In this article, let's take a look at Alcoa Inc. (AA, Financial), a $20 billion market cap, which is one of the world's largest producers of primary aluminum as well as one of the world's largest suppliers of alumina, an intermediate raw material used to make aluminum products for a variety of end markets.
Cost curve and joint venture
To improve its cost curve, the company announced that it had formed a joint venture with Ma'aden, the Saudi Arabian mining company, to develop a fully integrated, world-class aluminum industry in the kingdom of Saudi Arabia, where infrastructures are growing to match the growing consumer demand.
Recently, the company has invested in a Saudi Arabian aluminum production complex because, with the deal with Ma'aden mining company, the firm is expected to be the lowest-cost aluminum production operation in the world. So with this deal it can capitalize on a low-cost natural gas supply to generate meaningful cost savings. We have to remember that energy represents about a third of Alcoa's aluminum production costs. Alcoa will control 25.1% of the joint venture, with the possibility to increase its participation to 40% in 2019.
Aluminum prices
The volatility on aluminum prices constitutes a risk to Alcoa's earnings, which is partially offset because primary aluminum is the output of the primary metals segment; it is also an input cost for the global rolled products and engineered products and solutions segments. This means that higher prices are positive for the company as a whole, and if they are low, it benefits Alcoa's downstream segments.
Little pricing power
Alcoa continues to have little pricing power in its alumina and primary aluminum products because they are undifferentiated commodities that are exposed to cyclical end markets. However, the company has an advantage in bauxite mining and alumina refining.
Revenues, margins and profitability
Looking at profitability, although its revenue declined, earnings per share increased tremendously by more than 500% in the most recent quarter compared to the same quarter a year ago. During the past fiscal year, the company swung to a loss, reporting -$2.15 versus $0.17 in the previous year. This year, Wall Street expects an improvement in earnings ($0.81 versus -$2.15).
Finally, let´s compare the best measure of performance for a firm's management: the return on equity. The ROE is useful for comparing the profitability of a company to that of other firms in the same industry.
| Ticker | Company | ROE (%) |
| AA | Alcoa | -19.85 |
| ACH | Aluminum Corporation of China Limited | -5.96 |
| AWCMF | Alumina Ltd. | -1.51 |
| Â | Industry Median | -8.55 |
The company has a negative ratio which is lower than the one exhibit by Aluminum Corporation of China (ACH, Financial) and Alumina Ltd. (AWCMF, Financial). In general, analysts consider ROE ratios in the 15-20% range as representing attractive levels for investment, so this ROE does not look attractive. It is very important to understand this metric before investing and it is important to look at the trend in ROE over time.
Relative Valuation
In terms of valuation, the stock sells at a price-to-book ratio of 1.6x indicates a premium versus the industry average of 1.55x while the price-to-sales ratio of 0.8x is below the industry average. This P/S indicates that the stock is relatively undervalued and seems to be an attractive investment relative to its peers.
As we can see in the next chart, the stock price has an interesting upward trend in the five-year period. If you had invested $10,000 five years ago, today you could have $10,905; that is a 1.25% compound annual growth rate (CAGR).
The stock has doubled over the past year, outperforming the rise in the S&P 500.
Final comment
Let´s start with the macro view. Global aluminum demand is expected to stay at about 7% this year. Sub-industries relevant for Alcoa will also remain attractive. The aerospace industry is expected to grow in the range of 8% to 9%, and automotive is expected to grow between 1% and 4%, packaging between 2% to 3%, and building and construction between 4% and 6%. With this outlook I feel bullish on this stock. So in this opportunity, I would recommend fundamental investors consider this attractive option for their long-term portfolios.
Hedge fund gurus like Ken Heebner (Trades, Portfolio), Steven Romick (Trades, Portfolio), Paul Tudor Jones (Trades, Portfolio), Stanley Druckenmiller (Trades, Portfolio) and Mario Gabelli (Trades, Portfolio) added the stock in the second quarter of 2014, as well as First Pacific Advisors (Trades, Portfolio).
Disclosure: Omar Venerio holds no position in any stocks mentioned
