Why Alcoa Won't Make You Rich and 2 Miners That Can

Alcoa (NYSE: AA  ) investors have had a fantastic year. Shares are up 93% based on three main perceived growth catalysts.

First, Ford made headlines with its aluminum F-150 truck, which is 700 pounds lighter and gets substantially better fuel economy as a result. Ford is a big advocate of aluminum auto construction, recently unveiling a concept Fusion sedan made 25% lighter through heavy use of aluminum. The company is also investing in heavy duty aluminum truck wheels, which are 47% lighter than steel.

Next, Alcoa is partnering with Phinergy to develop revolutionary aluminum-air batteries that could increase the range of electric cars by 1,000 miles. The partnership has actually built and tested a demonstration car, and Alcoa is researching methods to commercialize the technology.

Finally, Alcoa's recent $2.85 billion acquisition of Firth Rixson has Wall Street cheering because it will increase Alcoa's aerospace division's revenue by 20% this year, and 42% by 2016. With Alcoa guiding for 8% to 9% growth in aerospace in 2014, Wall Street is expecting this division to help fuel Alcoa's earnings growth by 11.5% annually through 2023. 

Growth potential less than expected
There are several flies in the ointment of Alcoa's growth story. First, despite Ford's enthusiasm for aluminum vehicles, Alcoa is guiding for just 1%-4% growth in its automotive division this year. 

Second, although its aluminum-air battery sounds interesting, the efficiency of this battery is only 15%, equivalent to that of an internal combustion engine, and woefully inferior to lithium ion batteries' 80% to 90% efficiency. 

In addition, aluminum-air batteries are very complex, requiring air to be highly filtered and mixed with water in very narrow temperature ranges. Once empty, the aluminum must be replaced and recycled, meaning the need for new, large-scale, and expensive infrastructure.

Alcoa faces competition on the battery front in the form of IBM and its Lithium-air battery as well a Panasonic, who is partnering with Tesla to build its Gigafactory, which aims to cut battery costs by 50% by 2020.

Finally, Alcoa's aerospace dreams may prove an illusion. Planes were traditionally built from aluminum because of the material's strength and light weight. Boeing's new 787 Dreamliner represents its largest program ever, with the average plane costing $250 million and the company having 1,031 orders. This $273 billion (and counting) plane is 50% carbon fiber and other composites, which are 20% lighter than aluminum. 

If Boeing is trusting carbon composites with its most important undertaking, than perhaps Alcoa's aerospace dreams will not prove to be as profitable as Wall Street imagines. 

Which brings me to one final reason to avoid investing in Alcoa. Its recent run-up leaves it trading at 23.8 times next year's earnings. That's a 15% premium to Alcoa's 21-year average P/E ratio. This indicates that a large portion of Alcoa's expected earnings growth is already priced into the stock, and it may be poised for a correction. Investors at these prices may end up regretting their decision, as did investors who invested a decade ago. 

AA Total Return Price Chart
AA Total Return Price data by YCharts.

As seen in above, over the last 10 years, Alcoa's revenues have been stagnant, its earnings have collapsed (partially because of shareholder dilution), and investors have lost nearly half their money. Before investing in Alcoa, whose growth track record and valuation leave much to be desired, long-term investors should consider two of my favorite miners.

Best-of-breed miners: Superior growth potential

Company Yield 10-Year Projected Earnings Growth 10-Year Projected Dividend Growth 10-Year Projected Annual Total Return
Alcoa 0.80% 11.48% 2.92% 3.20%
Vale 6.10% 59% 32.06% 64.60%
Rio Tinto 4.20% 16.80% 13.40% 23.10%

Source: S&P Capital IQ, Yahoo Finance.

VALE Total Return Price Chart
VALE Total Return Price data by YCharts.

As the charts show, over the last 12 years, Alcoa's dividend has been decimated, and it has lost investors money. Meanwhile, Rio Tinto (NYSE: RIO  ) has doubled the market's total return and quadrupled its dividend. Vale (NYSE: VALE  ) has quadrupled the market's return and increased its dividend ninefold. Analysts are expecting Vale and Rio Tinto to be two of the best-performing companies of the next decade for three primary reasons.

First, these miners have massive diversification, both in geography and materials. For example, Rio Tinto produces aluminum, copper, and diamonds while Vale mines nickel, copper, coal, and makes fertilizer.

