Ejected from the Dow...should be injected into your portfolio? (part 1)

Reuters ran an interesting story earlier this week:

'In the biggest shake-up of the Dow Jones industrial average in nearly a decade, Goldman Sachs, Visa and Nike will join the storied 30-stock index, with Bank of America, which just two years ago was the largest U.S. bank by assets, one of the names exiting the Dow.

The three newcomers - an investment bank, credit card payment processor and apparel company, respectively - will also replace Alcoa, in the index since 1959, and Hewlett-Packard Co.

The changes will take effect at the opening of trading September 23, said S&P Dow Jones Indices, whose index committee makes decisions on the make-up of the average'


Whenever I hear about index changes I think opportunity...specifically for those companies being ejected.  Removal from an index can induce an opportunity as index trackers sell.  This is especially true about the Dow Jones index which is price-weighted rather than market capitalisation weighted. 

So, where do I start?

Hewlett-Packard

I wrote about Hewlett-Packard (HP) a couple of weeks ago.  You can find the full report here.  In summary, I concluded that US$20 was a better level to re-consider this high cash flow generative but structurally challenged company.  Share price today?  US$22.20.  I have the watch level alert on near US$20.

Alcoa

As for Alcoa, I wrote up some thoughts about the company, following their early July Q2 numbers, a week or so before the launch of this website.  I reproduce these below. 

Some brief headlines on the numbers:

Aluminum producer Alcoa's adjusted EPS earnings came in at $0.07. Analysts expected EPS of $0.06.

The stock was up 1.5% after hours.

Revenue also beat at $5.85 billion versus estimated $5.79 billion.  Second quarter 2013 net loss of $119 million, or $0.11 per share, compares to net income of $149 million, or $0.13 per share, in first quarter 2013, and a net loss of $2 million, or $0.00 per share, in second quarter 2012, the company said.

Speaking on CNBC, CEO Klaus Kleinfeld said he was not concerned by a China slow down. The company does not make any mention of China, Asia or the Pacific in its release.

Some key charts from the presentation –

If you strip out the special items then the company did make money in their Q2 although sequentially less qoq as shown below…mostly due to lower LME aluminium prices, volumes/productivity etc were positives –

Cash flow and debt – getting better but not a consistently FCF generator yet.  Still getting on for US$500m of debt reduction in FY13 to date is not bad. 

 

In the conference call the management team said that the aim was just FCF generation for the FY…implied that H2 FCF generation would not be as strong

This is the chart most analysts talk about…lots of Chinese and Global ‘green’ whilst Europe is the most negative area.  Not that most consistency sector-by-sector. 

Europe the laggard globally too – aluminium still an emerging markets growth commodity

 Here is what the Alcoa management said on the conference call re China –

 So in total the capacity that we see in China is pretty stable and an important thing that I can't emphasize enough I have the feeling is that in spite of what China does, I mean China for us on the aluminum industry is living on a different universe, so there's the universe let's call it earth aluminum and China aluminum and they rarely communicate, right?

Because they are high cost and they are not going to export and that is extremely important. I believe that we will continue to see the Chinese aluminum industry to restructure.

Aluminium in small deficit using the below chart but ultimately dependent on demand. 

So what do we think of Alcoa?  Well they are on the right track (cash flow focus, productivity improvements) but are still scraping around on wafer-thin margins for a business with an EV of over US$16bn.  Consensus earnings for this year put the stock on a p/e of x22 odd.

The shares are kicking around a 1 year low (c. US$8) and this will attract some value buyers.  I am struggling though to get very excited.  There are better focused metals/mining companies around with equivalent correlation to emerging market growth. 

Have another look at US$7?

So back to the present day now...Alcoa shares have been volatile over the last two months but are still just north of US$8 but have never retraced to the US$7 level.  My instinct is to stick with this level despite some talk about improvements in the European economy which does help global demand at the margin.  Price:book is around x0.7 but there will be a lot of historic unproductive assets in there.  The P/e rating today for this year, due to further downgrades in the last couple of months, is now x26.  Not exactly value. 

So nothing of interest at prevailing share prices for HP or Alcoa.  What about Bank of America?  Part 2 - which will look at this major financial - will follow in the next 24 hours.