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Joint Venture: Value Proposition? A Look at the Aluminum Industry
Posted by: Victor Selva (IP Logged)
Date: October 9, 2013 05:03PM

A main factor affecting demand for aluminum products is economic growth and, in particular, demand for durable goods. The three largest end markets for aluminum in North America are transportation, containers/packaging, and construction. If the price of aluminum in 2013 falls below 2012's levels, this will cause earnings to be lower. So let's take a look at two companies in this sector and see which one is doing better and thus stands as the best investment.

Alcoa Inc. (AA) is one of the world's largest producers of primary aluminum as well as one of the world's largest suppliers of alumina, an intermediate raw material used to make aluminum products for a variety of end-markets. Alcoa is involved in every step of the aluminum-production process, from bauxite mining to the sale of specialized aluminum products. Aluminum demand and pricing are poised to recover from great lows, driving significant earnings growth potential for the company.

$1.1 Billion Investment

On Dec. 21, 2009, the company announced that it had formed a joint venture with Ma'aden, the Saudi ArabianMining Company, to develop a fully integrated, world-class aluminum industry in the Kingdom of Saudi Arabia, where infrastructures is growing to match the growing consumer demand. Alcoa will control 25.1% of the joint venture, with the possibility to increase its interest to 40% in 2019 which sounds as a promising participation.

The company is focusing in the aerospace and auto markets. The company, which makes aircraft wings and fasteners, is seeing how airline fundamentals are improving with a projected air travel demand rising and a roughly 10% in the growth of the aerospace market and 12% for large commercial aircraft segment. With respect to the auto industry, vehicle sales are high in the last 12 months. But looking forward, Aluminum represents the second largest-volume component material in automotive vehicles and is expected to double by 2025.

In terms of valuation, the stock sells at a trailing P/E of 72.2x, trading at a premium compared to the industry average of 14.6x. Analysts’ expectations imply a forward P/E of 18.53. For the third quarter of fiscal year 2013, the company reported a profit of $24 million or 2 cents per share in the compared with a loss of $143 million or 13 cents per share in the year-ago quarter.

Time to Go Away

Aluminum Corporation of China (ACH) is the largest player in the Chinese aluminum industry. The principal products include alumina, primary aluminum, aluminum fabricated products, gallium and carbon-related products.

The company is highly dependent on the price of aluminum in China and a slow-down in that economy could affect earnings even more. The company is currently operating at a loss and will continue to do so unless it will be able to cut costs: transportation costs associated with importing the bauxite and the refineries high-cost which requires the use of caustic soda during the refining process.

Indonesian export regulations on bauxite severely impact the business. In 2012, the government imposed a 20% export tax on bauxite; with a disastrous outcome for the company that had to close two refineries, because 80% of the bauxite imported is from that country. The Indonesian government is now considering a total ban on the export of bauxite and other raw materials that could come into force in 2014.

Finally, I always like to see the evolution of one of the most important financial ratios applying to stockholders, the best measure of performance for a firm's management: the return on equity.

Company ROE Compared to Aluminum industry median (=0.0)
Alcoa 1.4 Above
AluminumCorporation of China (18.8) Below

Looking at the table we can see that Alcoa shows a ratio above the industry average.

Final Comment

I see an important risk in Aluminum Corporation of China because the company imports approximately half of the bauxite that it refines, so its supply could be affected by a severe disruption when regulations change. Regarding Alcoa, the low-cost production from the new Saudi Arabian joint venture led the company remains on the low end of the industry cost curve. We expect Alcoa profitable numbers to improve, as the global economy gradually recovers, as reflected by higher global GDP growth.

Hedge fund gurus like Joel Greenblatt, Steven Cohen and Arnold Van Der Berg added this stock to their portfolios, and I would advise fundamental investors should consider adding this stock to their portfolios as it seems to be an attractive option for long-term investors.

Disclosure: Victor Selva holds no position in any stocks mentioned.

Guru Discussed: Joel Greenblatt: Current Portfolio, Stock Picks
Stocks Discussed: AA, ACH,
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