitions have helped reduce its exposure to the commodity industry, while increasing the exposure to the aerospace industry.
And less than a month ago Alcoa signed two major contracts worth more than $2.5 billion to supply Boeing (NYSE: BA) with parts for airlines. It also signed a similar deal with Airbus, which is the number two airline maker in the world, behind Boeing. That deal’s worth $1 billion.
Alcoa managed to secure $9 billion in aerospace contracts last year – double what it secured in 2014.
The Big Catalyst
One of the big positives for Alcoa is that it’s looking to split itself up. The split is expected to happen next quarter and will lead to two publicly traded companies: an upstream aluminum and smelting business and a higher-growth downstream specialty metal products company.
The spinoff will help the market better assess Alcoa’s operations. It has the higher-growth materials business, but the market is focusing on its metals unit, which is exposed to aluminum prices.
Its “value-add business,” which includes engineered products, posted $3.3 billion in revenues on a 6.5% after-tax operating margin. Meanwhile, the market mainly focuses on the upstream business, which generated $2.4 billion in revenues during the fourth quarter on a 2.4% after-tax operating margin.
Looking Beyond the Pain
The market is looking at the recent weakness that Alcoa has had in the mining and aluminum business and extrapolating it. Meanwhile, the company has been cutting its exposure to mining and upping its exposure to the higher-growth aerospace end market.
Alcoa’s costs are lower than other aluminum peers. Since 2007, Alcoa has managed to cut about a third of its high-cost capacity. In addition to being a supplier for aircraft, it’s also a major player when it comes to providing aluminum to the automobile industry. The fact that 2015 was a record year for automobile sales and the major carmakers are upping their expectations for 2016 is a positive for Alcoa.
The upcoming company split will help the market better judge the businesses, which should lead to higher multiples for both stocks. In particular, the value-add downstream business should benefit. Once the spinoff happens, the downstream business should trade at a premium to the mining business, which faces commodity headwinds.
Alcoa has quietly become less of a commodity play and more of a company tied to secular growth in autos and aerospace. This has helped the company build up years of backlog.
Don’t fear China, either. Some of the stock price pressure at Alcoa has been related to the slowdown in China. However, Alcoa notes that any slowdown in China will not have a material impact on its business.
Buying when others are fearful is a key consideration when it comes to value investing. Although I’m not generally a fan of commodity-related companies, the rewards outweigh the risks at Alcoa and present a buying opportunity.
DISCLOSURE: Marshall Hargrave personally owns shares of Alcoa (NYSE: AA).
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