Australia | Apr 09 2008
By Greg Peel
A quarterly earnings report from the Aluminum Company of America, or Alcoa as it has long been known, traditionally kicks off each US reporting season given Alcoa is the first of the thirty Dow stocks to report. After the bell on Tuesday in the US, Alcoa reported a first quarter reduction in profit of 54%. While revenues were better than Wall Street consensus estimates, earnings per share missed.
If a US company misses Wall Street consensus EPS by a little as a penny it can mean curtains for the stock. As it was, Alcoa’s shares fell 4% in the aftermarket on Tuesday evening but managed to hold that loss in last night’s session.
Given Australian companies have become far more globally oriented in the last decade or so, analysts now often closely watch the results of offshore competitors in order to gauge what might be expected for the local mob. However, in the case of Alumina Ltd ((AWC) and Alcoa the association runs a lot deeper than simply being another alumina/aluminium producer. Alumina’s most significant asset is its 40% interest in Alcoa World Alumina & Chemicals (AWAC).
So one would be quickly forgiven for expecting a bad result for Alcoa will translate into a bad result for Alumina. Alumina’s shares have indeed fallen from a high over $6.00 on Monday to $5.60 now. But is the relationship that closely correlated?
Not according to four out of five brokers who reported on the Alcoa result this morning. None of Macquarie (Overweight), Merrill Lynch (Buy), Deutsche Bank (Buy) or Credit Suisse (Neutral) saw any reason to change their ratings following what all agree was a pretty poor first quarter in the alumina business. While elements such as rising costs and currency issues impacted heavily on Alcoa, local analysts have already incorporated such expectations into their numbers.
(In Alcoa’s case a weak US dollar has greatly increased the cost of raw materials and energy, while in Australia’s case a high Aussie dollar means lower local revenues. Note that Alcoa beat revenue expectations.)
But it is important to note that under the pricing structure of alumina contracts there is a two-three month lag. This means the Alcoa result did not reflect any of the recent price jumps in either alumina or aluminium. The aluminium spot price increased 27% during the first quarter. Analysts are thus expecting that a strong second quarter will more than make up for a weak first.
Moreover, Alcoa’s result was further affected by tax issues peculiar to the US.
What this left was a group of analysts remaining happy with their views on Alumina, which incorporate bullish expectations for the aluminium price ahead and a recognition that the replacement cost of Alumina’s smelting assets renders them irreplaceable in today’s market. (And if Alcoa ever stops messing around trying to block the Rio Tinto takeover as revenge for Rio having bought Alcan, then most in the market expect Alcoa would happily make an offer on the other 40% of AWAC).
But wait, there is a stick in the mud.
JP Morgan downgraded Alumina to Underweight in October last year and has held fast ever since. Given that the share price that day was $6.74 and it’s $5.60 now you’d have to take your hat off. But then there has been a small matter of a global credit crunch and subsequent equity bear market ever since.
The JP Morgan analysts’ favourite game since the beginning of the super-cycle has been to plug spot prices into their five year earnings forecasts and decide resource stock share prices were still overvalued were that to be the case. The only problem is JPM has been forced to constantly update its forecasts. Most famously the local analysts defiantly maintained an $11 target price for Energy Resources of Australia when uranium was heading to the moon and everyone else had targets round $25-26. Then one day JP Morgan US bit the bullet and raised its uranium forecast significantly, and the local team were forced to raise their ERA target to $31 in one go, and then stand at the bar while only two inches tall.
Nevertheless, JPM defiance is at work again. This time the analysts have taken the Alcoa result and extrapolated a result for Alumina based on the AWAC relationship, making all the necessary adjustments. The result is that they can only come up with a 2008 profit range for Alumina of $218-221m when market consensus is at $330m. Their own forecast is $262m, so they feel somewhat vindicated.
JP Morgan traditionally is amongst the lowest of forecasters for commodity prices, but even if the analysts plug in spot prices they can only come up with a value of $4.70. Hence JPM has maintained an Underweight rating. It is alone among the major brokers, and even the Holds are bullish but just think the current share price is a fair representation.
Alumina is showing a 7/2/1 B/H/S ratio in the FNArena database, with an average target of $6.26 on a range of $4.27 (JP Morgan) to $7.40 (Deutsche Bank). Take JPM out of the equation and the target rises to $6.51.