Alcoa

Trade Unit:
Long: Alcoa (AA) $650,000
Short: 1 LME 15-month Al (about $65,000)
Short: 9 mini Sp500 futures (not for long-only traders)

Alcoa has been in the news a lot recently, mostly because of purported takeover attempts. The hard names mentioned have pretty much said no, but smoke keeps rising from this particular slag heap.

Slag heap is a good metaphor here. AA has underperformed virtually all its peers and the aluminum market as well. The graph on the left (click on it) shows AA indexed to nearby aluminum and the SP500. Pretty bad - you would have thought the bull market in Al would have helped this name. Why has this happened? The earnings models give a lot of reasons, mostly having to do with cost increases and capital spending. The nut of it seems to be a typical entrenched management story - empire building and valuing stakeholders over stockholders.

In the past, management like AA's would probably be able to get away with this. However, the flood on money into activist hedge funds has made even big caps like AA targets. There seems to be no question that the assets of AA, both fixed and long term contractual, cannot be duplicated for the current stock price. So I'll bet the takeover story has some good legs.

The other thing I think the market is missing is the effect of the price of aluminum, which has just had a (belated) bull move. This is definitely not factored into AA's price. This is a big deal because AA has a lot of operating leverage. Analysts are estimating about $3.05 this year, based on about $1.00 LME aluminum. If you factor in current futures prices, this rises to about $4.50. Note: This number comes from a detailed earnings model, not published here. This would give a forward P/E of 7.7 and a price to free cash flow of about 6.5! In reality, these are too high: we can count on AA's management to waste part of this away.

OK, how do we trade this one? The standard commodityequity trade would be to buy AA and sell Al. In this case however, I would keep the commodity hedge pretty small. The case for AA is mostly one of a principal-agent problem that the market will fix, not a pure commodity one. For this post I'm arbitrarily putting the hedge at 10%. In fact, smaller accounts could do fine by not doing it at all. In any event, don't use the normal 3-month forward. AA's price will vary more with the longer-dated forwards.