Alcoa Downgraded

We are downgrading Alcoa Inc. (AA: 11.43 0.00 0.00%) to Underperform from our previous Neutral recommendation. The short term (1 to 3 months) strong sell rating is supported by its Zacks #5 Rank.

Alcoa Inc., the U.S. aluminum giant, is facing lower aluminum prices and higher input costs. In our view, Alcoa’s near- to medium-term profitability is likely to come under pressure from rising energy and caustic soda costs. We also believe that the depreciation of the U.S. dollar is likely to translate into higher costs for Alcoa’s Australian, Canadian and European operations and restrain earnings. Additionally, higher restructuring charges are pressuring margins of the company.

Alcoa recorded its fifth consecutive loss of $194 million or $0.19 per share in the first quarter of 2010. However, losses narrowed from a loss of $480 million or $0.59 in the first quarter of 2009. Accounting for restructuring and special charges of $295 million or 29 cents per share, Alcoa earned 10 cents per share.

Alcoa’s share price has declined consistently in the last couple of months after it reported first quarter 2010 results. We believe Alcoa’s weak performance will continue for the rest of 2010. However, higher downstream volumes and prices may drive its top-line growth. Nonetheless, we are downgrading the stock to Underperform.

Liquidity Under Pressure

Alcoa’s free cash flow position is likely to worsen considerably due to higher capital expenditure on growth projects. While these projects could have longer-term benefits, they have depressed Alcoa’s return on invested capital in the interim. The company reported a negative return on equity during 2009 and in the first quarter of 2010. Alcoa’s debt-to-capitalization has hovered around 36% in the past three quarters while debt-to-equity has remained above 50% in all the three quarters.

Value Fundamentals

On a price-to-book basis, Alcoa is currently trading at 0.7x, a 69% and 78% discount to the industry average and S&P, respectively. Our Underperform recommendation on the stock indicates that it would perform below the broader market. During the last six months, shares have traded in the range of 1.0x to 0.7x book value (as of March 31, 2010).

We believe the depreciation of the U.S. dollar will have negative cost implications. Consequently, a significant expansion in Alcoa’s valuation is less probable in the near term.

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