One of the American industrial icons, Alcoa (NYSE:AA) has fallen behind in a modern transformation of its business, when many old peers have moved on with their renewed products for the changing times. GE, for example, is no longer a manufacturer of lighting fixtures and household appliances, things that the company was known for through many years, as those products can now be made by anyone without needing advanced technologies. GE has transformed itself into a modern industrial company, supplying jet engines, wind turbines, rail locomotives, etc., a wide collection of higher-value industrial products.
Meanwhile, Alcoa still has the same operations that it was founded on more than 120 years ago, namely bauxite (aluminum ore) mining, alumina (aluminum oxide) refining and aluminum smelting. Such raw materials productions are certainly not at the forefront of developing today's aluminum engineering technologies and also not very representative of the broader economy, which probably is one reason for the recent exclusion of Alcoa from the Dow Jones Industrial Average. Without transforming itself from a producer of commodity aluminum to a manufacturer of value-added, modern industrial aluminum products, Alcoa may even run the risk of someday being excluded from investors' portfolio lists.
Compared to the challenges that GE once faced in getting out of its then low-margin, increasingly commoditized consumer products, Alcoa is in a situation whereby producing aluminum still relies on this one early-day invention called the Hall-Héroult process, making it possible for anyone to set up a smelter and become an aluminum producer. The most recent aluminum glut is partly the result of excess supplies brought on by emerging aluminum smelters newly built in some emerging countries.
It's not surprising that Alcoa can't gain much competitive advantage in aluminum producing, when everyone uses the same aluminum producing method. Along with others, Alcoa has suffered from aluminum price declines when a lot of what it does is also what everyone else can do, that is, making primary aluminum metals.
Almost 60% of Alcoa's 2013 sales comes from its primary metals business of making aluminum ingots and billets, as well as the company's flat rolled product segment, whose production includes aluminum plates and sheet, another form of relatively low-value, basic aluminum materials. After adding revenue from its alumina refining operation, the entire upstream aluminum business at Alcoa contributes nearly 75% of its total sales.
That leaves about only 25% of the total sales attributable to the company's higher-value business of engineering products and solutions, its so-called downstream aluminum business. If Alcoa can turn its current sales distribution between its upstream and downstream operations upside down, it will both increase sales and improve margins, irrespective of any potential excess world supply of primary aluminum.
To transform itself into a modern aluminum powerhouse, Alcoa should seriously consider getting out of the business of bauxite mining and alumina refining, or at least spinning it off to form a separate operating entity. This would help free resources from its low-margin commodity aluminum business and redeploy them for developing value-added aluminum industrial products.
Alcoa could retain some of its upstream smelting business to provide a secure base of aluminum starting stock, such as ingots and billets, for the company's own downstream operations. Once again, its mining and refining operations would have to be scaled down to a level at which enough mined aluminum ore and refined alumina are available to feed only its own smelters.
Eventually, companies of commodity aluminum producers will come into aluminum mining, refining and smelting and become suppliers of basic aluminum materials to someone like Alcoa, more of a manufacturer of aluminum industrial products. With its advanced engineering expertise, Alcoa must move onto providing more technological industrial applications and solutions for a variety of industries, including aerospace and automotive, that have many practical uses of light aluminum or aluminum alloys.
Alcoa's recent proposed purchase of aerospace parts maker Firth Rixson is a positive move towards a much-needed transformation of itself into a modern aluminum business. Time has changed, and Alcoa has to let go its old identity as a proud producer of primary aluminum. If little is done over time to restructure its primary aluminum business, including its mining and refining operations, Alcoa's future growth and earnings will be rather limited, as the business of commodity aluminum consumes a lot of resources but doesn't provide many upsides.
Disclosure: The author has no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.