Amid Headwinds, Alcoa Is Worth a Look

Although we had long expected aluminum premiums to decline, we were surprised that aluminum LME spot prices also moved lower during the quarter. As a result, Alcoa's realized price per metric ton of aluminum declined to $2,180, a 10% sequential decline.

The adverse aluminum price environment brought Alcoa's cost-cutting efforts into focus. Although high-cost capacity closures have required the booking of sizable restructuring charges, they have allowed the Primary Metals segment to move lower on the global cost curve for smelting. Management has now placed 500,000 metric tons of additional smelting capacity under review, approximately 15% of total installed capacity. Accordingly, our valuation model reflects both falling primary aluminum shipment volumes and lower cash costs through 2017.

The second quarter also served as a reminder that we are still in the early phases of Alcoa's transformation from a commodity producer to a manufacturer of specialty metals. As expected, the company's Engineered Products and Solutions segment reported a record high aftertax operating income result. However, the incremental earnings power provided by the company's acquisitions of Firth Rixson and RTI International Metals won't be on full display until 2016. At that point, if not before, we expect share prices to decouple from the trajectory of aluminum spot prices.

We've lowered the Primary Metals segment's operating margins to account for the impact of lower all-in aluminum prices. As a result, we've lowered our fair value estimate to $17 per share from $19. Our no-moat rating is unchanged. We assert that investors have become overly focused on short-term headwinds and we think the stock is trading at a very attractive entry point for long-term investors.

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