Second, both companies are trading at deep discounts to their historical valuations because of a sharp downturn in iron prices. Rio Tinto trades 25% cheaper, while Vale is 40% discounted.

Finally, Both Rio Tinto and Vale are fantastic at cutting costs. 

  • Vale is planning on slashing capital expenditures by 42% from 2011 to 2016 while still increasing production.
  • Rio Tinto plans to cut capital expenditures by 55% from 2012 to 2015 while increasing production at its largest mine by 66%, and still investing in efficiency maximizing technology such as autonomous trucks and trains.

Foolish bottom line
Alcoa's recent run-up is based on growth assumptions that look to be exaggerated, and even if they're not, the improved growth prospects are already priced into the stock. Long-term investors at these valuations are likely to underperform the market. Meanwhile, Vale and Rio Tinto are two best-of-breed miners trading at deep discounts. They offer generous yields likely to grow quickly over the next decade and result in market-thrashing total returns.

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Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On July 07, 2014, at 7:55 PM, focobovespa wrote:

    Iron ore protects Vale price reduction

    The current scenario of iron ore lit the yellow sign around the business of mining, however, the valley is seen as the company's most protected sector in relation to price cuts and only a more rapid drop in fact affect the profitability of Brazilian. As the holder of the best quality iron ore in the world and owner of title to mining lower cost, the company is in a better competitive position against competitors, while the lower price is already beating their financial data. This year, the ore accumulated losses of 28%.

    "When prices of iron ore fall about to reach the Valley of fact, all other mining companies in the world have already been impacted much earlier," said mining expert and former director of the Brazilian Mining Institute (Ibram) Mendo José de Souza, and consultant J.Mendo. This year, the price of iron ore recorded the least in almost two years, hitting $ 89 a tonne in the Chinese spot market last month. On Thursday, 03, was U.S. $ 96.5 per ton in China.

    Calculations from UBS, the equilibrium point (break even point) ore price for Vale, ie value that separates the profitable activity that generates losses, is $ 68 a tonne in China. "Vale is very lucrative with the ore at $ 100 a tonne," says the analyst of Swiss bank Andreas Bokkenheuser. Although prices are currently slightly below this value, the forecast is that they are around $ 100 in the third quarter, according to experts interviewed for this article.

    "We believe that prices will be supported over the next four to six weeks due to seasonal construction activity in China," says Bokkenheuser. In a recent report, BTG Pactual said that, in his view, the average price for this year to be $ 105 a tonne, the same amount projected for 2015. For the long term, would go to $ 90. "In our opinion, the only reason to reduce Vale is if prices fall around $ 80, we consider a scenario unlikely, "according to the analyst Leonardo Correa, Luiz Antonio Fornari and Heluany. The recommendation for the BTG shares of Vale's purchase.

    BTG analysts point out that most of the iron ore industry would be under great pressure to prices at U.S. $ 80 a tonne. One point that deserves to be looked at, remember, is how will the reaction of the Chinese mining companies in relation to the further decline in prices of inputs, since most of these companies is costly. Professionals point out that in September 2012, when prices fell below $ 90 a tonne, some local miners suspended activity.

    In the market, the perception is that Vale could over the past few years to expand its competitive position, given that investments in logistics approached his main consumer market, China. The difference in distance between Australia and Brazil to China has always been a point in favor of Australian BHB Billinton and Rio Tinto. In the first half of this year, for example, the distribution center of the Vale in Malaysia began to receive Valemax vessels, which have a capacity for 400,000 tonnes, which were banned from Chinese ports in 2012. Vale Him will stockpile ore and so may meet at close its Asian customers.

    This year, one of the factors of pressure on the prices of iron ore is the entry of new capacity. The forecast is that the four largest mining companies in the world will add an offer of 100 million tonnes per year in the international market by 2015. Another point that generates caution is concern around the Chinese economic activity. However, from January to May, steel production also recorded high in the annual statement. According to the World Steel Association (WSA, its acronym in English), steel production in China rose 2.7% in the first five months of the year to 342.519 million tonnes.

  • Report this Comment On July 08, 2014, at 7:11 PM, AdamGalas wrote:

    Thank you for the article.

    I agree its unlikely iron goes below $80 so Vale is never likely to reach a point where it's unprofitable, unless a major world recession hits suddenly.

    However, that would result in quiet a buying opportunity. Remember to be greedy when others are fearful and fearful when others are greedy:)

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