This commodity company is much safer than rating agencies suggest
Commodity businesses are cyclical businesses. They rise and fall with commodity prices.
Due to their cyclical nature, these businesses are often regarded as risky. However, it’s highly beneficial to catch the good cycles in these commodity businesses, especially when there are visible catalysts.
This is exactly what has been going on with Alcoa Corporation (AA). After its spin-off from Arconic in 2016, the commodity-based aluminum smelting business has been unloved and considered risky.
Now it has significant tailwinds behind it but rating agencies seem like they are continuing to overlook the business.
Let’s take a look at the company using Uniform Accounting and evaluate its actual credit risk profile.
We can use Uniform Accounting to put the company’s real profitability up against its obligations and decide for ourselves the true risk of this business.
Also below, a detailed Uniform Accounting tearsheet of the company.
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Spin-offs can be complex and might lead investors to favor one specific part of the business. This is what Alcoa Corporation has been experiencing for the last several years.
Back in June 2016, Alcoa wanted to separate its two main businesses.
One became the new Arconic (ARNC) which is effectively a value-added specialty aluminum business.
This new company focused on providing high-performance engineered products and solutions, including aluminum sheets, plates, extrusions, and architectural systems.
On the other hand, the legacy business was focused on mining, refining, and smelting of aluminum.
The investment world favored the new business as it included value-added processes and seemed like it had better growth opportunities.
As a result, the legacy business has been highly overlooked and unloved because it was just a boring commodity business.
However, dismissing the importance of aluminum would be a massive mistake as it has significant tailwinds behind it.
With the electrification of everything, aluminum becomes more and more important in our lives.
In order to support this trend, the need for long-distance power wires presents aluminum as one of the most important raw materials that will be used in this process.
Additionally, as electric vehicles and aircrafts gain popularity all around the world, the need for lightweight components is significantly increasing. This fuels the need for even more aluminum.
This is great news for Alcoa, as demand for its aluminum products could massively increase.
Yet, rating agencies seem to underestimate the power of these trends, rating the company as a high-yield name and thinking that it has around a 10% chance of going bankrupt in the next few years.
This is a highly overstated credit risk evaluation for Alcoa Corporation and does not reflect the company’s actual credit risk.
We can figure out if there is a real risk for this company by leveraging the Credit Cash Flow Prime (“CCFP”) to understand how the company’s obligations match against its cash and cash flows.
In the chart below, the stacked bars represent the firm’s obligations each year for the next five years. These obligations are then compared to the firm’s cash flow (blue line) as well as the cash on hand available at the beginning of each period (blue dots) and available cash and undrawn revolver (blue triangles).
The CCFP chart clearly shows that Alcoa Corporation’s cash flows are much more than enough to cover all its obligations going forward.
The chart shows the company does not have any concerning obligations going forward and even its cash earnings would be enough to cover all obligations.
Additionally, aluminum is still an essential metal, and there are important catalysts to show demand isn’t going away, which means Alcoa’s cash flows aren’t vanishing soon.
Even in the case of a recession or a slowdown, the company’s cash buffer gives it the ability to manage all its obligations including debt maturities.
Because of these factors, we think that the company deserves to be among the investment-grade names and should have a much better credit rating.
That is why, we are rating Alcoa Corporation “IG4+”, which places the company where it belongs and implies only around a 1% chance of bankruptcy.
It is our goal to bring forward the real creditworthiness of companies, built on the back of better Uniform Accounting.
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SUMMARY and Alcoa Corporation (AA:USA) Tearsheet
As the Uniform Accounting tearsheet for Alcoa Corporation (AA:USA) highlights, the Uniform P/E trades at 19.6x, which is above the global corporate average of 18.4x and its historical P/E of 13.3x.
High P/Es require high EPS growth to sustain them. In the case of Alcoa, the company has recently shown a 30% Uniform EPS shrinkage.
Wall Street analysts provide stock and valuation recommendations, that in general, provide very poor guidance or insight. However, Wall Street analysts’ near-term earnings forecasts tend to have relevant information.
We take Wall Street forecasts for GAAP earnings and convert them to Uniform earnings forecasts. When we do this, Alcoa’s Wall Street analyst-driven forecast is for a -88% and 815% EPS growth in 2023 and 2024, respectively.
Based on the current stock market valuations, we can use earnings growth valuation metrics to back into the required growth rate to justify Alcoa’s $36 stock price. These are often referred to as market-embedded expectations.
Furthermore, the company’s earning power in 2022 was in line with the long-run corporate average. Moreover, cash flows and cash on hand 3x its total obligations—including debt maturities and capex maintenance. The company also has an intrinsic credit risk that is 150bps above the risk-free rate.
Overall, this signals a moderate credit risk and a low dividend risk.
Lastly, Alcoa’s Uniform earnings growth is below its peer averages and is trading below its average peer valuations.
Joel Litman & Rob Spivey
Chief Investment Strategist &
Director of Research
at Valens Research