'The Little Engine That Could': Bank Of America Upgrades Alcoa

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Bank of America Merrill Lynch has upgraded Alcoa Inc AA to Buy from Neutral on aerospace opportunity.

"While aero-heavy downstream results have disappointed over the past ~18 months, we are confident in an upswing at a minimum as it starts up the new isothermal forge it acquired via Firth Rixson, which is especially levered to engines," analyst Timna Tanners wrote in a note.

"While investors may be justifiably disappointed with Firth Rixson missteps and stagnant aero-heavy EPS segment performance, we think the engine opportunity is real going forward," Tanners continued.

The analyst highlighted that Alcoa's increasing aerospace exposure now leaves it with an estimated about 75 percent of its EPS segment levered to the space or $1 billion in 2016 estimated EBITDA, of which she believes a third may be destined for engines.

Noting that next generation engine models generally lock in longer-term contracts, Tanners noted that such engines demand more complex metals, benefiting Alcoa and its Howmet and Firth Rixson forge and casting product offerings.

"While aero build rate views may prove too optimistic, AA can benefit from greater engine exposure and we think little positive aerospace developments are priced in shares. Once Firth's forge comes on line, expected in H216E, we see a positive engine demand catalyst opportunity."

The analyst cited an Airline Monitor forecast of 10 percent higher engine deliveries in 2016 and 18 percent in 2017. Airline Monitor expects 142 LEAP engines delivered in 2016 to the 737-MAX and A320-NEO versus just 34 in 2015, and 740 in 2017 ramping to 1,676 in 2018.

"These numbers imply 9% engine market share in 2015 for LEAP versus legacy CFM engines, climbing to 37% in 2017E and 80% in 2018E for these aircraft. Increased aircraft production rates can also bolster the outlook," the analyst highlighted.

Tanners also noted that shares of Alcoa are still linked with Aluminum price despite Aluminum and alumina has comprised a shrinking portion of Alcoa's earnings, "for just 23 percent of 2016E EBITDA."

According to TipRanks, Tanners has a success rate of 56 percent with an average return per recommendation of +5.8 percent. The analyst is ranked 750 out of 3,929 analysts.

Shares of Alcoa have dropped 6.6 percent year-to-date, and Tanners said the recent pullback in shares provides a buying opportunity. The stock is currently up 2.41 percent to $9.33, while Tanners raised her price target on the stock to $11 from $10.50.

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Posted In: Analyst ColorUpgradesPrice TargetAnalyst RatingsBank of AmericBank of America Merrill LynchTimna Tanners
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