Alcoa - Bonds Look Cheap

Alcoa's (Baa3/BBB-) earning are out and look decent.  I have been waiting for the earnings to take a look at the bonds.  The company has been somewhat of a leper for a while now as it is somewhat overlevered and underearning.  Things are improving here.  Do I think the ratings will stabilize in investment grade space?  Yes, I do.  Do I see upgrades?  Not in the near-term as the company must show it is serious about debt reduction (through greater reduction in actual debt rather than increases in equity or EBITDA) and continue to de-lever their balance sheet.  Alcoa’s debt-to-capital ratio stands at 34.8 percent at the end of the fourth quarter, 90 basis points better than the third quarter of 2010, and 390 basis points lower than the fourth quarter of 2009.  Problem with this is that the company has an expressed target of 30-35% debt/capital, so its not gonna get much better from here.

Liquidity improved, with $1.5 billion in cash on hand at the end of the fourth quarter compared to $843 million at the end of the third quarter of 2010.  I would expect that liquidity (in terms of cash) will be somewhat reduced as the company increases capital expenditures.  CAPEX came in for the full year at $1B, down from '09 full year of $1.6B.  While yes, this does increase free cash flow, it will not help grow the business.  Depreciation was $1.4B, so essentially, the business shrunk (yeah, from an accounting perspective).  Capex is expected to come in somewhat higher this year ($1.5B +) which is necessary for maintenance (about $500MM for growth capex) and should help smooth things out.

Accrued pension and post-retirement have shown a marginal improvement as well (which will reduce adjusted debt metrics), but I would like to see a more meaningful reduction.  The company has stated it is evaluating the pension issues and will come up with a minimum funding target.  I would still like to see them go beyond the minimum and take a chunk of their pension down.  Pensions are the same as debt (or very close).

Outlook:

The company has said:  “In 2011, we see aluminum growing another 12 percent on top of last year’s 13-percent improvement. We are well positioned to outpace the recovery in the markets we serve and grow shareholder value.”  This is evidenced by the company restarting three smelters in the US which will increase Alcoa’s aluminum production by 137,000 metric tons over the course of 2011 and by 200,000 metric tons on an annual basis thereafter.

I agree with their assessment of the near-term business conditions and growth prospects (especially should China - isn't it always about China? - reduce their smelting capacity) and therefore think the company is in decent shape in the near to intermediate term.  We should see further financial improvement which should drive spread tightening.  I would be a buyer of the bonds.

Value:

AA      (Baa3/BBB-)  6.15    20   @ 210/200
AA      (Baa3/BBB-)  5.72    19   @ 195/185
RIOLN (A3/BBB+)    3.50    20   @ +79
BHP   (A1/A+)         6.50   19    @ 53/43
CLF    (Baa3/BBB-)  4.80   20    @ 185





Some stats and thoughts (emphasis mine):

2010 Full-Year Highlights

• Revenue of $21.0 billion compared to $18.4 billion in 2009, up 14 percent
• Income from continuing operations of $262 million includes a negative impact from special items of $297 million
• Cash from operations of $2.3 billion, compared to $1.4 billion in 2009
• Free cash flow of $1.2 billion, a $1.5 billion improvement over 2009 - (driven by changes in working capital - notably inventories)
• Debt reduced, cash on hand of $1.5 billion
• Debt-to-capital ratio reduced to 34.8 percent, 390 basis point improvement over 2009 - (due mainly to increases in the equity line ad debt is down by less than $600MM)

Improved earnings were driven by higher pricing, continued strengthening in most end markets and improved productivity as a result of the company’s Cash Sustainability Program. Results were offset somewhat by a weaker U.S. dollar and higher energy and raw material costs.

4Q 2010 Highlights

• Income from continuing operations of $258 million, which includes a net benefit from special items of $35 million
• Net income of $258 million
• All-time record cash from operations of $1.4 billion
• Record fourth-quarter free cash flow of $1.0 billion
• Adjusted EBITDA improves to $782 million, 13.8 percent margin up from 11.4 percent in the third quarter of 2010 and 3.4 percent in the fourth quarter of 2009
• Revenue of $5.7 billion, up 7 percent from third quarter and 4 percent from year-ago quarter
• Projecting global aluminum growth rate of 12 percent for 2011