I would be cautious about Alcoa (AA) going forward for several reasons – firstly, its dependence on alumina and aluminum prices; secondly, the company’s relatively low free cash flow (FCF); thirdly, the lack of near-term catalysts. Coupled with its high level of adjusted net debt and outsized pension liability, the c. 10% FCF yield seems far from sustainable. I believe shares are fairly valued at this juncture.

Favorable Aluminum Pricing Trends Buoy Earnings

Alcoa recently reported a solid quarterly report, with both the top line and EBITDA exceeding consensus. The sequential increase in sales was largely attributable to higher aluminum and alumina prices, along with higher alumina shipments. Meanwhile, the stronger EBITDA also benefited primarily from improved aluminum pricing, coupled with an increase in contribution from value-added product sales.

Source: Alcoa FQ3 Presentation Slides

Encouragingly, Alcoa sees global aluminum demand improving, taking its cues from the inflection in transportation this quarter. Chinese demand, for instance, was up 5-10% Y/Y across all segments for FQ3, in contrast to North America and Europe, which were down 0-10% Y/Y. Following the FQ3 trends, Alcoa ended the quarter with $1.7 billion of cash and sequentially flat leverage (adjusted on a pro forma basis for the new debt issuance raised in July).

Cautiously Optimistic on the Backdrop but FQ4 Outlook Downbeat

The strong FQ3 will not extend into F4Q, however, even though management is cautiously optimistic on the supportive underlying demand trends continuing. This was reflected in management reaffirming its shipment guidance for bauxite at 48-49m dmt and aluminum at 2.9-3.0m mt, while Alumina shipment guidance was raised by c. 0.2m mt to 13.8-13.9m mt.

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The Bauxite segment is guided to see sequentially flat results in FQ4, while the Alumina segment is guided to be lower Q/Q due to higher energy costs and an unfavorable mix shift in customer shipments. Within the aluminum segment, the negative cost impact is slated to include c. $18 million of Section 232 tariffs, although this could prove conservative (or otherwise) considering current uncertainties around the tariff.

On the flip side, should Canadian producers be subject to Section 232 tariffs, we could instead see upward pressure to the Midwest premium. Nonetheless, I see more downside than upside to FQ4 EBITDA for now.

A Closer Look at the Full-Year Outlook

On a full-year basis, the bauxite and aluminum volume guidance has also been left unchanged. However, like FQ4, the alumina shipment guidance was lifted slightly to 13.8-13.9mt (vs. 13.6- 13.7mt previously).

Yet, projections of annual market balances for bauxite, alumina, and aluminum remain suspended, with management citing COVID-19-related uncertainty. Nonetheless, management sees demand continuing to strengthen, with China continuing to lead the recovery going forward, with North America and Europe following at a slower pace.

Source: Alcoa FQ3 Presentation Slides

Interestingly, Alcoa also noted elevated interest in “green” aluminum, which has reached an inflection point this year. It is hard to gauge the potential opportunity at this point, considering the lack of information around pricing and premiums. What we do know, however, is that Alcoa now offers a sustainable Alumina product called “Ecosource” as part of its Aluminum brands. I expect to hear further details about the addressable market opportunity in the upcoming quarters.

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Source: Alcoa FQ3 Presentation Slides

Cash Flow Concerns Weigh on the Capital Return Prospects

Encouragingly, Alcoa remains on track to achieve the c. $900 million of cash savings communicated prior. On the FQ3 earnings call, management noted that it was also still targeting c. $500 million -$1 billion in asset sales to boost the balance sheet. Depending on market conditions, the company is also open to using proceeds to either fund the pension or address its pending bond maturities.

Source: Alcoa FQ3 Presentation Slides

However, even with the supportive near-term aluminum prices, I think Alcoa will struggle to offset the range of near-term headwinds at play in FQ4. These include higher power costs in Europe and section 232 tariffs, along with unfavorable seasonal factors. At the moment, it appears that the aluminum market will stay adequately supplied for the foreseeable future, and barring an unforeseen macro shock, Alcoa looks to be on track for another Y/Y decline in EBITDA in FQ4. The lower EBITDA should translate into lower free cash flow as well, with deleveraging likely to be pushed back to fiscal 2021 as a result.

Meanwhile, the planned Rockdale land package sale remains the only other near-term funding source. Alcoa will also have to contend with sizeable pension cash outflows, which currently stand at a minimum of c. $180 million in fiscal 2021 (including the c. $380 million pre-funding). Coupled with the existing debt servicing needs, I suspect capital returns will need to be further delayed into fiscal 2022.

Why I am Passing on the c. 10% Cash Flow Yield

Overall, I am neutral on Alcoa shares. While Alcoa does benefit from a strong liquidity position and relatively low-cost upstream assets, the underwhelming FQ4 EBITDA guide and the outsized cash drain from pension and debt servicing needs keep me cautious. Coupled with Alcoa’s dependence on aluminum pricing, I think the c. 10% FCF yield is far from sustainable, and expect this to moderate in fiscal 2020 and 2021. As such, I view shares as fairly valued at current levels, with no near-term catalysts ahead.

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What could change my mind? Should free cash flow improve and drive a cleaner balance sheet, I think Alcoa shares will warrant a revisit as the deleveraging should add to the equity value. However, I do not expect this to play out anytime soon, and therefore, I am firmly on hold.

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Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

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