Description

Century Aluminum is the third largest domestic primary aluminum producer in North America, with additional capacity in Iceland.  Their strategy for the seven years I’ve followed them closely has been to reinvest their always strong free cash flow into new aluminum capacity, either through acquisition or expanding their existing smelters.

Not a bad strategy in hindsight as aluminum prices have doubled since the lows of 2000-2003.  (to put that in perspective, copper has quintupled).  The stock has performed well, needless to say.  This used to be my no-brainer buy at 7 back in 2000 through 2003, but over the last three years I’ve become reasonably comfortable paying a lot more than that for it.  I never thought of it as more than a trade, and it has been a very lucrative series of trades going back to 2000, but it would not have been a bad buy and hold either looking back. 

Free Cash Flow vs. GAAP Accounting

Free cash flow generation has always been outstanding, but the accounting can be extremely confusing and misleading.  I suspect that is why the stock has so often been very cheap.  This is because they are hedged way out to 2013 on a lot of their production – they seem to shoot for participating in half the price move of aluminum up or down through a variety of hedging strategies.  That is something important to keep in mind when you dig into the numbers and think about the impact of a move up or down in the metals price.

Those hedges on the metal all the way out to 2013 get marked to market every quarter if the metals price goes up.  So when the price of aluminum goes up, they show a big loss on the income statement which is non-cash except for the cash flow impact of the hedge in that quarter.  So the last two years of strong aluminum pricing they are minting money, but the income statement shows a $5 loss over those two years.  And the balance sheet gets messy with this huge liability for the long-term hedge, which of course is only a liability if aluminum prices, and thus cash flow, stay this strong.  I pray to God as an owner of this that that liability is real because that means aluminum prices stay up. 

I’ve learned over the last seven years watching this stock to just watch free cash flow, and understand the leverage to a change in aluminum prices is half what it would appear to be both up and down.  GAAP accounting is extremely confusing and misleading.

Valuation

I define free cash flow as discretionary cash flow coming out of existing assets.  They don’t pay a dividend and they don’t buy back stock.  It all gets parlayed into new aluminum capacity.  Its debatable whether that is the right thing to be doing now, but these guys plow all the cash back into growth.  Maintenance cap-ex has always been low, total cap-ex has always eaten every dollar of free cash flow and then some.  I would prefer at this point that the cash flow come back to shareholders, and a takeover by private equity could accomplish that and capitalize that gain into a nice premium (I’d like to see 70+ in a takeover, and if we saw a bid for this company I suspect a bidding war could develop.)

OK, lets go to the numbers.  Start with 2006 free cash flow of about $4.50 per share.  I have conservatively adjusted the share count and interest expense for the economics of unwinding their $175 million of convertible debt (adds 2.5 million shares to the share count and 7.7 million to interest expense after tax). That’s a more conservative analysis than GAAP.

I am going to make two adjustments to that $4.50/share number.

1)      They spent a lot of money last year adding 90,000 tons of capacity to their Iceland operation.  That is an increase of about 15% to existing capacity, and this is their lowest cost capacity.  Assume there is some operating leverage to fixed costs like G&A and interest and lets take FCF up by 18%.  (The first quarter number indicates I might be too conservative there.)  This capacity was on the balance sheet by year end, but was just starting to hit the income statement and cash flows.

2)      I estimate they get about 14 cents per share of free cash flow for every 1 cent increase in the LME price of aluminum.  The 2006 number reflects LME aluminum at an average of $1.17.  It is at $1.27 today and the forward curve looks pretty solid in the $1.20s out a year.

Making those two adjustments my estimate for 2007 free cash flow per share is about $6.60, or a 13% free cash flow yield.  That looks cheap, though admittedly the stock has been a lot cheaper than that over the years.  In this takeover environment both from private equity and other metals companies, I think we have a big catalyst to realize full value.

To demonstrate that maybe I’m even being a little conservative here, their first quarter free cash flow number was $95 million with all the new capacity operating and aluminum at its higher price.  That number looked too good to be true to me, so I haircut it to $70 million, or $2 per share.  Annualize that and the free cash flow yield is 16%.  How many 16% yields are you finding in this stock market?  If so, care to share, I’d love to own a couple more.  Though I own this on my conservative numbers above, this quarter is indicative of what I’ve seen trading this stock since 2000 – my analysis has always been conservative on what they report for free cash flow. 

The stock did nothing after that earnings release which just knocked our socks off when we looked at the cash flow statement because the EPS number “disappointed”.

Catalyst

We have seen a number of takeovers in the metals industry, mainly strategic buyers.  Several wound up being rabid bidding wars.  There have been many takeover rumors on Alcoa and Alcan, with the rumored buyers being several Russian companies.  Apollo in private equity-land just bought a Swiss aluminum company.  Century looks like a sitting duck for a takeover. 

They have relationships with Alcoa and Alcan if either of them wanted to bulk up (though Alcoa’s announcement last week makes them less likely).  They also have a relationship with the Russians through their largest owner Glencore who last year did a deal with one of the Russian companies.

We have seen several bidding wars in the metals industry.  If Century, which has always been kind of invisible to Wall Street, were to get a bid, it would not surprise me at all if it turned into a bidding war between two or three parties and that’s how we get 80 out of this.

Risk

The risk is clearly the metals price.  That 14 cents per 1 cent change in the metals price works on the way down too.  I am not a metals analyst.  I just like free cash flow yields in the teens especially in stocks that are not visible to Wall Street in industries with a lot of M&A activity.  But that’s my risk.

I take some comfort that aluminum prices do not look at all crazy when compared to the runup in other metals.    The two big drivers are China and aerospace.  Aerospace looks just perfect, and China demand went up more than supply coming out of China last year.  China is now the largest consumer of aluminum in the world, and if the China growth story were to break in the near term we lose some money here.  This stock gets very volatile on “China news”, but “Boeing news” gives me a little comfort.  Aluminum going back to 90 cents would not be pretty, but supply-demand looks OK. 

Catalyst