My Thoughts On Arconic\'s Downtrend

Arconic (ARNC) is the result of a separation of Alcoa Inc. in 2016. Alcoa Inc. became Arconic and Alcoa Corp. (AA). Alcoa Corp. is focusing on the production and distribution of aluminum while Arconic is a producer of various aluminum products, serving markets ranging from automotive aluminum to aerospace supplies. The stock price is currently more than 40% below its January 2018 highs due to the pressure from rising input prices. img src="https://static.seekingalpha.com/uploads/2018/7/11/31557165-15313267679343417.png" width="640" height="284" data-width="640" data-height="284" data-og-image-twitter_small_card="true" data-og-image-twitter_large_card="true" data-og-image-twitter_image_post="true" data-og-image-msn="true" data-og-image-facebook="false" data-og-image-google_news="true" data-og-image-google_plus="true" data-og-image-linkdin="true"">>

Source: Arconic (Photo: Arconic Fasteners)

'Something' Broke In The First Quarter

The first graph of this article is a comparison between the stock price of Arconic and the Industrial Select Sector SPDR ETF (XLI). Industrial stocks had a tremendous performance in 2017 with returns close to 20%. Arconic did go sideways with two major peaks. The first one happened in the first quarter of 2017 while the other one took place in the last quarter of 2017. At this point, we see that industrials are weak while Arconic has broken down below its opening price of 2016.

img src="https://static.seekingalpha.com/uploads/2018/7/11/31557165-15313342329239874.png" width="640" height="332" data-width="640" data-height="332" data-og-image-twitter_small_card="true" data-og-image-twitter_large_card="true" data-og-image-twitter_image_post="true" data-og-image-msn="true" data-og-image-facebook="true" data-og-image-google_news="true" data-og-image-google_plus="true" data-og-image-linkdin="true"">>

Source: TradingView

There are many things that could be the reason of the current weakness. However, economic growth fears are not a reason as I discussed in this article. One of the reasons why the stock market is weakening is the fear of an escalating trade war. Every short-term rally has ended with some kind of news regarding new tariffs on Chinese products.

So, why is Arconic being punished this much?

Higher Input Prices Ruin The Day

Even though the company is presenting its second-quarter earnings on the 31st of this month, it still makes sense to look at the first-quarter results of this year. These results reveal strong organic growth across all segments. Engineered products and solutions saw 2% organic growth while global rolled products saw 4% higher organic sales. Transportation and construction solutions hit it out of the park with 13% organic growth in an environment of high trucks and construction demand.

That being said, rising aluminum prices are a challenge on top of secular problems like lower industrial gas turbines demand. The company is not part of Alcoa anymore which increases the negative effects of a rising aluminum price. Arconic needs high margins since its business is based on turning aluminum into high quality parts and products. In this case, the company needs outperforming demand and an underperforming aluminum price.

The result in the first quarter were very depressing operating results with operating income down in all segments. Especially, global rolled products were down 18% despite a consistent auto market with an increasing demand for high quality aluminum.

img src="https://static.seekingalpha.com/uploads/2018/7/11/31557165-1531351177243735.png" width="640" height="358" data-width="640" data-height="358" data-og-image-twitter_small_card="true" data-og-image-twitter_large_card="true" data-og-image-twitter_image_post="true" data-og-image-msn="true" data-og-image-facebook="true" data-og-image-google_news="true" data-og-image-google_plus="true" data-og-image-linkdin="true"">>

Source: Arconic Q1/2018 Earnings Presentation

Getting an ugly hit due to higher input prices is one thing. The problem, however, is that the inflation effects are pushing down the full-year expectations. EPS guidance has been lowered $0.19 due to higher aluminum prices. This translates to a (negative) 13% effect on the lower EPS range.

img src="https://static.seekingalpha.com/uploads/2018/7/11/31557165-15313526648300326.png" width="640" height="359" data-width="640" data-height="359" data-og-image-twitter_small_card="true" data-og-image-twitter_large_card="true" data-og-image-twitter_image_post="true" data-og-image-msn="true" data-og-image-facebook="true" data-og-image-google_news="true" data-og-image-google_plus="true" data-og-image-linkdin="true"">>

Source: Arconic Q1/2018 Earnings Presentation

Another problem is the company's debt load. The current long-term debt value is 1.2x the company's total equity. Even though this ratio is well below its 2016 highs at 1.56, it is a challenge to further lower this ratio in an environment where operating income gets clubbed due to rising input costs. However, the company's liquidity as measured by the current ratio is safe at 2.10. Even adjusted for inventories (quick ratio) the value is at a solid 1.20.

