Alcoa Inc (AA): Going Long on the Dow (.DJI)’s Most Shorted Stock

The Aluminum Company of America, or Alcoa Inc (NYSE:AA), has not been receiving much love from investors lately. This is understandable, as the shares have fallen over 16% in the last 12 months. Alcoa shares are trading at the same levels now as in April 2009. Recent underperformance has made betting against the firm popular on Wall Street–more than 8% of outstanding float is being shorted, by far the highest percentage of any stock in the Dow Jones Industrial Average. But in many instances, placing your capital in companies that the masses dare not touch can prove a shrewd decision. Can we be reasonably certain Alcoa Inc (NYSE:AA) is a bargain for $9.3 billion? The company’s reports with the SEC will tell us everything we need to know.

What Alcoa does

The Aluminum Company of America is a dominant player in the aluminum industry, involved in practically every aspect of the business. Its operations consist of four segments: Alumina (also known as aluminum oxide or bauxite), Primary Metals, Global Rolled Products, and Engineered Products and Solutions. Alcoa Inc (NYSE:AA) controls massive bauxite reserves, with mining rights at many sites extending several decades beyond today. Wonderful, but Alcoa realizes that its potential isn’t being maximized when it acts only as a miner and smelter of aluminum. There are profits to be earned in these areas. But management at Alcoa foresees fortunes being made from new applications for the metal. The company’s engineered products and solutions serve a wide variety of industries, including aerospace, automotive, and construction. Active efforts are being made by the company to shift away from classic mining and smelting and into higher margin engineered products. A Wall Street Journal article last month quoted CEO Klaus Kleinfeld as saying  “This is a different Alcoa Inc (NYSE:AA), with more profits generated from value-added downstream operations and less reliance on basic mining and smelting.” Leadership at Alcoa is aware that the way the world uses aluminum will change, as more efficient applications will be discovered in response to changing demands. As such, management is committing substantial resources to stay on top of the aluminum industry.

The debt situation

As a potential owner of Alcoa Inc (NYSE:AA), knowledge of the company’s debt situation is essential. Investors have a fairly wide variety of techniques to analyze debt. To get a good idea of a company’s current financial position, working capital is a very useful metric. Comparing the proportion of working capital to market capitalization and the growth rate of working capital between companies in the same industry can be very informative.

Alcoa conducts most of its alumina refining activities through an entity known as Alcoa World Alumina and Chemicals. This group of companies is 60% owned by Alcoa and the other 40% by Alumina Limited (ADR) (NYSE:AWC), an Australian company. All of Alumina’s business activities involve its partnership with Alcoa.

Along with Alumina Limited (ADR) (NYSE:AWC) I selected Century Aluminum Co (NASDAQ:CENX) as another company to compare with Alcoa. Century  is headquartered in Monterey, California and has production facilities in the southern United States and Iceland. Here is how these three companies stack up in terms of working capital.

*Average is for 2001-2002

In terms of working capital, Century Aluminum Co (NASDAQ:CENX) has done especially well.  Of the three companies its working capital is largest relative to market cap and has experienced the most growth in the last 10 years. Century has done very well managing its working capital during the last decade, but do not let the numbers mislead you. Century’s minuscule size undoubtedly played a key role in the growth rates it has experienced.

Meanwhile Alcoa, despite its massive size, was able to grow its working capital at rates that are nothing to scoff at. You may notice that Alcoa’s Q1 2013 figure is a bit lower than the 2010-2012 average. Do not necessarily take this as a negative sign–you can’t place too much importance on fluctuations from one quarter to the next. Looking at the balance sheet will tell you that Alcoa added $600 million of short-term debt in the first quarter. What were management’s reasons for doing this? Was it in the best interests of the company? Alcoa’s financial statements will give you the answer to the first question, thereby allowing you to reach your own conclusions as to the answer of the second.

The working capital numbers can tell you a lot about a company’s current financial position. Alcoa’s current financial position is strong enough as to scare away only the most conservative of investors. But how does the long term debt look?

*As of Dec. 31, 2012. All other figures in that row are current as of the Q1 2013.

**During this period AWC had not yet separated itself from WMC Limited. A conglomerate that eventually got taken over by BHP Billiton.

Of the three companies Alcoa employs the most leverage, but has taken steps in recent years to significantly reduce it. The debt-to-equity ratio of Alcoa is much higher than the other two. Does Alcoa have the profit generating power to make assuming $7.745 billion in long term debt palatable to investors?

How are the earnings?

When it comes to earnings records, none in the aluminum industry stretch back farther than Alcoa because Alcoa practically invented the modern aluminum industry. Alcoa was founded in 1888 as The Pittsburgh Reduction Company, back when the only valuable thing owned by the company was a patent–a patent for a new process of extracting aluminum from aluminum oxide which finally made aluminum production economical. This discovery has allowed Alcoa to dominate the aluminum industry for over a century. How profitable has this dominance been for Alcoa? Cash flow from operating activities can give us some clues.

As you may notice from the chart, the aluminum industry hasn’t been doing so great. Only one company, Century Aluminum, managed to raise its three-year operating cash flow average between 2002 and 2012. All three companies registered lower operating cash flow in 2012 than their average over the preceding three years.

The Foolish final take

The less-than-stellar results of the past few years may have you doubting whether or not aluminum is an industry you want to invest in. When those doubts creep into your head remember these things. Alcoa has the longest history and possibly the greatest stability of any aluminum company on Earth. Its profits have dipped in the past few years, but the company is still very much in the black. The same cannot be said for Chinese aluminum giant Chalco, which lost over $1.3 billion dollars last year. The current financial condition of Alcoa, as measured by working capital, is solid. Alcoa’s balance sheet has more than a little bit of debt, but management has been taking steps to significantly reduce this burden. Times may be tough now for the aluminum industry, but the incredible importance of products made from aluminum all but ensures the industry’s survival. Alcoa’s 125 years of operations have given it knowledge and experience that other companies can only dream of having. This knowledge has allowed it to achieve margins better than any aluminum company I could find on fool.com.

The current condition of the aluminum industry may not bode well for the weaker aluminum companies, but Alcoa is not just another aluminum company. It is the Hercules of aluminum companies. If any American companies are still profitably producing aluminum in 50 years, Alcoa will be among them. So consider buying some shares of Alcoa and holding them for a couple decades.

The article Going Long on the Dow’s Most Shorted Stock originally appeared on Fool.com and is written by Ryan Palmer.

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

Copyright © 1995 – 2013 The Motley Fool, LLC. All rights reserved. The Motley Fool has a disclosure policy.