News Analysis date published New: 
Monday, September 20, 2010 - 15:02
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Wednesday, September 22, 2010 - 09:32
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Monday, September 20, 2010 - 15:02

The Best Rebound Play in the Dow

Monday, September 20, 2010 - 3:02pm

September has been a wonderful month for stocks. The S&P 500 Index, for example, has risen in 10 of the past 13 sessions, rebounding to levels seen last May, before the bears took the reins. Shares are rising on expectations that we're increasingly likely to avoid a double-dip recession, and with a little momentum on the jobs front (and eventually the housing front), animal spirits could conspire to help push economic growth rates back up to respectable levels by the second half of next year or 2012. And if history is any guide, that economic strength could feed on itself, and set the stage for even more robust growth in 2013 and 2014.

Of course, serious problems remain and Washington will have to find a way to truly lead rather than follow if it is to restore confidence. But there are simply too many positives to ignore, including: cash-rich balance sheets, still-solid profit margins, newly-expanding trade opportunities in Latin America and Asia thanks to growth in key countries in those regions, and with a little luck and finesse, a slightly weaker dollar that could materially boost U.S. exports.

In that context, investors need to make sure they have exposure to companies that stand to benefit from rising economic fortunes in developed and emerging markets. Yet many blue chips have moved up off of their lows and already discount an eventually brightening outlook. But one Dow component, although struggling right now and trading on the cheap, should represent massive upside once business improves. I'm talking about Alcoa (NYSE: AA), the world's largest aluminum producer. It's much reviled, but wheezing back to life.

My colleague Paul Rolfes recently laid out a logical bear case for Alcoa. [See: This Stock Could Disappear from the Dow] And he's right. The company's dividend is paltry, and most analysts rate the stock as a "hold." But it's important to know that analysts rate stocks on current operating trends, and have a lousy track record of looking out a year or two. Even when they turn bullish and raise their rating, they only boost their price target by a small amount, and then keep raising it again and again. That's how I believe Alcoa will play out, either later this year or in the first half of 2011. Here's why…

Darkest before the dawn
Massive aluminum smelters cost huge sums of money to build and operate. So when demand slumps, those heavy costs can eat up any potential profit. Alcoa's 2009 results were nothing short of dismal. Sales fell -31% and operating margins, which had hit 16% just two years earlier, fell to -8%. Since then, management has had to cut costs wherever possible (37,000 jobs have been shed since 2008) while awaiting a rebound in sales. That process has just begun.

Alcoa lost nearly $400 million last December and lost another $100 million in the March, 2010 quarter, but was able to finally move back into the black in June, generating operating profits of about $230 million. The volume of aluminum produced rose +4% sequentially. Business still stinks, but less so than before.

More than likely, results will remain subpar (relative to historical peaks) for at least another year or two. But my favorite investor maxim clearly applies here: "The market always looks ahead." Alcoa's stock is now trading on anticipated 2011 results, but come this winter, they will start to trade on anticipated 2012 results.

And by 2012, Alcoa should see a solid turn in two key metrics. Demand for aluminum should rebound, thanks in part to ever-rising content of aluminum in autos and planes. And the spot prices for aluminum should also start to bounce back from recent lows. That combination should help revenue rise at least +10% in 2012, and since this is such a high fixed-cost business, profits should rebound at a far better pace.

On Alcoa's most recent conference call, Chief Financial Officer Charles McLane noted that costs are likely to remain in check, even as demand rebounds. "We are not only holding head count levels, but are also driving restructuring this quarter that will result in further reductions." The company's labor costs should remain firmly in check for several years to come as the United Steelworkers Union agreed to major concessions in its most recent multi-year contract.

China is the swing factor for Alcoa. Chinese aluminum production surged in 2008, creating a global glut right at a time when demand started to crater. The Chinese government has since decided to cut back production on this energy-intensive product. (Alcoa's energy costs are the lowest in the business, thanks to a building spree in the last decade that placed new factories where energy is cheap and reliable, such as Iceland, Trinidad & Tobago and several locations that have abundant hydro-electric power).

Chinese aluminum factories have started to throttle back output. The surplus of Chinese aluminum available for the spot market fell from 400,000 tons in March to 200,000 tons in June, and has apparently fallen further since then. Alcoa's management notes that more than 1 million tons of production has been taken off-line in China in the third quarter.

Action to Take --> Alcoa kicks off earnings season in about three weeks. At that time, management is expected to talk about typical seasonal weakness seen every fall, but management's cost-cutting efforts, coupled with a newly-restrained China, could be the real focus of the conference call. If so, this stock may finally start to get up off the mat.

Coming up with a future profit target for Alcoa is a bit tricky. The company typically earned $1.50 to $2 a share in normal years, and EPS exceeded $3 during an industry boom in 2007. There's no reason to expect boom conditions to return, but "normal" results could be seen within a few years. Yet Alcoa has taken so many costs out of the business, that EPS should be nicely higher on "normal revenue," perhaps in the $2.25 to $2.50 range.

When the global economy -- and Alcoa -- is back on its feet, shares could easily trade up to 10 times profits, or $22 to $25. That's a double from current levels, though still below the $30 to $40 range seen in 2006 and 2008. There are other Dow components that will also solidly benefit from an improving global economy, but none are as beaten down as this one.

David Sterman does not personally hold positions in any securities mentioned in this article.
StreetAuthority LLC does not hold positions in any securities mentioned in this article.