Alcoa Stock Upgraded: What You Need to Know

By Rich Smith Markets Fool.com

Alcoa (NYSE: AA) reported its fiscal Q4 and full-year earnings yesterday, and the upgrades are already rolling in.

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This morning, international megabankers Citigroup and Deutsche Bank both announced new upgrades on Alcoa stock. As StreetInsider.com reports, Citi has upped Alcoa to buy with a $45 price target. Deutsche assigned a hold rating (not great, but better than its previous sell recommendation), and said the stock is worth $30.

What does this mean for investors? Well, if Citi is right, then Alcoa stock (currently trading at $38 and change) has 17.5% upside from today's prices, and could go even higher than that if conditions are right. Meanwhile, Deutsche Bank's upgrade, while apparently a positive for the stock, actually suggests Alcoa stock could still decline by 22%.

So which of these analysts is right? Here are three things you need to know.


Blue skies ahead for aluminum roller Alcoa? Image source: Getty Images.

1. Alcoa's earnings could have been worse

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Announcing earningsyesterday, Alcoa reported a net loss of $2.19 per diluted share for fiscal 2016 -- but only a $1.24 pro forma loss if you exclude "special items." The GAAP loss was also less than half what Alcoa lost in all of 2015 -- $4.73 per share. Revenue declined 18% year over year to $9.3 billion when compared to "carved out" results for rump Alcoa prior to the separationfrom Arconic (NYSE: ARNC).

That still doesn't sound great. But emphasizing the results it wants you to focus on, Alcoa pointed out that sequentially, it grew its revenue 9% quarter over quarter in Q4, and grew its earnings before interest, taxes, depreciation, and amortization (EBITDA) twice as fast -- up 18% in comparison to Q3 2016. EBITDA was $335 million in Q4.

2. Citi takes the bait

Following Alcoa's lead, Citi upgraded its evaluation of Alcoa stock this morning, and placed most of the emphasis for its reasoning on EBITDA. According to the analyst, Alcoa stock currently sells for 6.2 times trailing EBITDA of $1.1 billion, but should be properly valued at seven times.

Furthermore, Alcoa management says it will generate EBITDA of between $2.1 billion and $2.3 billion this year, assuming average global prices of $0.81 per pound for aluminum metal, and $335 per ton for raw alumina. Taking Alcoa's projections at face value, this would imply a valuation of as much as $15.4 billion by the end of this year, which Citi says would turn Alcoa into a $60 stock, creating the potential for 60% upside to the stock price.

Citi is not quite ready to accept these projections at face value, however. Instead, the analyst posits a $0.76-per-pound price for aluminum, and $285 per ton for alumina. But even using these inputs, Citi gets an output of $1.35 billion in EBITDA for Alcoa this year. On this basis, Citi foresees at least the potential for Alcoa's market cap rising to $9.5 billion (38% higher than today).

3. How to move those prices higher

So what might drive aluminum and alumina prices higher, yielding more EBITDA for Alcoa, and higher stock prices for its shareholders? Here, Deutsche Bankchimes in with a prediction that China may idle aluminum production capacity this year, pinching supply and resulting in higher prices on constant demand. Even if that happens, however, Deutsche doesn't seem to agree with Citi's valuation method.

Instead of taking Alcoa's bait and valuing the company on EBITDA, Deutsche takes the approach I prefer, and focuses on the company's free cash flow. The news here is good -- Deutsche predicts cash profits of as much as $1.5 billion this year, and says that would be enough to pay off the company's entire net debt in 12 months, should Alcoa be so inclined. Yet apparently, it's not good enough to convince Deutsche to give Alcoa a buy rating.

Bonus thing: Is Deutsche being too stingy with its buy ratings?

Is Deutsche Bank making a mistake? After all, if Alcoa generates $1.5 billion in free cash flow this year, then on its current market capitalization of just $6.8 billion, Alcoa is selling for a mere 4.5 times free cash flow. Even factoring in the company's $1.4 billion debt load, its enterprise-value-to-free-cash-flow ratio would still be only 5.5, which would seem to be an incredibly cheap price to be paying for one of the world's leading producers of aluminum.

The problem, of course, is that no matter what Alcoa says, and no matter what Citi or Deutsche Bank think, Alcoa hasn't generated anything on the order of $1.5 billion in free cash flow any time in recent memory. Carved out (ex-Arconic) results from S&P Global Market Intelligence instead show Alcoa burning cash in 2013 and 2016, and averaging just $13 million (no, that's not a typo) in positive free cash flow annually over the past four years.

Long story short: Alcoa may be a buy if it can find a way to increase its free cash flow production a hundredfold in the next 12 months. But that's an awfully big if -- and Deutsche Bank is right to be skeptical.

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Rich Smith has no position in any stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. The Motley Fool has a disclosure policy.