AA Preview: Have We Seen a Cyclical Bottom?

Earnings season kicks off today when Alcoa (AA - commentary - Cramer's Take) is the first major company to report. The consensus has it earning $1.40 a share on about $28 billion in sales for the full year, but the company probably posted a small loss of 10 cents per share in the fourth quarter on $5.26 billion in sales. These numbers would not include estimated charges of over $1 a share for discontinued operations in electrical, wheel and transportation systems. In the current depressed market, they are expected to fetch only about $100 million, even though they accounted for almost $2 billion of sales last year.

We think that the company may have seen a cyclical bottom and will be able to earn perhaps $1.00 a share on $20 billion of sales in 2009. This is a guess, more than an estimate, however. Prices of most commodities are less than half of last summer's peaks, although aluminum may see a decline of less than half off last year's peak of $1.70 a pound because aluminum prices have not exploded in the same way as copper, oil, or gold in the current cycle. Nevertheless, the unusual volatility of metals' prices makes our estimates very tentative.

With profitability in question, liquidity is now the key issue. Alcoa has been successful in rolling out the debt maturities that would otherwise have come due in 2009 and early 2010. Capital spending has been cut in half, to $1.8 billion. The company is suspending its share buyback program. The dividend may be the next to go, although it is not a heavy burden for more normal times. Also, the company plans to lay off about 15% of its global work force in connection with a planned reduction in output of 18%.

Alcoa stock is now a classic "deep value" play, which is why we own it. The issue is selling for about half of book value, which is to say that it will have value even if the dividend is reduced or eliminated. The exceptional severity of the current economic downturn has amplified the company's and stock's characteristic cyclicality, but it has also increased the equity's long-term reward potential. Even so, it may be several years before this potential will be realized. It's noteworthy that the stock has nearly doubled off last November's lows.

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At the time of publication, Au was long Alcoa, although holdings can change at any time.

Thomas P. Au, CFA, is a principal with R. W. Wentworth, a financial services firm in New York City. Earlier he was an emerging markets portfolio manager for the investment arm of Cigna Corp. and an analyst with Unifund, S.A. of Switzerland and Value Line. He graduated cum laude with a B.A. in Economics and History from Yale University and an M.B.A. in Finance from New York University. Au is the author of A Modern Approach to Graham and Dodd Investing. Au appreciates your feedback; click here to send him an email.