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Alcoa Inc. Courting Growth and Security at the Same Time

By Lennox Yieke – Jul 23, 2014 at 11:09AM

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Alcoa's impressive strategy will allow it to deliver safe growth

Alcoa Inc's (AA) iconic recovery, which commenced in October 2013, has seen its stock rise unabated to levels intimately close to its 52-week high of $16.71 a share. Despite the extended run, there is still more upside in Alcoa. This is because the Aluminum miner, which is the largest in the US, has an integrated strategy that courts growth and security at the same time.

Heavy focus on high-margin segments
Alcoa is repositioning itself to widen the scope of its business beyond the mining and sale of basic commodities. It is deepening its involvement in specialty products by engaging in the complete production of high end products such as structures, fasteners, and engine parts for the aerospace market. The rationale behind Alcoa's greater involvement further down the aluminum value chain is the fact that downstream operations generally yield higher margins when compared with the mining and sale of the basic commodity.

Accordingly, specialty products made up roughly 57% of Alcoa's revenue in 2013. Alcoa is further looking to expand the already pertinent role that specialty products play in the overall business. This is signaled by its $2.85 billion acquisition of UK-based manufacturer of jet-engine components, Firth Rixson.

Alcoa also believes that vigorous growth in the auto market will amplify demand for auto sheets and other components that Alcoa sells to automakers. Alcoa Chairman and CEO Klaus Kleinfeld previously told analysts on a conference call that Alcoa's sales of auto sheet would rise to $1.3 billion in 2018, from $330 million this year. Growth in the auto sector has largely been driven by economic recovery in key markets such as North America and Europe, as well as the monstrous demand for cars in China. While announcing Q2 2014 earnings, Alcoa projected that the North American auto market would grow between 2% and 5% this year. In China, growth will range between 6% and 10% during the year.

Continued demand for automobiles as well as healthy growth in the aerospace market will prompt a corresponding increase in the demand and price of specialized aluminum products such as auto sheets and jet engine components, allowing Alcoa to record higher margins through its fast-growing specialty products segment.

Floor under earnings
Although the prospects that high-margin segments presents are mouthwatering, good management always spread exposure to multiple segments to prevent earnings from slipping below a certain point, putting a floor under earnings.

Alcoa's equivalent of putting a floor under earnings is to deliberately maintain some level of exposure to its upstream segment, despite the specialty products segment and other downstream operations yielding comparatively higher margins.

Alcoa is banking on the rising price of aluminum to keep its mining operations afloat. This year, aluminum prices rose from lows of just under $0.75 per pound in February to $0.89 per pound as at July 18, 2014. While the price still has some ground to cover before it surpasses historical highs of over $1.20 per pound in April, 2011, prevailing trends in the market suggest that there is still some considerable upside.

There have been nine years of excess global aluminum output. This supply glut has largely been inspired by inordinate supply from China, which, according to data compiled by Bloomberg, has tripled over the nine year period. Alcoa, however, expects the nine-year-long global supply glut to come to an end shortly. It further projects a global supply deficit of 730,000 metric tons by the end of the year as opposed to a 106,000 ton surplus predicted earlier in January, 2014.

Furthermore, aluminum supply is normalizing against the backdrop of increased demand, which has largely been driven by general improvements in the overall global economy. According to the World Bank's 2014 Global Economic Prospects report, "Global GDP growth is projected to firm from 2.4 percent in 2013 to 3.2 percent this year, stabilizing at 3.4 percent and 3.5 percent in 2015 and 2016, respectively, with much of the initial acceleration reflecting stronger growth in high-income economies."

The report further argued that the global economy was finally turning a corner. As is the case with every economic recovery, demand for industrial goods such as aluminum always increases. This one will not be any different, especially considering that supply is contracting.

Bottom line
The configuration of all these factors will allow Alcoa's upstream segment to bring in higher sales revenue compared to previous fiscal periods. This will enable it to sufficiently cover up operational costs in the overall business. In doing so, Alcoa will be able to put a floor under earnings, ensuring that anything it gets from the specialty business is purely profit.

Alcoa's healthy balance between the specialty product segment and the traditional upstream segment allows it to court both growth and security at the same time. There is nothing better for investors than a company that bundles growth and safety in one investment opportunity.

Lennox Yieke has no position in any stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. 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.

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