I believe that a major opportunity is shaping up in Alcoa (NYSE:AA). Part of this has to do with the current undervaluation of aluminum metal; the rest is about the company itself. First I'll give you the reason for my bullishness on aluminum. Then I'll go through the corporate fundamentals.
I've been trading commodities professionally for over 30 years, and I still can't make accurate short-term forecasts. But long-term forecasts are another issue. Commodity prices have a very strong tendency to revert to cost of production plus risk-adjusted profit. Occasionally there is the "this time it's different" change, such as in natural gas fracking, but it's quite rare. So if you can buy a commodity for much less than cost, and you have the ability to wait out the cycle, you will do well. Easily storable commodities like metals show this effect particularly strongly. Many investors consider metals an inflation-protected store of value, so they are willing to buy scale down. This puts a floor of sorts under the price.
Aluminum is now in this situation. Figure one demonstrates what I mean. It uses the IMF's series of monthly aluminum prices since 1980. The x-axis is the inflation-adjusted (2013) price of aluminum. This is a pretty good proxy for the cost of production since costs tend to go up with overall inflation. In fact, it may understate current costs. Aluminum production is highly energy intensive, and energy costs have gone up more than overall inflation. The y-axis is the forward ten-year return of aluminum from that date. For example if you had bought aluminum in Jan 1990 at $1,528 ($2,802 in 2013 dollars) you would have gotten only 83% back in the next ten years, a loss of 17%. The graph has an R-squared of about 70%. This is a somewhat poorer fit than similar charts for pure inflation hedges like gold, but somewhat better than charts for financial assets like equities. Right now aluminum is at $1,750, implying about a 30% real price increase in the next decade. If inflation is 2% per year, this would put the actual increase at 60%.
It's important to keep in mind that this is a very long-term analysis. Over the next year or so there will be increases in aluminum capacity in China, keeping pressure on prices. China has a history of expanding capacity without regard to prices or alternatives. However, things in China may be changing to be more market friendly. I expect that there will be little new capacity that is not already underway.
So let's move on to AA. AA uses an oil industry vocabulary to describe its operations. Primary aluminum production is called upstream. This is itself a combination of bauxite mining, alumina production and metal production. Processing metal into intermediate products like rolled and coiled aluminum is called midstream. Finally, processing these into finished products like auto and aircraft parts is called downstream. The interesting thing about AA is that although upstream commands most of its capital (and most of its investor perception), downstream makes most of the profit:
2012 Annual Report
% of Land, Mining Rights, Equip and Machinery
% of pre-Tax Operating Income
Bauxite + Alumina
The downstream is why AA is currently making a small profit despite the depressed prices for Al metal. The primary customers for downstream are autos (booming in US and China), aircraft (booming worldwide) and construction (still depressed in US, decent in emerging markets). AA is the largest company in this industry and by all accounts is run effectively. It has long and symbiotic relationships with customers like Boeing. I expect this to grow at high single digit rates due to the current cost effectiveness of Al and the need for fuel economy in transportation equipment.
So here's the basic thesis. We have a company with a profitable and growing proprietary segment, and a commodity segment that is at best breaking even. My thesis is that the downstream will enable AA to weather the storm of the Al cycle. The company will do OK even in today's environment. Additionally, AA provides no-cost optionality if I'm right that Al metal prices will move up over the coming decade.
Some SA analysts have mentioned the company's debt load and pension obligations. It is true that AA is a levered company. AA has $7.5 billion in long-term debt (my end-2013 est.). Of this $750 million is due in 2014; the rest from 2017 onwards. In my view AA should have no trouble rolling over its debt. In fact, AA has been using current credit conditions to call and refinance debt at progressively lower interest rates. I know many SA readers are loath to invest in "low-quality" companies with high debt ratios. But the Bernanke/Yellen credit markets have been particularly kind to this type of company. I believe there is a high probability that this will continue for several more years.
According to Merrill Lynch's analysis, AA is about $4 billion underfunded for accrued pension/benefit obligations. In 2010 and 2011 AA was forced to issue stock to shore up its plans. I do not find the current number all that onerous. Like debt, only a small part of this is due in any one year. Moreover the rally in financial markets has strengthened the plans' positions. In the last quarter, AA had a gain of $124 million on the change in value of its plans. Note: this shows up in the financial statement table "other comprehensive income." It does not flow to the income statement. If interest rates continue to move higher, the underfunding will diminish.
One final point - a technical one: Since this site is called Seeking Alpha, here is a graph of the cumulative alpha of AA over the last year. It shows a strong downturn followed by potential bottoming action. The bottoming began before the Goldman call of two weeks ago. I am long a half position in AA and plan to add to my position on confirming breakouts on the alpha chart.
A big reason I enjoy posting my analyses on SA is the feedback from readers. I will read and try to answer all comments, especially those with differing views.
Disclosure: I am long AA. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.
Additional disclosure: I plan to add to my position in the future.