Alcoa: You Gotta Know When To Hold'em, Know When To Fold'em

Jun. 10, 2022 3:22 PM ETAlcoa Corporation (AA)CRIT, XME, XMMO, PYZ, MNM, JZRO, IYM, JHMA, PDP, PAVE, VAW, UYM, PICK, FMAT9 Comments5 Likes
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  • Alcoa is facing a tough market, affected by inflationary pressures and the associated interest rate increases.
  • The company has made good steps in controlling their production cost and is transitioning rapidly into "greener" aluminum products.
  • Despite aluminum prices expected to fall towards the end of 2022, the EV transition may support demand.
  • Trading at 4.7 times its forward earnings, and with very conservative quarterly earnings of $1 per share, shares offer a large upside potential.

aluminum stones on electronic scale. Metal used in industry. Mineral extraction concept.

RHJ/iStock via Getty Images

Do you know how to play poker? I'm sure you do. I prefer Texas Hold'em. It's simple, yet very interesting to players of all experience levels. I used to play more often when I was younger, but now, with two kids, I'm not keen on investing 2-3 hours of my free time playing poker. One of the best first-hand combinations you can expect is a pair of aces. It takes some skill to hide the excitement when you see such a hand.

Today we will be looking at another set of aces: Alcoa Corporation (NYSE:AA). In fact, I'm talking about two red aces: the ace of hearts, as I generally love this company, and the ace of diamonds, as we're talking about a mining company, and diamonds are some kind of mineral also. Let's see how the world-class poker player, Lumina, will play this hand. Here we go.

The Flop - 8 of hearts, 9 of clubs, 10 of hearts

A poker player holding a pair of aces can live with a wide range of flops, assuming that she didn't slow play the pre-flop. In our case, Lumina doesn't have the best flop, but still chances are that she's good. How is this translated into Alcoa?

Well, Alcoa is a "nuts" card for several reasons. First of all, the company has a unique advantage against its competitors. They sell the largest part of their mined alumina, but they also keep some for their own uses. This means that they gain on the very sale of the alumina while also their final product, aluminum, is still cheaper than that of their peers.

In addition, the company entered into several agreements regarding the association of power prices with aluminum prices, in order to shield itself from increasing energy costs. In addition, another agreement is going to become effective in September 2022. Last but not least, one-third of the company's power needs is supplied by owned hydro-electric facilities, moving production cost down and participating into the production of "green" aluminum. That last part has a lot more implications than one can imagine. These implications go beyond the reduction of production cost and touch the hot issue of the climate change.

More and more companies are adopting ESG governance standards, which in the future, if not now, they will play a part into corporate valuations. This new, environmentally friendly economy requires economic participants to provide "greener" products and adopt "greener" production policies. Despite the fact that, whether these "green" policies are better than the traditional ones, from a total harm measurement standpoint, remains subject to debate, it is clear that ESG is becoming the new normal. A few days ago, the company reached an agreement with Hellenic Cables, a subsidiary of Cenergy Holdings and one of the largest cable producers in Europe, for the sale of its EcoLum products, the production of which doesn't create more than 4 metric tonnes of carbon dioxide for every one tonne of aluminum. The uptake of such products is so high, that Alcoa expects the orders of its environmentally friendly product series to triple in 2022.

But the board doesn't look too good. The CPI in the U.S. was announced today and hit a record of 8.6%, up 0.4% from consensus. This could lead the FED to proceed to a more drastic increase of its base interest rate. In addition, yesterday it was announced by the ECB that the quantitative easing is over and that it will increase its basic interest rate in July by 25 basis points. All these are measures that will hurt consumption in one way or another. This leads us to the "Turn."

The Turn - Jack of hearts

So, with a Jack of hearts, the situation gets a little more complicated. Lumina is frustrated that a straight is forming in the table, but at the same time, she fancies her chances for a flush, with another heart on the river. Except for the 9 of hearts, that is...

In the case of Alcoa, the Jack of Hearts could be the anticipated slowdown in the world economy. It is frustrating for Lumina's aces, but it is what it is. And there's more to that. Not only a decrease in demand will hurt aluminum prices, but also will the subsequent build-up of stock. This, in fact, was the main argument in the recent aluminum conference. It was argued that aluminum will reach $2,300 per tonne in December of this year, meaning a 20% decrease from today's levels.

Aluminum price forecast, alumina, bauxite

Aluminum price forecast (Trading Economics)

However, Lumina is not scared. Something is calling her to pursue her chances for that much-wanted flush. Same for Alcoa, aluminum inventories in May reached record low levels. Although this is mainly due to supply chain problems, rather than increased demand, it is still a relatively bullish sign on the metal. Artificial, but bullish.

The River - Two of hearts

What the market hasn't accounted for adequately is the global transition to electric vehicles. As with every transition, so with this one, the road isn't always smooth. In our case, as Mr. Ambrose mentioned correctly in his recent article about the company, the issue of the semiconductor scarcity is a real headwind to the e-vehicle transition. However, I wouldn't consider Alcoa to be a short-lived trade vehicle, but rather a long-term investment. After all, the company is standing there since poker was played with a Colt .45 on the table.

The company is currently trading at 4.7 times its forward earnings, which can be regarded as conservative, especially if we account for the Q1 2022 earnings of $2.49 per share. At a share price of $53, even if the next three quarters result in $1 EPS each, we're talking about a P/E multiple of just above 10x. In other words, the current share price has some serious upside. Alcoa will come across the true decline in aluminum and alumina demand sooner or later, which will affect its share price. However, as I wrote above, the company is a long-term holding and the EV transition has the potential to counterbalance some of the negative effects of the decline in the traditional aluminum demand.

Lumina fancied her chances to go for that flush and she got it. It's not a foolproof hand, and that two of hearts in the river may not had gotten out at all. But as the old country song by Kenny Rogers goes:

"You gotta know when to hold'em

know when to fold'em

know when to walk away

and know when to run"

Lumina knows what she's holding - that lucrative AA - and she's not folding.

This article was written by

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True Orion is comprised of two notions. Orion, the ancient mythical hunter, and truth. The neverending pursuit for truth. This is my motto. I believe that knowledge is key to achieving oversized returns in a financial as well as in a personal level. As a private investor, with a real estate investment educational background and with more than 15 years of investing experience in the real estate and stock market, I can tell you that. Here in SA, I provide my readers with articles regarding specific stocks, or market analysis. My main focus is in REITs and value/growth smallcap stocks. Megacaps leave me tremendously indifferent. The purpose of my articles is to express my ideas and get them tested by reality, while at the same time gaining additional knowledge throughout the process. As I said above, the notion of the neverending pursuit of truth is hidden behind True Orion. If you like my content, don't forget to follow me, like, share and comment. As a contributor affiliated with SA, signing up for the SA's premium annual subscription plan by clicking here, you are supporting my efforts even more.

Disclosure: I/we have no stock, option or similar derivative position in any of the companies mentioned, but may initiate a beneficial Long position through a purchase of the stock, or the purchase of call options or similar derivatives in AA over 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.

Additional disclosure: This article was written for information purposes only. You should not, in any case, take the contents of this article to be an urge to buy, hold or sell securities. Always perform your own research before investing in the stock market.

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