Adding Alcoa To My $100,000 Portfolio

| About: Alcoa, Inc. (AA)

By David Sterman

Time waits for no one. The market has rung in the New Year, and slow-to-move investors may miss out on further gains ahead. So I'm moving quickly to name the second pick in my $100,000 portfolio.

As is the case with Ford (NYSE: F), my initial holding, it's also a well-known company. Its roots go back to 1887, when chemist (and company founder) Charles Martin Hall figured out how to make aluminum through the use of an electric current.

If you missed the initial installment, then allow me to explain. StreetAuthority is giving me $100,000 to invest in my absolute best investment ideas. I'll be sharing my trades with you for free -- but only for a limited time. This morning, I bought 1,090 shares of Ford at a price of $11.44, after a self-imposed two-day waiting period. The stock has moved up more than 5% since I mentioned it on Friday, Dec. 30, so readers who jumped on my recommendation already are showing a nice gain.

The advances are coming from stellar sales figures for last month. Sales rose 10% from a year earlier in December, which was at the top end of the forecast consensus range. On a full-year basis, sales rose a healthy 17%. That strong finish to 2011 is why I think the current consensus earnings-per-share (EPS) forecast of $0.26 for the fourth quarter is too conservative and likely to be exceeded.

Now, on to today's business...

Buy #2: A beneficiary of a shrinking industry

The prolonged economic weakness in the United States and Europe has surely been hard on industrial firms, as demand for many goods remains well below levels seen in the middle of the last decade. Adding insult, Chinese manufacturers have ramped up quickly, flooding the world with lower-priced products.

Perhaps no companies have felt the twin pressures of falling demand and rising supply as acutely as the world's makers of aluminum. Not only has economic activity slowed in recent years in the world's largest economies, but China has in recent years built dozens of new aluminum smelters that created a glut of the lightweight shiny industrial material, which goes into everything from soda cans to premium cars.

Making aluminum consumes lots of electricity. But one company's management made a brilliant move, building new aluminum smelters where energy is really, really cheap, in places like Iceland and Trinidad & Tobago. The fact that this company is the lowest-cost producer of aluminum in the world has made life even more difficult for rivals in China and elsewhere. That's why, when I looked at Alcoa (NYSE: AA) back in October, I mentioned that the Chinese government has begun to deprioritize aluminum.

I am reproducing this chart from that story, as a picture tells a thousand words.

With China now a net importer of aluminum, Alcoa has one less migraine to worry about. Some market forecasters even say China's 2013 aluminum output will drop back to 2009 levels.

Of course, demand is the other part of the equation, and this stock is near a 52-week low on concerns that European demand for aluminum will crater.

How dim is the view for Alcoa? At a recent $9, the stock is nearly 80% below levels seen back in 2007.

Using the parlance of the investment business, the Alcoa story "has warts on it." The decision to build a network of low-cost energy-efficient smelters came at a painful price: The company spent a combined $10.3 billion in 2006 through 2008. Management was unaware that demand for aluminum would soon plunge.

The good news: the spending program is winding down. Alcoa doled out just $1 billion in capital spending in 2010, enabling the company to generate $1.1 billion in free cash flow. The company's capital spending plans are unlikely to top $1.0 billion to $1.5 billion in current and future years. In effect, Alcoa is now positioned to post respectable free cash flow in tough times, and poised to post stunningly high levels of cash flow when the global economy perks up.

The past 12 months tell the tale. Sales in 2011 came in around $21 billion -- roughly $7 billion below 2007 levels. Yet free cash flow likely exceeded $1 billion once again.

Actual financial results in the near-term will rest on aluminum pricing. The spot price has fallen from around $1.17 per pound in August (before the European financial crisis gained steam) to a recent $0.88 per pound. As the European crisis is resolved, look for a quick move back to $1 a pound. And when the global economy is truly healthy, I see the spot price heading north of $1.25 a pound.

As a point of reference, Alcoa would likely earn around $0.65 a share with aluminum prices at $1.05 at pound (EPS would build by about $0.20 a share for each $0.05 rise in aluminum prices). We're not there yet, but that's the profit framework you need to keep in mind as shares scrape along the bottom. (If you want a really long-term view of where profits can go in the peak of the cycle, Alcoa earned more than $3 a share in 2007, and shares trade for less than three times that earnings peak.)

The downside protection --> Alcoa's stock is worth slightly more than the $9.65 billion in tangible book value on its balance sheet. Yet that book value figure is quite understated because the value of a number of manufacturing facilities has been written down due to depletion. In terms of replacement value, if one were to build Alcoa's factories from scratch, then you're likely looking at a market value closer to 40% lower than the real value of the company's assets.

Equally important, Alcoa should remain free cash flow positive, even if the global economy slumps further in 2012. A weak economy would actually benefit Alcoa as higher-cost rivals get flushed out. As it stands, many aluminum producers are operating at a loss with aluminum trading for roughly $1 a pound. That's a price point at which Alcoa can still turn a profit.

The upside triggers --> The Alcoa trade requires a leap of faith. The company will kick off earnings season on Monday, Jan. 9. I suspect the company will actually deliver a small loss instead of the consensus $0.08-a-share forecasted profit. (The losses are coming from the timing of costs and pricing, and Alcoa likely remains profitable on a core production-per-pound basis.)

Why get into this stock ahead of such an event? Because the market anticipates a sorry outcome, and there's a solid chance investors will start to focus on management's expected long-term bullish outlook for supply, demand and pricing.

This stock chart tells you one thing. Alcoa has few fans right now. That's my favorite kind of set-up.

I expect any rebound to be slow and steady. It may take several quarters, but a move back to the mid-teens, with fairly solid downside support, looks like a favorable risk/reward to me.

Action to Take --> In light of the risk associated with the coming quarterly results, I am opening a fairly modest position by buying 300 shares at the opening of trading on Friday, Jan. 6. That equates to about $2,500. I will re-assess that stance once the numbers are out, and may look to boost the stake.

Here's the Latest Snapshot of my $100,000 Real-Money Portfolio...

Disclosure: D. Sterman and/or StreetAuthority, LLC hold a position in F.