Alcoa Inc (AA), Rio Tinto plc (ADR) (RIO): This Aluminum Producer Could Be Worth the Risk

Alcoa Inc (NYSE:AA) is well known for being one of the world’s largest aluminum producers, not to mention the unofficial opener of every earnings season. However, like most materials companies, Alcoa has underperformed over the past couple of years, as rising expenses and oversupply in the market combined with a lack of demand. Alcoa has taken several steps to turn things around, but the light at the end of the tunnel isn’t quite there yet. Is this aluminum leader worth taking a chance on, and if so, what can we expect out of it in the next few years if things begin to go well.

Why Alcoa has underperformed
The main reason for Alcoa Inc (NYSE:AA)’s underperformance is that aluminum prices have been depressed for some time now. There has been a problem since late 2008 in the aluminum industry, as well as in most other metal industries, of too much supply and not enough demand. This has picked up in the past two years due to slower than expected growth in the emerging markets and very little, if any, production cuts. China produces about 44% of the world’s aluminum, so it’s easy to see how if China produces too much for their own needs, they have more to sell in foreign markets (such as the U.S.), which depresses prices.

Data from http://www.infomine.com

The profitability of aluminum producers is almost entirely dependent on the spot price of aluminum. Consider the above chart of the price of aluminum since 2008, and compare it with Alcoa Inc (NYSE:AA)’s share price over the same time period (below).

Data from TD Ameritrade

While it’s not a perfect correlation by any means, there is a definite link between the spot price of aluminum and Alcoa’s share price. There are other factors that cause shares to rise and fall, such as labor costs and production costs, which have been disproportionately high, especially after the price of aluminum started to fall several years ago.

How do they plan to turn things around?
Alcoa and its competitors are beginning to realize that the keys to long-term profitability are production cuts and more efficient operations. A recent Bloomberg report indicates that while aluminum consumption is expected to grow by about a 6% annual rate worldwide for the next several years, there are about 3.2 million tons of announced capacity cuts that may take place by the end of next year. To put this in perspective, worldwide aluminum production totaled 45.2 million tons last year, so this would be a capacity reduction of over 7%. When combined with 6% higher demand, we can expect aluminum prices to rise by around 13% in total, if everything goes according to plan. However, at this moment, that is a big “if.”