Alcoa has Rewards for the Patient
November 1, 2012
From:  The Motley Fool
By:  Nihar Patel

Aluminum is a basic material that is used in everything from the construction of houses to the packaging for sodas. Alcoa, (NYSE: AA) one of the biggest aluminum producers in the world, has had a depressed stock price (below $10) for a very long time. I have been expecting a move in Alcoa for almost a year, but I have not seen any indication that it is impending. Instead, I am comfortable with my opinion that the potential magnitude of the move justifies being extremely patient. I think anyone that is patient with Alcoa will be nicely and justly rewarded.

I am not overly concerned with the inner workings of Alcoa to fuel the upward movement. I think the inner workings are necessary to provide a sturdy foundation, but the macroeconomic environment will be critical for setting the stock on its path. Since we cannot know when the economy will be at full steam, all we can do is make sure that Alcoa has a solid foundation. With the foundation we can at least be comfortable that modest gains are probable, and at least wealth will not disappear into a black hole.

I recently went over the Alcoa earnings call and was very interested in some of the developments. I mentioned in a previous article that the new stretched Dreamliner that Boeing (NYSE: BA) has was made of plastic composites, and if the wider trend is toward these lighter composites it could be bad for Alcoa. Skins of aircraft were aluminum, and this use accounts for a significant portion of aluminum demand. The earnings call discussed that Airbus is going to deploy wingtips, which can lower fuel burn by over 3%. Boeing uses these too, and it should help fuel retrofit and upgrade costs for Boeing, and raw material demand for the aluminum industry.

Airbus is working with Alcoa, but if the patented alloy Alcoa developed has a substantial gain on alternative alloys then Alcoa can win Boeing over too. If Boeing moves to composites with new designs because they are lighter with the same strength, then these winglets should help mitigate the damage from reduced demand. Fuel efficiency gains of over 3% are extremely substantial for the ever cost-conscientious airlines.

The other development discussed in the call is that cars will start to use more aluminum and less steel. Aluminum is lighter than steel but has the same strength, which means it is easier to hit to those rigorous fuel efficiency standards. Fuel efficiency is increasingly being demanded by consumers as well as regulations, so this is not simple a move to comply with those dastardly government regulations. If a gallon of gas costs $4.50, you want to get more than 20 miles.

As long as costs of the cars are kept under control it makes sense to use aluminum in cars, even in developing economies. Increased demand for aluminum per car is great for the aluminum industry as a whole. Countries like China and India have extremely packed cities, and with more and more cars on the road Alcoa is well suited to grab its fair share of the revenue from this source.

I like Alcoa because it is cheap in absolute terms. With the share price below $10 the impact on your cash position will be less than going with a more expensive competitor like Rio Tinto (NYSE: RIO). I think when the economy starts moving again and global demand increases, the Aluminum market will rebound. Demand will catch up and hopefully surpass supply.

More importantly, hopefully full-steam demand exceeds even potential supply. What I mean by that is the companies will have to make capital expenditures to ramp up production, and even then it will take some time before Aluminum becomes scarcer. Years of avoiding expansion because of economic doldrums hopefully pushes the price of Aluminum higher for some time before production can be ramped up. Hopefully companies won't simply be turning on some machines, but developing new mines.

Alcoa is the pure aluminum play. If you want something that is less beaten up, or something that offers a mix of metals, you can go with the aforementioned Rio Tinto. There is no way to just invest in Rio Tinto Alcan, which is the aluminum subsidiary, so you take Rio Tinto as a whole. That means you are looking at copper, aluminum, diamonds, coal, and even uranium. Going into the global demand structure for all of these for Rio Tinto's potential returns would form a saga, so lets focus on the broadest of strokes.

Iron ore is the biggest part of Rio Tinto's business in sheer volume. Iron ore is as well situated to a resurgent global economy, much like aluminum. Rio Tinto is the second largest producer of aluminum in the world, after Rusal and above Alcoa. That puts the iron ore operations into perspective. Additionally it mines copper and coal, both of which are industrial materials that will see increasing demand as the economy improves. In terms of sheer diversity, Rio Tinto is the choice over Alcoa. That diversity insulates Rio Tinto from the fluctuations of one commodity. I think that provides the key difference between Rio Tinto and Alcoa for me.

The diversity cushioned Rio Tinto in this terrible global economy. Alcoa, with its singular focus, did not have that safety net. Even while iron ore was kicked in the shin by the global economy, Rio Tinto's copper operations produced gold as a byproduct. Silver is found in much greater quantities in copper deposits, both of those precious metals had their time in the sun over the last few years. Gold is again starting to recover, which is at least a sliver of light for Rio Tinto.

Alcoa has suffered more, but I do not want to call it undervalued, because I do not believe that is the case. I just think Alcoa fell further, and with a resurgent economy I think it has more ground to make up. Alcoa will beat Rio Tinto in percentage gains over the next five years as long as the economy has an upward trajectory. With Alcoa in the $8 range it seems like a good time to start a position.


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