Image Source: Boeing; image source: Alcoa
Alcoa (AA) kicked off first-quarter 2016 earnings season April 12, but nobody reading our work should have much interest in shares. Our $10 fair value estimate for the company explains the lack of opportunity, and we laid in out in no uncertain terms in April 2015 that we thought, “The Time to Consider Owning Alcoa Has Passed.” Even a few months before that write-up, we said the aluminum giant was trading at a peak multiple on peak earnings, a classic valuation “no-no,” and since that time, shares of Alcoa have fallen more than 40%, “Alcoa Kicks Off Fourth Quarter (2014) Earnings Season:”
From our Jan 13, 2015 article: Would we ever considering owning Alcoa near a cyclical peak in economic demand, roughly 5-7 years into one of the strongest stock-market recoveries in history, or said differently, in the current environment? The short answer is: No. Market veterans know that the time to consider buying Alcoa is at a cyclical trough, not at peaks, and only then if there is no tangible risk of default. Having run from under $8 per share in mid-late 2013 to nearly $16 per share, Alcoa is tired. We doubt there’s enough juice left in the firm’s tank to drive annualized earnings much higher than the $1.32 per share current organic run-rate ($0.33 per share x 4). Any further earnings expansion will be driven more by acquisitive behavior, and we’re not sure Alcoa is getting the best deal on these transactions. We’re staying on the sidelines with respect to Alcoa’s shares for the foreseeable future. Any potential upside in shares is more than offset by downside risk that we know is real once the economy slows.
We like talking about our track record at times because we think it is important for readers to understand that avoiding big missteps such as the one in Alcoa may be as valuable, or in many cases more valuable, than finding the “next big winner.” We’ve had a couple losing positions in the Best Ideas Newsletter portfolio over the past five years as even the best fund managers have, but they weren’t nearly as bad as Warren Buffett’s foray into British grocer Tesco or IBM (IBM), for example, and certainly not like Bill Ackman’s disaster in Valeant (VRX) or David Einhorn’s misstep in SunEdison (SUNE). Readers ought to be shocked to hear that in the near-$6 billion Sequoia (SUQUX) at one point in 2015 Valeant had accounted for 30% of assets, with shareholders having “lost 25% over the past year, compared with a flat S&P 500.” We’re not exactly sure what went wrong at Sequoia – an overconfidence bias, a breakdown in oversight, too much pressure to outperform, or a combination of all three or something else, but shareholders aren’t happy, in any case.
Valuentum’s stock-selection methodology in considering a robust discounted cash-flow process, a relative valuation overlay, and technical and momentum indicators itself offers a series of checks and balances to aid in our team’s qualitative portfolio management overlay within the newsletter portfolio context, but we also have stringent risk management controls in the newsletter portfolios. At cost, for example, we’d never add a new position to the newsletter portfolios in a magnitude greater than 5% of assets, and we’d never let a winner run past 10% of the assets of each newsletter portfolio. In recent years, we’ve had to trim equity positions in EDAC Technologies (formerly EDAC), Apple (AAPL), Altria (MO), Visa (V), and Medtronic (MDT) because of these particular risk controls. The Dividend Cushion ratio, while not perfect, acts as an important risk control in the Dividend Growth Newsletter portfolio, having alerted us to the impending dividend cuts at ConocoPhillips (COP) and Kinder Morgan (KMI) far in advance of the actual dividend cuts.
The biggest news out of the Alcoa quarterly report was probably expected, and something that we’ve been mentioning for some time, if not directly than in passing. The aluminum bellwether modestly lowered its 2016 outlook for the aerospace market, now projecting 6%-8% growth versus a previous estimate of 8%-9% expansion for the year – not a big change, but the direction is important. We first outlined the prospects of a potential “bubble” in wide-body market, “Surveying the Aerospace Arena (Oct 2015),” and it wasn’t but April 7 that we noted in “Debt, Debt and More Debt,” that, while expected, Boeing’s (BA) commercial deliveries in the first quarter of 2016 fell more than 4%, even as shipments of its workhorse 737 and 787 Dreamliner remain robust. Investors in the commercial aerospace supply chain, which includes heavy hitters such as General Electric (GE), United Technologies (UTX), and Rockwell Collins (COL) remain very well-positioned, in our view, but we continue to describe the ongoing commercial aerospace upswing as “tired.”
Alcoa’s primary reason for the downward growth revision in aerospace is a rather benign one, pointing to lower orders for legacy models (e.g. Boeing’s 767) and the timing prior to the ramp in new model introductions across the aircraft size spectrum. Aerospace equities, however, tend to be “priced” on incremental changes in demand, often in terms of order momentum rather than deliveries, per se, and in light of more recent developments, a plateau is forming, if only because order books are so full. Said differently, while there remains a strong commercial jet order book of ~14,600 planes, amounting to more than 9 years of production at 2015 delivery rates, shares in the supply chain could still face pressure in the event new order growth slows, fair or not. Alcoa noted that there are ~23,800 aircraft engines on firm order, so the visibility of commercial aerospace remains as clear as ever, even as emerging market weakness and volatile crude oil prices complicate fleet replacement decisions.
Though we continue to remind investors that we are more than seven years into stock market strength following the depths of the March 2009 panic bottom, we have a number of favorite ideas within commercial aerospace. First, we include General Electric in both newsletter portfolios, “GE Pulls Back from 8-Year High.” Second, we’re strongly considering adding Berkshire Hathaway (BRK.A, BRK.B) to the Best Ideas Newsletter portfolio as it recently gobbled up our favorite commercial aerospace supplier Precision Castparts (formerly PCP), but we’re being patient with price. We’re fans of Boeing, United Technologies and Honeywell (HON) on a fundamental basis, and while there are small-cap opportunities in the supply chain (see here), we’re generally shying away from adding cyclical exposure to small caps so late into the economic and credit cycle as investors continue to bid shares higher.
Aerospace Suppliers: AIR, AIRI, AL, ATRO, COL, HEI, HXL, ISSC, PCP, SPR, TATT, TDY, TXT
Metals & Mining – Aluminum: AA, ACH, ATI, CENX, KALU
Related Firms: EADSY, ERJ, BDRBF, BDRAF