Alcoa's Alchemy

| About: Alcoa, Inc. (AA)
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It is a material that we come in contact with every day. When we use our computers, drive our cars, paint our houses, and ride our bicycles. It is the most abundant metal in the Earth's crust and the third-most abundant element in the world. Aluminum serves great purpose to the world today. Alcoa (NYSE:AA) has been producing aluminum for quite some time now. In 1886 Charles Martin Hall discovered a unique process for smelting aluminum. He discovered that passing electrical current through a bath of cryolite with Aluminum Oxide submerged in it left the Aluminum that we know and use today. He named the process the Hall-Heroult process and it is the same and only process used to make aluminum to date. This was the beginning of a company that would go on to be the world's third-leading producer of Aluminum operating in 31 different countries around the world today.

At the time Alcoa started, it did not face much in terms of competition for producing aluminum. There were only about 10 producers of aluminum and they were not producing aluminum efficiently. Prior to the discovery, Aluminum was made by heating ore with Sodium or Potassium in a vacuum. This was a complex process that required materials that were expensive at the time. Aluminum was more expensive than Gold or Platinum because it was so laborious to produce. The Hall-Heroult process made producing Aluminum much more inexpensive and became a distinctive competitive advantage for Alcoa in its early years.

This advantage turned into many years of consistent profits. Going public in 1978, the stock price had reached an all-time high of about $47 in July of 2007 contrasted to the current price of almost $9. The financial crisis and weak aluminum prices have dealt critical blows to Alcoa's ability to turn a profit. The four main segments of the market that Alcoa serves are Alumina, Primary Metals, Flat-Rolled Products, and Engineered Products and Solutions. The two segments of the business that represent the most significant proportion of Alcoa's earnings is the Alumina and Primary Metals division. This makes Alcoa's earnings very sensitive to the price of Aluminum. Although Alcoa is increasing its focus on the profitability and scope of the Engineered Products and Solutions division, it is still currently suffering from low Aluminum prices. Since 2008 it has cut over $5 billion in cost by increasing productivity and improving process efficiency. It is working on paying down corporate debt, which totals over $8 billion and has been placed under review by Moody's for a potential credit downgrade. Alcoa is still staying positive and estimates demand to double worldwide by 2020. In the short-term outlook, unless the macroeconomic environment in the United States and Europe improve in the near future, Alcoa faces an uphill battle in the next couple years.

Alcoa has not only faced economic threats to its profits, but also environmental regulatory threats due to the nature of the business. Many times, Alcoa’s (and other companies) processes to build and run plants are not exactly environmentally-friendly. Certain measures have to be taken to ensure that byproducts and wastes are not detrimental to the surrounding environment. These measures are often costly and consequently low priorities to companies like Alcoa. In the 1980s, the Rockdale power plant, used to power the company’s aluminum production facility, was reaching the end of its useable life. Instead of tearing down the plant and rebuilding a newer and more environmentally friendly power plant, Alcoa decided to undertake a $63 million "Betterment Project" that revamped the plant (this plant was not directly used to make aluminum, but rather, it was used to power the aluminum production facility). Unfortunately, the new modifications to the plant actually increased the amount of pollutants being released into the atmosphere by 13,000 tons according to the Environmental Protection Agency.

Alcoa started to experience regulatory pressure on reducing the amount of emissions and pollutants its plants release into the atmosphere. In 2003, Alcoa and the Environmental Protection Agency reached a settlement under the terms of the Clean Air Act to significantly reduce the amount of pollutants being released by the plants. Alcoa agreed to install new pollution controls and to supply funding to several environmental projects and initiatives. The agreement had sizable impact on the pollution caused by these operations. The amount of Nitrogen Oxides was reduced by over 15,000 tons, a 95% reduction. The amount of Sulfur Dioxides was reduced by almost 53,000 tons, a 90% reduction. These two chemicals have a range of unwanted effects on the environment including acid rain, low water quality, ozone depletion, and increased risk of respiratory diseases. One project that Alcoa helped fund under the agreement included spending $750,000 for a project that redesigned school buses in the Rockdale/Austin Area to reduce particulate matter pollution. Alcoa also provided $1.75 million to the Trust for Public Lands, which purchases and maintains property designed maintain air quality and also protect the toad habitat in the "Lost Pines." Taking into consideration that producing Aluminum is typically not a clean process, Alcoa has taken major steps to be an environmentally responsible corporation.

Alcoa also faces high competitive risk in the aluminum market. The three other major competitors are Rusal, Rio Tinto Group, and Aluminum Corporation of China. Rusal is the largest producer of aluminum in the world with over 4 million metric tons per year. Rio Tinto produces about 3.8 million, Alcoa 3.6 million, and Aluminum Corporation of China comes in at 3.1 million. The aluminum industry is a commodity business, which means that profit margin is based on efficiency and production amount. The more aluminum that you can produce at a lower cost and in a shorter amount of time means that you will be able to price your Aluminum more competitively. As previously stated, Alcoa has already been taking steps to make operations more efficient. Rough economic times have forced it to cut over $5 billion in costs since 2008, which has not been enough to offset the sharp decline in aluminum prices. If Alcoa's predictions are correct, that aluminum demand will double by 2020, it could put the company in a very favorable position by continuing to find ways to cut costs and improve productivity. When the demand finally starts to catch up, the processes will already be in place for great profits.

Alcoa has transformed a simple discovery in the late 19th century into a company that today that has transformed the entire Aluminum industry. It has been through trials and tribulations, but survived and came out on the other side stronger because of it. It stands poised to stay competitive in the marketplace and expand market share. If it continues to make the progress it has already made, the potential for Alcoa is unlimited.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

Business relationship disclosure: This article was written by an analyst at Catalyst Investments.

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