I had gotten some e-mails from readers asking about Alcoa’s proposed spinoff of Arconic later this year, and I don’t currently have any comment on the quality of Arconia as an investment because I don’t know enough specifics about the operations that are about to be spunoff. But I do know enough about Alcoa’s core aluminum business to say this: Never make a long-term investment in the aluminum sector. Especially an operator that has a lot of debt and steep losses during extended declines in the sector which are never offset by the short-lived and dispersed years of high aluminum prices.
Since 1990, Alcoa shares have only returned 2.38% annually. That wouldn’t have even kept the pace of inflation. Your $10,000 in 1990 purchasing power would be reduced to around $8,500 in purchasing power today once the effects of inflation were added to the calculation. You waited 25 years holding the stock, and you ended up losing $1,500 in inflation-adjusted purchasing power. It’s a real reminder that “time” in the market is only an ally if you are dealing with a wonderful business. A mediocre business does not benefit from the passage of time, as it spends the years putting out one fire after another and constantly reshuffling corporate activity to sell investors the promise of a better future because the actual reality of the business is nothing to get excited about.
The price of Alcoa stock is down to $9.73. Some people wonder: “Is this a good time to buy the stock for the long term?” No, it’s never a good time to buy the stock for the long term. Since 1990, it has never grown profits consecutively more than three years in a row. After profits recovered and then exploded to an all-time high of $2.5 billion in 2006 and 2007, the corporation’s profits fell to $228 million in 2008 and then a billion-dollar loss in 2009. The $0.68 dividend got rebased to a lower level of $0.12 annualized, where it has since remained.
And because the industry is capital intensive, you have all this debt creating a junk balance sheet that lends itself either to taking on additional debt at a higher interest rate (and thus creating a higher cost of capital that raises the hurdle to create shareholder wealth) or issuing shares during difficult operating environments when the price of the stock is probably low.
Right now, Alcoa has $9.1 billion in balance sheet debt. It’s on pace to make somewhere between $200 and $400 million in net profits this year. What’s crazy is that, despite the fact that it has been profitable, Alcoa has still felt the need to raise capital by issuing new share amid a declining stock price. There were 1 billion shares of the stock in 2013. As the stock price has slid from $17 to $9 in the past three years, the corporation has issued almost 300 million new shares to bring the share count up to 1.31 billion. Yikes.
Even if you could somehow become the owner of Alcoa with no debt on the balance sheet and $1 billion in the bank, it would still be quite difficult to deliver high single digits over the long term. But what’s even worse for current Alcoa shareholders is that the company is a poor operator in a poor industry with a poor capital structure–it has created 300 million shares during a period of bad but not terrible conditions.
The interest payment on the debt alone is $450 million. In other words, it may very well owe more in interest payments over the next ten years than it will make alone in profits this year. Another issue is that $4 billion in debt obligations are coming due between now and 2000, and Alcoa is only expected to generate about $6 billion in total free cash flow over that time. Another 20% or so downturn in the aluminum market, and it would be difficult for Alcoa to cover the required payments on its debt from the ongoing cash flow that the business throws off.
Some people are touting it as a bargain because its book value is $9.50 per share. I am currently unclear on how the debt and pension obligations will be handled between Alcoa and the spin-off corporation Arconic. There’s $9 billion in debt, plus an underfunded pension that is supposed to have $16.5 billion in assets but only has $10.9 billion.
Alcoa doesn’t release the specific terms of its $9 billion in contract debt. But usually, when a bank or lender provides money to some corporation, it includes an anti-assignment clause in the provision. This means that a corporation cannot transfer your debt through merger or demerger activity without going back to the negotiating table with creditors. Sometimes, if there is a situation like Instagram creditors dealing with Instagram during the process of merging with Facebook, the creditors will happily transfer the debt obligations onto Facebook’s balance sheet because Facebook poses a lower credit risk than Instagram.
Other times, the credit risk of a corporation increases when it spins off, as the creditors of assets that are trying to be transferred to Arconic will no longer have the right to claim the assets of both Arconic and Alcoa in the event that they don’t get paid. In this type of situation, creditors are more likely to create a fuss about transferring any debt onto the balance sheet of Arconic, and therefore, would demand a higher interest rate for shifting the debt towards a corporation that has a smaller asset base on which to lay claim in the event of a default.
Or, Alcoa could have negotiated debt contracts that transferred automatically with the subsidiaries in the event of a spinoff. The point is that we don’t know, as the Alcoa annual report doesn’t disclose how debt transfers are treated in the event of a common stock spinoff.
For those investors that have a short-term horizon, I have no idea what Alcoa’s stock price will do in the short term. It very well could climb to $17. Or fall to $4. I don’t know what the short term movements of aluminum will do. If you are looking to make an investment in this stock lasting less than five years, I have no comment on the strategy.
But if you are intending to hold Alcoa stock for the longer term, seeing the recent price decline as the opportunity to make a value pick, I do have an opinion: Stay far away from Alcoa. It’s a terrible core business that never has three up years in a row, but sure does give its shareholders more than three bad years in a row. The gains during the years of high aluminum pricing are never enough to offset the lows and losses when aluminum is cheap. Furthermore, the pension is quite underfunded to the tune of almost $7 billion, there is $9 billion in total debt due, $4 billion due within five years which creates pressure in the event of a subsequent aluminum price decline, and the shareholders just recently experienced almost 300 million shares of dilution.
Yes, you can argue that all of these things are priced into the stock at $9.73. The problem is that there is always more bad news ahead with this industry in general and this stock in particular. It’s not a coincidence that this stock has only returned a little over 2% annually for the past 25 year. It’s causation.
Originally posted 2016-04-11 20:00:42.