It May Take a While, but Metal Producers Could Pay Off in the End

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

Alcoa (NYSE: AA), one of the largest aluminum producers in the world, has struggled over the past few years, just like most metal producers have. In fact, shares of Alcoa today are worth just over 23% of what they were five years ago. What will it take for Alcoa to thrive, and will it happen anytime soon?  And are other metal producers in the same boat?

About Alcoa

Alcoa (short for "Aluminum Company of America") is a U.S. aluminum producer with about 3.74 million metric tons produced last year. The company is also a very large supplier of alumina, the raw material used to produce aluminum, with over 16 million metric tons produced last year. 

There are two main reasons for Alcoa’s (and other metal producers’) underperformance. First, there is the problem of overcapacity and oversupply. Second, the demand for aluminum products is very highly correlated with economic growth, which we all know is happening in the United States, but not so much in other parts of the world.

There is an excess of aluminum supply, mainly due to overproduction in China over the past several years. Over the past decade, China’s aluminum production has quadrupled. However, its rate of economic growth has slowed down in recent years.

In order for aluminum prices and Alcoa’s profits to experience any kind of sustained gains, two things need to happen: Aluminum companies around the world will need to lower production until the surplus is gone, and worldwide demand for aluminum, fueled by economic growth, must increase faster than the companies are producing aluminum and adding to supply.

Projections and valuation

In April, during Alcoa’s last quarterly report, the company reiterated its projection that worldwide aluminum demand will grow by 7% in 2013, and its long-range projection of demand doubling between 2010 and 2020. This should result in a modest increase in the price of aluminum this year, and when combined with the company’s recent cost-cutting measures, it should produce a good amount of earnings growth going forward.

Alcoa is projected to earn $0.44 per share this year, rising to $0.69 and $0.84 per share in 2014 and 2015, respectively, on the combination of increased worldwide economic growth and steady or lower production rates. At just 11.9 times forward earnings, this makes Alcoa look very attractive right now, based on its own projections for the industry.

U.S. Steel: an even more underperforming metals play

The problems of slow growth and oversupply are by no means unique to the aluminum producers. Steel companies have performed even worse lately, with the same issues of foreign oversupply and slow economic growth, especially in Europe and China. While U.S. Steel (NYSE: X) is expected to post an operating loss for the current fiscal year, it is expected to turn a profit of $1.42 per share in 2014 and $2.26 in 2015, due to the same reasons that Alcoa is projecting earnings growth. 

Worth noting is that the projections by all of the analysts following the company vary quite widely, with 2014’s projections ranging from a loss of $0.20 per share to a $3.00 profit. So, in a very bullish scenario, if all goes well, U.S. Steel could be trading at just 5 times forward earnings.

A more diversified alternative: Rio Tinto

Rio Tinto (NYSE: RIO) is a very large and diverse metals company, and has been a bit less volatile than other metals companies. Rio Tinto offers investors the benefit of exposure to several different types of metal production, with operations in aluminum, copper, diamonds and other minerals, and iron ore. Rio Tinto looks to be the most cheaply valued of the three, but the company is projected to grow less rapidly, mostly due to the very diverse (and established) nature of its businesses.

The company trades for just 7.5 times forward earnings, and they are projected to grow their earnings at a rate of around 9% going forward. While this sounds extremely cheap compared to the valuation of the broader market, the risk that investors take when investing in the metal companies right now warrants a discount, as the supply/demand dynamics of the metal industry are extremely difficult to predict, especially having to do with China.

Conclusion

While most metal stocks are hovering very close to their 52-week lows and mostly have “sell” ratings, these stocks could provide tremendous gains over the long run for investors who are willing to ride out the tough times. It is my belief that within the next several years, as the economic recovery continues, demand will slowly begin to overtake supply due to increased infrastructure and industrial spending. 

Bear in mind, this could take quite a few years, but for those with the patience (and stomach) to ride out the rollercoaster ride in these stocks, I believe you will be very handsomely rewarded indeed.


Matthew Frankel owns shares of United States Steel.. The Motley Fool has no position in any of the stocks mentioned. 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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