Chart

ARNC Debt to Equity Ratio (Quarterly) data by YCharts

Expectations Are Low

At this point, there are two major factors to consider. The first one being the economic growth rate of the US. At this point, leading indicators are still very solid which supports coincident indicators like new orders, industrial production and GDP growth.

The second factor is a trade war. Even though Arconic conducts only 4.7% of its business in China and 63% in the US, there is a risk of rising aluminum prices.

At this point, the price is well above $2,000. This means two things. The first one being the fact that Aluminum prices did not continue to rally over the past 3 months. The second point is that prices are still 9% higher on a year-on-year basis. This will once again impact second-quarter earnings.

img src="https://static.seekingalpha.com/uploads/2018/7/12/31557165-15313933183491366.png" width="640" height="269" data-width="640" data-height="269" data-og-image-twitter_small_card="true" data-og-image-twitter_large_card="true" data-og-image-twitter_image_post="true" data-og-image-msn="true" data-og-image-facebook="false" data-og-image-google_news="true" data-og-image-google_plus="false" data-og-image-linkdin="true"">>

Source: Markets Insider

The same goes for 2018 and 2019 EPS estimates. Even though 2019 is expected to see higher earnings than 2018, there are no signs of rising optimism as expectations have gone down lately after going sideways for more than 12 months.

img src="https://static.seekingalpha.com/uploads/2018/7/12/31557165-15313925340201254.jpg" width="640" height="249" data-width="640" data-height="249" data-og-image-twitter_small_card="true" data-og-image-twitter_large_card="true" data-og-image-twitter_image_post="true" data-og-image-msn="true" data-og-image-facebook="false" data-og-image-google_news="true" data-og-image-google_plus="false" data-og-image-linkdin="true"">>

Source: 4-Traders

On one side, we have the company's problems regarding low earnings while we also see slight improvements after 2019 (higher EPS estimates). This puts the forward PE ratio at 11.11 while the stock is trading at 0.62x sales. Both ratios are cheap.

Takeaway

Arconic is going to publish its second-quarter earnings at the end of this month. The Wall Street consensus expects EPS to come in at $0.30 which means that EPS is flat on a Y/Y basis. Personally, I do not think this is a problem given that expectations have been very low for quite some time now. What is important, however, is the company's ability to turn higher sales into higher earnings. I hope to see concrete steps towards a higher profitability.

If the company is able to beat EPS or even raises guidance, I expect to stock price to jump higher. The stock price has been crushed after last quarter's disappointment which has resulted in a dirt-cheap valuation and a severe downtrend. Every sign of positivity could fuel a short-term stock rally.

img src="https://static.seekingalpha.com/uploads/2018/7/12/31557165-15313940090830336.png" width="640" height="311" data-width="640" data-height="311" data-og-image-twitter_small_card="true" data-og-image-twitter_large_card="true" data-og-image-twitter_image_post="true" data-og-image-msn="true" data-og-image-facebook="false" data-og-image-google_news="true" data-og-image-google_plus="true" data-og-image-linkdin="true"">>

Personally, I am not buying the stock because I am already long both basic materials and companies that produce tools/equipment/parts like Illinois Tool Works (ITW). However, I will continue to monitor the situation because I expect an interesting bull case if the company is indeed able to turn things around.

Stay tuned!

Thank you for reading my article. Please let me know what you think of my thesis. Your input is highly appreciated!

Source : https://seekingalpha.com/article/4186968-thoughts-arconics-downtrend

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My Thoughts On Arconic\'s Downtrend

Source:U.S

My Thoughts On Arconic\'s Downtrend