Alcoa reported fourth quarter earnings after the close of trading today, beating analysts estimates. Alcoa reported $.21 per share beating the $.19 estimate. EBITDA for the quarter was over $780 million.
Valuation is the most important measurement on Wall Street. With Alcoa, I would start by looking at the balance sheet. The company has a tangible book value of $8.5 billion. Subtract this from the market capitalization of $16.5 billion and we get $8.0 billion. This is the valuation the market it putting on future cash flows. Alcoa generated over $1.4 billion in cash flow for the fourth quarter and over $2.3 billion for the year. The market is valuing the company at less than 4x its cash flow. This strong cash flow could yield future dividend increases.
In an interview on CNBC following the earnings, the CEO discussed his optimism with the company and said he sees the aluminum market doubling over the next decade. This is a very positive sign for Alcoa going forward. Analysts estimate earnings growth of 15% per year over the next 5 years. CNBC commentator Jim Cramer listed Alcoa as one of his stocks of the year.
I believe Alcoa is undervalued. I believe the company is worth 8x its cash flow plus its tangible book value; yielding a valuation of $27 billion, or $26.50 per share. This is my 18-24 month price target.
The one truth that has held true through market ups and downs: Cash is King. There are many examples of bubbles throughout history that exist because the market loses focus of this truth. Even the housing bubble can be attributed to this. If you are willing to purchase a home at 40-50 times the amount it rents for… you have lost sight of the value of the properties income. Even the companies that survived the bursting of the tech bubble took a decade to achieve positive cash flow that warranted the price paid in the late 90s; most never did.
Speaking to the bond investors who read the previous article, a cash rich company with a high dividend yield could be a good alternative investment. Income is still available for your portfolio, preferred tax treatment exists, and you will benefit from positive economic growth. If you want large companies with strong cash flow and high yields, look no further than the “Dogs of the Dow”. Even moreso than bonds, equities are subject to price changes. These changes can be volatile and dramatic. The economy is rebounding and growing, corporations have scaled back workforces, increased cash levels, and are a far superior alternative to bonds at these levels. Lets examine a few of these companies.
The top two yielding “Dogs of the Dow” are Verizon and AT&T. One important key to a strong portfolio is diversification. Given that these companies operate in the same industry, my advice would be to pick one. Both companies have tremendous cash flow, are rapid trying to expand their network, and yield over 5%. There is one variable that differentiates the two companies; the iPhone. AT&T has it, and Verizon is going to get it. While analysts predict that AT&T will only lose 5% of its revenues once it loses its US monopoly on the iPhone, I expect Verizon to outperform AT&T over the next 12-18 months.
The decline in home prices, mortgage fallout, and stock market decline of 2008/2009 has led to many individual investors becoming risk averse. All investors want a high rate of return, but many more no longer are willing to take the risk to achieve it. The United States Treasury bond is the ultimate risk off asset class, and yields have plummeted as more investors crowd the space. This can be said about the entire bond market over the past few years. Tremendous price profits have been made in a sector known for yield.
Bond funds such as iShares Barclay’s 20 year treas bond fund, (TLT, 92.43) show spikes during periods of high risk aversion (December 2008, and during the flash crash of 2009) while supporting a yield around 4%. Over the past 6 months however, prices have begun to decline as yields on treasuries increase. This is the start of a long term trend; a bear market in bonds. Not a problem is you plan to hold the bonds to maturity, a big problem is you are investing in bond funds which do not. Bond funds buy and sell at the market price to maintain a set duration; these funds will come under pressure in years to come.
One bond fund that I have personally invested in over the past two years and made a handsome profit in is the iShares iBoxx High Yield Corporate Bond Fund, (HYG, 90.76). This is the risk on trade for bond investors. Investing primarily in low credit quality corporate bonds, junk bonds, HYG has a yield over 8% and has returned price appreciation of the past few years. With corporate balance sheets looking healthier than in years past; this is one bond fund that could buck the trend but will not have performance returns that match the past few years.
The Federal Reserve’s recent decision to purchase up to $600 Billion in treasury bonds will also negatively impact future bond performance. Chairman Ben Bernanke’s policies, referred to most recently as QE2, have artificially deflated yields in the short term. Once the Federal Reserve stops purchasing bonds yields will normalize at a level higher than they are today. While the Federal Reserve most likely will hold the bonds until the mature, if they did decide to sell those bonds at any point in the future, the opposite effect would exist; yields would be artificially inflated in the short run; another negative for bond prices.
As money comes out of bond funds and into equities; I urge investors to take a look at their portfolios and increase their equity exposure. Bonds produce steady income but that income can be offset by a decline in bond prices. If your desire is to invest in bonds, I would recommend individual bonds or corporate bonds that you hold to maturity; not bond funds as it is in the funds that price changes and fees deteriorate return. Bond investors should note the opportunities that exist in high yielding equities with strong cash flow.
