Alcoa Exemplifies The Type Of Business That You Don't Want To Invest In

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About: Alcoa Corporation (AA), Includes: ARNC
by: Wealth Insights
Summary

Alcoa is well-known, thanks to its long operating history and status as a former component of the Dow Jones Industrial Average.

However, Alcoa has a long history of terrible performance against the market and things are not likely to change following its spin-off of Arconic.

Alcoa's poor performance is fueled by a high CAPEX, low-margin business model, its lack of a dividend, and a business model that relies on unstable commodity prices.

As one of the world's greatest economies, America is a bedrock of wealth creation and innovation of industry. Within that confine are the great companies of industrial expansion, one of which is Alcoa (AA), a producer of aluminum and former member of the Dow Jones Industrial Average. Chances are that just about any working class baby boomer knows Alcoa, and what industry it is in. Sometimes name recognition plays a role in investment selection, especially when an investor's range of knowledge regarding securities is limited. For long-term investors looking at Alcoa as a potential option, let this article serve as a public service announcement as to why Alcoa is a terrible choice for long-term investors - regardless of your investment goals.

The problem with Alcoa's business is that it misses in various areas that drive companies with long-term records of success. Before we get into those, let's start with the results.

Source: Dividend Channel

While the S&P 500 has averaged annual returns of 9% over the past two decades, Alcoa has actually produced a loss after all these years. Ever since the company spun off a large portion of its operations as Arconic Inc. (ARNC) in late 2016, Alcoa has underperformed the market (it did have a period of drastic outperformance when commodity prices peaked in 2018). The reasons for this poor track record of performance vary.

Aluminum Prices Just Aren't Reliable

Similar to how oil companies trade with the price of oil, the market for aluminum has a huge impact on the trading patterns of Alcoa stock. The obvious reason is that the price of aluminum has a direct impact on how profitable Alcoa's business is.

The problem is that aluminum prices have been extremely volatile over time. This makes it very difficult for Alcoa to flourish for any extended period of time. This means that dividends are much harder to afford - Alcoa doesn't currently offer a dividend so an investor's total returns are reliant on capital appreciation alone.

Source: YCharts

When the company's bottom line is a gyrating yo-yo, how can investors comfortably rely on Alcoa to build wealth for them over time?

Alcoa Doesn't Currently Pay A Dividend

One of the most important aspects of investing to build wealth over time is the role dividends play. This is two-headed. First, a company's ability to pay a dividend - and increasingly grow that dividend over time, is an inherent characteristic of a company that continually increases its intrinsic value. In other words, a continually rising dividend typically means that the stock price is rising with it.

The second aspect of the dividend is that it turbo charges total returns. Whether dividends are pooled for alternative investments, or reinvested back into the companies that paid them, dividends crank up your total returns over time. Look at the figure below to see how drastic of an impact dividends have had on S&P 500 total returns from 1960-2018.

When a company doesn't pay a dividend, a negative event or recessionary environment can crush stocks and literally undo years of capital appreciation. Dividends are permanent returns, and can only be undone if you reinvest and the company goes bankrupt (when was the last time this happened?).

Alcoa Is Capital-Intensive, And Lacks Margin

When it comes to finding companies that generate tons of cash flow for investors, I look for businesses that are not overly capital-intensive and fetch healthy margins. These businesses may also be referred to as "cash cows." In Alcoa's case, we see the antithesis of this.

Source: YCharts

The high CAPEX (CAPEX typically consumes 90%+ of cash from operations) and low margin nature of a competitive commodity-based business make it difficult to generate much cash flow. Despite generating $13 billion in revenues over the past year, Alcoa realized just $167 million in free cash flow. This is a paltry conversion rate of just over 1%, and it took aluminum prices peaking at the third highest levels since 1990 to get there! When aluminum prices soften, Alcoa turns into a cash burning entity which leads to debt.

Source: YCharts

Fortunately, Alcoa is in solid financial shape following the spin-off of Arconic, and the current leverage ratio of just 0.83X EBITDA is very comfortable. However, an extended downturn in aluminum prices could change this picture pretty quickly. Aluminum prices have trended lower over the past year, so this will need to be monitored.

Wrapping Up

When looking at potential investments, companies with long-term records of dividend growth, stable margins, and a business model that doesn't directly rely on uncontrollable variables have typically performed well over long time periods. With so many options for investors and the digital platform to educate yourself, it's important to identify what types of businesses tend to fail investors over time and why. Alcoa is a great case study of this.

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Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.