This Old Economy Stock Is Set to Run

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

With nearly $24 billion in revenues, Alcoa (NYSE: AA) is one of the most important players in the aluminum industry. It is the largest producer of alumina, a synthetic compound used for smelting aluminum. The company also makes aluminum products like soda cans and steel beams for construction. In addition, Alcoa has developed substantial economies of scale in alumina production and aluminum smelting. But investors have become skeptical of Alcoa's earning power as aluminum prices have fallen off substantially in recent years. However, the market has overdiscounted the company's headwinds; if the global economy continues to rebound, Alcoa is worth at least double what it currently trades for in the market.

Alumina Segment is Extremely Valuable

Alcoa's Primary Metals and Alumina segment is its most important. Responsible for 34% of total company revenues, the segment earns higher margins than any other division. There are significant barriers to entry in alumina production, which has created a small moat around the business. Barriers to entry have also made alumina an increasingly scarce resource whose value is increasing even as aluminum prices falter. However, the substance is still loosely tied to the price of aluminum, so the business remains cyclical.

Investing Upstream

Alcoa has sold or closed down several downstream assets in recent years to invest in mining and refining operations. Alcoa currently supplied about 25% of its own energy, but will be able to increase that percentage as it continues to build out its upstream operations. This will ultimately lead to lower energy costs and thus higher margins and greater profitability.

Higher Aluminum Prices on the Horizon

The price of aluminum rises and falls with the global economy. The recent global downturn caused the price to plummet, taking the price of aluminum producers' shares with it. However, emerging economies like China and Brazil will continue to use substantially more resources than they can produce, which should lead to commodity inflation across the board. This bodes well for Alcoa, which locates its factories in relatively low-cost regions compared to competition in China. So, eventually the price of aluminum will recover and Alcoa will become much more profitable.

This Stock Could Double

Alcoa's numerous tailwinds make it a prime candidate for a double. Alcoa earns an EBITDA margin and FCF margin in line with Allegheny Technology (NYSE: ATI) and Century Aluminum (NASDAQ: CENX), which is indicative of the commodity nature of its products. However, its substantial advantage in the alumina segment and superior access to capital markets allows the company to invest its cash flow at a higher rate than its peers.

Since 2002, Alcoa has averaged a 5.4% pre-tax return on tangible invested assets. Applying the 5.4% return to last-quarter's $33.5 billion in tangible invested assets gives a normalized pre-tax income of $1.8 billion. Applying a 10x multiple to this figure and dividing by total shares outstanding gives a value of $17 per share, which is roughly double the current stock price.

If Alcoa continues to earn what it has in the past, it is worth substantially more than it currently sells for in the market. In other words, a lot can go wrong and Alcoa will still be worth more than the current stock price. If the global economy improves quickly -- and aluminum prices along with it -- then Alcoa may be worth much more.


titans8904 has no positions in the stocks mentioned above. The Motley Fool has no positions in the stocks mentioned above. 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!

blog comments powered by Disqus

Compare Brokers

Fool Disclosure