Stay Away From Aluminum and Consider Copper Instead

Damian is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.

As aluminum has been experiencing a downward trend in price for over two years now, mainly due to a global oversupply amidst a sluggish economic environment, I believe that it is a good time to invest in copper, instead. In this article I will look into the largest producers of aluminum in the U.S. and China, Alcoa (NYSE: AA) and Aluminum Corp. of China (ADR) (NYSE: ACH), respectively, and provide reasons to stay away from these companies.

In addition, I will provide a brief analysis on Freeport-McMoRan Copper & Gold (NYSE: FCX), the world's largest publicly traded copper miner, which holds strong growth prospects and stands as an interesting alternative investment opportunity.

China is not always the way to go

Aluminum Corp. of China, or Chalco, is the largest producer of aluminum in China, and as such holds one of the lowest cost structures within the segment in the region. On the bright side, the company has little exposure to areas of weak demand, particularly Europe, and could largely benefit from the efforts of the Chinese government to consolidate the aluminum industry (as per Morningstar).

Moreover, its vertical integration and unmatched scale have helped it endure the strong competition that it has had to face (from over 100 companies) over the last few years. These are two elements that are expected to continue to provide a competitive advantage to Chalco over its local peers.

However, opposite to what many might believe, the cost of producing aluminum in China is quite high, particularly because of the need to import both raw materials and energy. Electricity prices have been especially volatile and are expected to continue to fluctuate, largely affecting the firm´s cost structure and margins (electricity represents about 40% of its primary aluminum production costs).

Given this condition, predicting the returns that Chalco will offer over the next few years becomes a difficult task, filled with uncertainties and possible miscalculations. Furthermore, Chalco's pricing power is highly limited by two facts: the fixed prices set by the Chinese government and the oversupply of primary aluminum, both locally and globally.

Although expected to largely outperform its global peers in terms of EPS growth and while priced reasonably in relation to its sales and book values, the uncertainty linked to the aluminum industry in China leads me to recommend holding onto this stock at the moment.

Big company, big misses

Alcoa produces 20% of the world's alumina and 10% of its aluminum, standing as the largest player on a global scale. The company is involved in the bauxite mining business; the refining and smelting of alumina; and the production of items used in various end-products -- from beverage cans to aircraft. Its scale and vertical integration allow important cost synergies and lower input expenses, leading to one of the widest operating margins in the industry, at 2.3%.

Going forward, its new refinery and bauxite mine in Brazil and The Ma'aden joint venture in Saudi Arabia are expected to deliver strong results on the back of low-cost structures and easy access to energy. Moreover, Alcoa´s strong position in the Chinese market and a cost structure that is about 25% lower than that of its Chinese competitors put the firm in an advantaged position to benefit from the growing demand for aluminum in this country.

However, depressed aluminum prices and a sluggish economic environment have led to low alumina prices and demand, reducing the company´s margins and threatening to further curb profitability. Alcoa reported weak quarterly results in the recent period, which proved that there is not much that the management can do to offset the secular trends affecting income.

Given the cyclical nature of commodities, I would stay away at this firm at the time, especially as it trades at about 35 times its earnings, 0.4 times sales and a 33% premium to the industry average. Nevertheless, keep an eye on this company as a recovery in aluminum prices could lead to strong returns and margins for a company like Alcoa, which stands on the lower end of the global cost-curve.

The alternative

Freeport-McMoRan Copper & Gold has been a great beneficiary of the upsurge in copper prices, mainly due to increased demand in China. As the world’s largest publicly traded copper mining company and the leading producer of low-cost molybdenum, its cost structure is amongst the lowest in the industry.

Going forward, its growth prospects look quite appealing, not only because demand in China is expected to remain high for a few years yet; but also because the firm's acquisition of Plains Petroleum and McMoran Exploration should further reduce its dependence on the Chinese and global copper market, adding exposure to the oil and gas segments.

The initial reaction to this news was negative and strongly impacted the company's stock price; consequently, I believe that an attractive entry point has opened for long-term investors. Trading at 9.4 times its earnings, a 16% discount to the industry average, and even more attractive valuations in relation to its sales and book-values, Freeport looks like a value investment.

Beyond the benefits of the upcoming diversification, Freeport continues to stand as a strong copper play. With plenty of copper projects in its pipeline, including brownfield expansions at Cerro Verde, Morenci, and Tenke Fungurume, production growth prospects look promising for the next several years. Overall, this is a mining stock to buy and hold, standing as a great option to the not-so-attractive aluminum-mining companies.

Bottom line

Valued cheap while offering compelling growth prospects, Freeport is the way to go within the mining segment. With aluminum facing depressed prices and expected to recover slowly, this copper (and now, diversified) company stands as the best option. Consider buying and holding; upside potential is plenty. Meanwhile, a 4.3% dividend yield should keep you content. 

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Damian Illia has no position in any stocks mentioned. The Motley Fool owns shares of Freeport-McMoRan Copper & Gold. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. Is this post wrong? Click here. Think you can do better? Join us and write your own!

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