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Avoid This Stock Ahead Of Its Earnings Announcement

One Stock I’m Bearish On Right Now

Major aluminum producer Alcoa (AA) split off Arconic (ARNC) this past October. The idea behind the split was that Alcoa had vertically integrated too much: they were both making the raw aluminum as well as the finished products.  

The combination makes perfect sense.  

Having a captive supplier ensures best pricing. But problems began developing over time.  

First, Alcoa became a victim of their own success.  

Instead of being a small part of their business, the finished products surged ahead. Demand expanded everywhere, like in the auto industry where the drive for fuel efficiency has meant more aluminum components. (The Ford F-150 took it to a new level by using aluminum in the body.)

And while the finished parts business was booming, the commodity business was getting shellacked by an out of control China. Unable to show restraint, Chinese factories had popped up, global production far exceeded demand, and they began dumping supply below cost.

The growth business was growing, the sagging business was sagging.

So Alcoa split the businesses.  

The new Alcoa would keep its name and still make aluminum.  

The products company – the younger, but bigger brother – would be called Arconic.  Oh, and they saddled ARNC with a lot of debt – the idea being that ARNC was in a better position to pay it off because they enjoy faster growth and better margins (this frequently happens during spin-offs.)

There is still some dust that needs to be settled before Arconic is out of the woods and clear of its major debt load.

In particular, anytime there is a restructuring, there is a change to operational efficiencies that can look better or worse.  

Analysts get a lot of advance information from management. But they still have to make educated guesses when it comes to revenues and earnings. (Which means that they could get surprised.)

Right now, my data shows that they are operating with a structure that reflects a lower revenue level.

I could be absolutely wrong: the spin-out may have left them with a structure that makes them lean and mean.

But, I doubt it…

Alcoa released earnings this week, for example, and they missed. Revenues were solid: volumes rose 4% and pricing firmed up. But they completely missed profit targets. In other words, analysts are still working through the models.

Getting those models right is important. ARNC has $9 billion (B) in debt with interest rates on the rise. This means analysts have to re-visit their assumptions.

Also, beyond whether or not analysts get their models right… ARNC has a fundamental problem.

What is good for Alcoa is bad for Arconic: higher aluminum prices put the squeeze on ARNC’s profits.

And that’s exactly what happened… Aluminum prices have moved up approximately 15% since last year.

That’s from a combination of several factors:

  1. Demand expectations that China and Trump projects will boost demand;
  2. Supply expectations that China will restrain production

It’s possible prices will come down in the future.

China has a really bad track record at showing self-restraint when it comes to production. (A major reason for the commodity collapse the last few years is that Chinese production exceeded global demand.)

But with prices rising, Chinese suppliers will again be tempted to increase production.  

For one, the falling yuan enables them to cut prices and still see good margins (aluminum is priced in dollars).  

That would be good news for ARNC, but it’s far off in the future.

The biggest factor is sales from their growth markets in autos and aerospace.

Yet, auto sales have essentially peaked. And the aluminum share of the components market is still small, mostly in engines and small parts.

A big opportunity is in the bodies and shell. Steel remains the preferred material for auto structure for safety reasons. (If you’ve ever crushed an empty soda can, then you can imagine what would happen to an aluminum car in an accident.)

But the shell is another matter – that’s more about looks than functionality.

Ford advanced the use of aluminum in its F-150 truck which also makes the truck bed out of aluminum. It’s been a winner for Ford, but not without some teething pains.

Ford began converting the F-150 truck to an aluminum skin and thereby shaved off 500 pounds while also boosting horsepower.  The market liked this and sales grew nicely. However, inventory got bloated and Ford idled some plants in November.

If they can break into other auto makers, then life will be even better.  

Ford is selling ~80,000 F series trucks each month or 1M units per year.  It looks promising. But so far no other automaker has joined the party.  

Plus a Trump administration could ease the Environmental Protection Agency (EPA) fuel requirements… removing demand for lighter weight parts that enable greater fuel efficiency.

But that’s the “bullish” case. In the near term, there are plenty of growing pains.

KEY TAKEAWAY: ARNC was on a serious downtrend until the Trump rally: they fell 30% from July to October. Since November, they are back to their trading range of $20~$25.

Because they are ‘new’, the market may give them a lot of latitude on things like margin compression or a miss on sales.

Instead, the market may buy the story of future promises.

As I stated before, Alcoa missed earnings and the market still pushed the stock up. I liked Arconic as a short, but now I’m afraid the market might follow suit and push its shares up too for missing.

For now, hold off on shorting.

With the market hitting new highs and a lot of seemingly euphoric investors, anything goes.

This could have been an easy trade to profit from. But not anymore. Stay away from Arconic.

Sincerely,

Andrew Zatlin

Editor of Moneyball Economics

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