What’s Up with Alcoa and Will its Stock Ever Move Up?
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Founded in 1888, Alcoa (NYSE: AA) has long become an American industrial icon and remains the world’s leading aluminum producer today. But fame doesn’t always bring an equal level of fortune with it. While the Dow Jones Industrial Average has recovered most of its losses from the index’s recent recession reading set in March 2009, Alcoa, a Dow component, has not kept pace with the index‘s moves. Having been stuck at the $8 level for the past three months, the stock is trading only a bit above its recession lows and actually right back at where it was 20 years ago. So what’s been going on with Alcoa and why hasn’t the stock generated consistent price appreciation for its shareholders? These are simple but interesting questions, given that many regard Alcoa as a world-class company with first-grade products.
Known to the public mostly as a base metal producer of primary aluminum, Alcoa also mines its own aluminum ore, or bauxite, and refines the ore into aluminum oxide itself. Aluminum oxide is commonly referred to as alumina, which is later used in the smelting process to extract the aluminum metal via oxygen removal. To make aluminum, a producer needs only to operate smelters, the very facilities used to turn alumina into aluminum ingots or billets. Some companies like Alcoa may also own aluminum mines and refineries in locations around the world in an effort to self-supply aluminum raw materials. But having a vertical integration in the aluminum business may not always be an advantage if a producer is not able to make the most effective use of the additional mining and refining assets often obtained at substantial costs.
On the other hand, an aluminum producer without its own mines and refineries can still win the competition by simply being a more focused aluminum producer. For example, Kaiser Aluminum Corp. (NASDAQ: KALU) operates as a specialty aluminum product manufacturer and has seen its stock price rising almost 25 percent so far this year, compared to Alcoa’s roughly one percent increase in the same period. There's also a stunning PE ratio comparison between Kaiser Aluminum and Alcoa: 42.3 vs. 12.6, based on their respective EPS at the end of 2011. The much lower PE ratio for Alcoa indicates that investors are not expecting substantial future EPS growth from the company.
A close examination of Alcoa’s individual business units may help explain why the company’s perceived value is not quite reflected in its stock price. For years, Alcoa’s internal use of its self-refined alumina for aluminum production was less than half the total alumina sold, meaning that the majority of its refinery products were shipped to aluminum smelters run by other companies. Furthermore, total alumina sales were less than the amount of alumina refined, resulting in unsold inventory and tying up funds. Investing in mining and refining often is very capital intensive and may become a drag on overall profitability if the investments are not used to their full benefits.
In Alcoa’s case, its mining and refining capability apparently went beyond what the company’s smelting facilities could handle, especially given that aluminum production has to respond to the changing aluminum demand in the market. What this tells us is that Alcoa probably has some cost overruns buried into its capital investments, and the full investment value may not be realized so long as the company is mostly concerned with using its mines and refineries for internal material supply. On the other hand, Alcoa’s aluminum smelting unit performed relatively well, generating almost twice the amount of total refinery sales, as aluminum production is more of a value-added business activity.
Now, think for a moment what Carl Icahn, the well-known veteran activist investor, might do if sitting on Alcoa’s board. Similar to what he did to Motorola and a host of other companies, he might just propose a breakup among Alcoa’s different business units to help release shareholder value. When a company has profitable and unprofitable segments all bundled together, the total net value is surely to diminish and earnings of the profitable operations won’t find their way into the stock price. A separation of Alcoa’s aluminum smelting business from the ore mining and refining operations could help the company reposition itself as a truly specialized aluminum producer that the public has actually come to know. Meanwhile, the independent mining and refining units could put more focus on how to compete in the mining and refining markets, not just serving as an internal material supplier without bearing any financial responsibilities.
Similar strategies have been considered by other companies within the metal mining and producing industry. Rio Tinto (NYSE: RIO), mostly known as a mining company, has been seeking to sell some of its aluminum smelting assets that it obtained from its 2007 acquisition of Alcan Inc., a former competitor of Alcoa. This would allow Rio Tinto to focus more on mining, its principal operation and the strongest part of its business. It is also true that not all iron ore mining companies intend to own steel plants and not all steel makers operate their own iron ore mines. Of course it’s desirable that certain arrangements are made between the two parties to ensure easier sale of and access to the raw ore. Given that Alcoa already co-owns some of its aluminum ore mining interests with mining companies including Rio Tinto, a potential spinning off of its other mining and refinery operations as independent entities won’t affect the company’s raw material access. Rather, such a corporate restructuring could put financial pressure on Alcoa’s mining and refining units now that they would be totally on their own without internal subsidies.
After over 120 years in business, there is no doubt that Alcoa has become increasingly complex and thus more challenging to manage. Operation inefficiencies have led to lower profit margins and poorer return on equity, inhibiting price advance of its stock. Until Alcoa addresses some of the structural issues in its business, investors should take heed that not every good-name stock guarantees good rates of returns.
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