Look for This Stock to Toughen Up

03/20/2013 9:45 am EST

Focus: STOCKS

Taesik Yoon

Editor, Forbes Investor and Forbes Special Situation Survey

Pricing and cost improvements should put the 'shine' back in this company's steps, says Taesik Yoon of Forbes Investor.

Producers of commodities tend to have volatile stock prices, due to the uneven nature of their cash flow.

When demand rises, this often results in higher selling prices and profit margins. But if demand falters and commodity prices fall, the typically high fixed-cost nature of these operations can lead to a significant decline in earnings.

Falling aluminum prices over the past year and a half have had a devastating impact on profits of aluminum producer Noranda Aluminum (NOR). This resulted in a wider-than-expected operating loss in the fourth quarter and a 71.5% decline in operating income for all of 2012. Predictably, the stock has responded in kind, falling 63% over the past year.

But the value of a company is based more on future expectations, not past operational performance—especially with shares of commodities producers, which tend to discount demand and pricing trends much further in advance.

Fortunately, these trends are beginning to improve for NOR. Coupled with ongoing efforts to enhance operational efficiency, we think the company will enjoy a substantial rebound in profits in 2013.

NOR is a fully-integrated producer and global supplier of value-added primary aluminum and high-quality rolled aluminum coil. Its operations are divided into four segments, which cover the entire aluminum production process.

Fourth-quarter revenue declined 1.7% year-over-year to $332.9 million, driven primarily by lower London Metal Exchange-linked prices in all businesses and weaker third-party volumes in Bauxite, Alumina, and Primary Aluminum, which more than offset the favorable impact from higher Flat-Rolled Products volumes.

Despite the decline, total revenue came in slightly higher than expected. However, increased operating costs, reduced volumes, and an unseasonably long rainy period resulted in an operating loss of $4.1 million in its Bauxite segment.

NOR was also negatively impacted by the reoccurrence of process control issues at its Gramercy refinery, which resulted in additional costs and lost production time. This contributed to an adjusted net loss of $7.8 million, or 12 cents per share, versus net income of $600,000 (or a penny per share) the prior year, and fell well short of the 3-cent loss analysts had predicted.

There are several reasons to expect much better performance in 2013. First, NOR expects further improvements in the US and global economies, which should help volume return to the approximately 580 million pounds shipped in 2011 from the 572 million pounds shipped last year. We believe this will have a positive impact on average realized prices.

And after trending downward since mid-2011, the company saw a slight recovery in quarterly average prices in Q4. This has continued into 2013, and NOR believes there currently is greater support for sustained periods of higher pricing.

On the expense side, NOR recently extended its long-term bauxite supply agreement by five years. This contract offers the potential for more volumes at competitive pricing levels, and should help address issues that led to the operating loss reported by its Bauxite segment in Q4.

Additionally, we expect NOR to continue benefiting from its ongoing CORE operational enhancement program, which generated $54 million in cost savings in 2012. Over the longer term, NOR should also benefit from expected upgrades to several of its facilities.

This may be why the current analyst projections call for a substantial rebound in earnings to 29 cents per share in 2013, and earnings growth of 250% in 2014.

So while near term challenges remain, we believe NOR's ongoing operational improvement efforts, coupled with the persistence of a more favorable pricing-demand environment, will allow the company to meet or exceed its earnings expectations for 2013. This, in turn, should result in a significant rebound in share value.

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