Aluminum King Reclaiming Its Throne

07/02/2012 11:45 am EST

Focus: STOCKS

This legendary firm has had a rough go of it recently, but it's on the way back and there's a lot of headroom, writes Nathan Slaughter of Scarcity & Real Wealth.

Alcoa (AA) doesn't need much of an introduction. The company has been at the vanguard of every major aluminum industry innovation for well over a century.

With aluminum below the industry's cost of production, plant closures are putting a crimp in supplies. As a result, the world could be headed toward an aluminum deficit in the next 12 months—perhaps marking the turning point from bust to boom.

From mining bauxite to refining it into alumina, Alcoa is a global leader every step of the way. This vertical integration cuts out the middleman and generates additional income that slips through the fingers of many rivals.

Alcoa is also the world's biggest supplier of primary aluminum, accounting for 4.5 million tons annually—or one out of every ten pounds used on the planet. Finally, it's the No. 1 maker of fabricated finished products for use in the auto and aerospace sectors and other markets.Combined, Alcoa sold $25 billion worth of aluminum products last year to customers in 30 countries.

Aluminum is a prime example of what happens when investors overreact. In 2011, prices tumbled to $2,000 per ton from $2,800, a precipitous drop of nearly 30%. Traders were undoubtedly expecting economic slowdowns in Europe and elsewhere to blunt manufacturing and bite into aluminum demand.

But physical demand didn't fall by 30%, or 20%, or even 1%. In fact, aluminum usage rose by 10%. Clearly, with demand rising by 10% and prices crashing by 30%, speculators were reacting more to external noise than real fundamentals.

And Alcoa actually outperformed the industry with impressive 19% revenue growth. But the market never bothered to correct its mistake. Alcoa stock, one of the Dow's best performers in early 2011, finished the year with a dismal 43% loss.

In the first quarter of 2012, Alcoa shocked the market by posting a solid profit when just about every analyst was expecting a whopping loss. The company reported positive shipment growth in all four business lines and managed to increase sales even as underlying aluminum prices dropped 9%.

Remarkably, profit margins in the key flat-rolled products segment nearly doubled from a year ago to reach $430 per ton. That's not just 87% above the historical ten-year average of $230 per ton—it's the highest in Alcoa's history.

Alcoa's upstream (alumina) business still has some work to do to reach full speed again. But overall aluminum demand has never been stronger. And profit margins in the midstream and downstream segments are at record highs.

All in all, you could argue that Alcoa has just about healed from the wounds inflicted during the Great Recession. To strengthen that argument, let me say that annual cash flows have improved to a $906 million gain in 2011 from a $2.2 billion loss in 2008. Also, the company now has $1.9 billion in cash on hand, up from $762 million in 2008.

But the market still thinks Alcoa is bleeding to death. The stock is trading for less than $9, about the price of a fast-food combo meal. Before the crash, investors were paying more than $50 per share.

Once some of the fear subsides, the market will adjust the price to more adequately reflect what this company is really worth. Forget about the cash that will be generated in the years ahead—AA is trading at a 33% discount to its current book value.

Even in the worst-case scenario where the company is forced to liquidate its assets and pay off debt, there would still be $13.21 per share. That implies upside of at least 40%—but investors with the faith to buy now could pocket even bigger gains once aluminum recovers.

Risks to Consider: Alcoa generates most of its sales in slower-growing markets in the United States and Europe. Aluminum pricing is determined more by sentiment and perception than actual consumption, so a full-fledged recovery is unlikely until there is more optimism.

Action to Take: The aluminum market is still dogged by millions of tons of excess inventory that have built up over the past five years. But that's exactly the type of environment that puts $50 stocks in the $10 bargain bin.

And again, the aluminum market could soon be in a deficit for the first time in years, catching the bears off guard. On top of all this, Alcoa is also about to open a massive new smelter in Saudi Arabia, where natural gas is abundant and cheap. With low electricity costs, this new aluminum plant could be among the most profitable in the world.

Last year's worst performing Dow stock, Alcoa could put in one of the best showing next year. It's not often that mature Dow stocks offer triple-digit potential, but I believe Alcoa is worth more than double its current $8.55 price tag.

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