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Morningstar | Alcoa Shares Down Sharply on Guidance Cut; Lowering FVE to $29 Due to Faltering Cost Position

Alcoa shares are down sharply despite impressive second-quarter results that comfortably beat analyst estimates. The July 19 sell-off stems primarily from a sizable guidance reduction. Management now expects 2018 adjusted EBITDA of $3.0 billion-$3.2 billion versus a previous range of $3.5 billion-$3.7 billion. The downward adjustment was driven by the unfavorable impact of the U.S. aluminum tariff program as well as unexpected operational challenges in alumina and aluminum production.

As a result of these unexpected headwinds, we are tempering our near-term profit outlook for Alcoa. Additionally, unrelated to the earnings result, we’ve lowered our terminal enterprise value/EBITDA multiple to 5.5 times from 6.5. This change more accurately reflects the company’s free cash flow conversion from EBITDA and long-term growth prospects. Harbor Aluminum data indicates that Alcoa’s positioning on the global cost curve for aluminum has worsened in recent quarters, a dynamic that will weigh on the company's profitability as well as its growth profile. As a result of these changes, our fair value estimate falls to $29 per share from $36. Our no-moat rating is unchanged.

In the second quarter, companywide adjusted EBITDA was $904 million, up roughly 80% from the prior-year period. Performance varied across the company’s three reporting segments, affected by dynamic prices for bauxite, alumina, and aluminum. Adjusted EBITDA in the bauxite segment was down around 10% versus the same period last year due to elevated operating costs at the Juruti bauxite mine in Brazil as well as unfavorable pricing. Meanwhile, adjusted EBITDA for alumina was up more than 60% year on year. Inflated alumina prices were supported by supply chain disruptions from late in the first quarter. Adjusted EBITDA for the aluminum segment was up around 50% year on year, again due to elevated spot prices.

While companywide profits were encouraging, upside was limited by a few key developments. First, when the U.S. aluminum tariff program was announced, most investors assumed it represented a tailwind for Alcoa. However, the decision not to exempt Canada from the tariffs represents a negative development, as the company operates three Canadian smelting facilities. Most of this production is ultimately exported to the United States, exposing it to the import tariffs. It is also important to note that only about one fourth of Alcoa’s aluminum smelting capacity is located in the U.S.

Second, when the tariffs were announced, we noted that the aluminum market remained structurally unbalanced due to continued overproduction in China. Alcoa’s management echoed that point during the earnings call, arguing that the tariffs do little to address the fact that roughly 40% of Chinese aluminum production is unprofitable. Alcoa further highlighted that it is only moving forward with one smelting facility restart in the U.S., limiting potential upside from tariff protection for its U.S. smelting operations.

Despite the flurry of events that have transpired over the past couple of quarters, our long-term negative outlook for Alcoa as well as the broader aluminum industry is intact. Trade flows will adjust over time to the various supply disruptions that took hold in the first half of the year, bringing prices down from their elevated levels toward global marginal cost. Additionally, China’s transition from an investment-led to a consumption-led growth model will weigh on fixed-asset investment growth, further damping aluminum demand.