Big Money in the Beer Can Sector

Miners and metal suppliers have had a tough year.

Share weakness reflects low commodity pricing, poor global prospects for basic materials and entire investment sectors that are simply out of favor just now. Many investors seem to prefer bonds and tech, if not plain-old cash.

So what does the future hold for investors in basic materials? Can we identify any secrets to success? Can we get in ahead of the turning wheels of the business cycle?

In the past two years… aluminum pricing has been shaky on the best of days and weak on most others.

Today, let’s look at a “basic” material supplier that has apparently found the bottom. Shares may be poised for a strong comeback — but beware on that last point, because you might have to wait awhile.

The company I’m about to discuss is NOT a “buy” just yet. But it definitely ought to be on your radar screen because of its importance to global industry and as a barometer for market sentiment.

The other day, I listened in on a conference call by Klaus Kleinfeld, CEO of Alcoa (AA.) The aluminum company’s shares trade at $8 — a four-year low — which is far down from the high of $18 about two years back. I followed Alcoa in the portfolio for my Outstanding Investments newsletter a few years ago, but sold out before the shares drifted into the current doldrums.

I’ve always liked aluminum. It’s a very useful, versatile metal. It’s abundant in the Earth’s crust, but hard to obtain. Indeed, in the olden days, aluminum was so rare and valuable that Napoleon had a set of serving tableware made from it, which he only used when he wanted to impress visiting royalty.

Basically, you manufacture aluminum metal by passing large amounts of electric current through the mineral bauxite. So aluminum is energy intensive, such that it’s like “storing” electricity for future application. Winners in the aluminum biz are usually players with the lowest-cost electricity.

Despite the energy cost factor, the global aluminum business is highly competitive. There are many players and plants scattered across the world, from the Middle East to Russia to Iceland (yes Iceland, based on cheap geothermal energy).

Aluminum prices crashed in the recession of 2008-09, and then rebounded. In the past two years, since about 2011, aluminum pricing has been shaky on the best of days and weak on most others.

“You can’t put beer in an ingot.”

Alcoa has survived all through the crummy metals market. In fact, Alcoa just announced surprisingly strong earnings to the upside. Alcoa booked third-quarter net income of $24 million, up from a loss last year of $143 million. A metal play that’s turning a profit? I’m all ears.

According to Alcoa’s Kleinfeld, two things helped improve profitability. Management has focused on restructuring the company away from primarily supplying commodity metal, while also adding value to every molecule of alloy that it ships.

In fact, Alcoa is making its best money downstream this year, with a 22% gain in after-tax operating income for the company’s engineered products and solutions. That is, you can smelt aluminum and cast it into ingots. But in the words of former Alcoa CEO Paul O’Neill (who left the company to become Secretary of the Treasury under President George W. Bush), “You can’t put beer in an ingot.”

Alcoa is much more than a “beer can” company, however — and don’t discount for a second the advanced tech that goes into making things like aluminum cans.

Part of Alcoa’s secret to success is the continuing stream of ideas that comes out of the company’s well-regarded technical center, near Pittsburgh. This includes things ranging from super-high-strength alloy for military aircraft to lightweight drill pipe for the oil and gas industry. The technology is simply stunning, when you get into it.

Adding value helps make Alcoa “independent of commodity pricing,” Kleinfeld said. Thus, the company can “win in the market” through its organic technical capabilities.

According to Kleinfeld, Alcoa has generated “$825 million in productivity gains” in 2013, based on management initiatives and willingness to adopt suggestions from employees, vendors, customers and outside consultants. Looking ahead, Alcoa has over 14,000 more “productivity-enhancing ideas” in the pipeline. So internal improvements have every possibility of continuing despite the external market and/or overall economic environment.

Kleinfeld stated, “I think all of our businesses have found a way to push back against headwinds” — meaning weak commodity pricing and slow global growth. The key idea is to grow productivity, which is “part of [the Alcoa] operating process.” Plus, this style of internal evolution is deeply ingrained and “only limited by the creativity of our employees.”

Kleinfeld foresees the average automobile holding 135 pounds of aluminum by 2025. That’s not quite a 10-fold increase in the next decade.

Looking ahead, the aerospace industry is growing over 10% annually, with associated demand for more and higher-quality aluminum alloys. Boeing and Airbus both have a solid backlog of over eight years of commercial airliner production — and that’s if zero new future airline orders come in, which is unlikely.

On the defense side, military procurement is already cut back to the bone. Yes, things could get worse… but actually, not by much. If there’s a turnaround due to the need to rebuild military capacity in the face of new threats, Alcoa is poised to deliver all manner of high-end, high-value products to aircraft and ship builders.

Meanwhile, on the ground, the automotive sector uses more and more aluminum. In 2012, for example, the average U.S. car contained about 14 pounds of aluminum. But looking ahead, that number is destined to increase to over 55 pounds by 2015, based on industry designs that are already fixed and contracts that are already signed. So this is demand that will happen, and the only limit is the end-market for automobiles at the showroom floor.

Looking out even further, the news from the auto sector is stunning. Kleinfeld foresees the average automobile holding 135 pounds of aluminum by 2025. That’s not quite a 10-fold increase in the next decade.

Alcoa has three major expansion projects in progress to meet growing automotive demand. These include a $300 million expansion in Davenport, Iowa; a $257 expansion at Alcoa, Tenn.; and a $380 million project in energy-rich Saudi Arabia, with output destined for the global auto industry.

Another upbeat business sector for aluminum is in commercial buildings and construction. According to Kleinfeld, “This is not the same market that it was before the recession.” Across the U.S., Europe and the rest of the world, Alcoa sees building energy requirements increasing. This opens up all manner of new ideas for engineered aluminum products in exterior surfaces, windows, elevators and more.

When you step back and take it all in, Alcoa is operating in the same price-challenged, investment-challenged marketplace as everybody else — gold and silver miners, copper miners, you name it. But Alcoa has focused on what the company can control and done well even during otherwise hard times.

The secret sauce is controlling costs internally and building that aspect of operations deep into company culture. Then there’s adding value to the output.

In the end, for management, it’s all about finding more and more value in the products that the company makes and sells.

That’s all for now. Much more to discuss in the weeks to come. And aren’t you glad that I didn’t digress into some discussion of the government shutdown? As if there’s not enough of that in the news!

Best wishes…

Byron W. King
for The Daily Reckoning

P.S. For now, let’s let this metal play simmer. In the meantime there’s a much more immediate profit opportunity. Indeed, just as manufacturers like Alcoa are benefiting from America’s abundant supply of energy, there’s one sector that’s red hot. In yesterday’s free Daily Resource Hunter email, I gave readers an opportunity to find out exactly what sector I’m talking about. If you’re not a reader of the DRH email edition, not to worry. You can sign up for free, right here. I’ll be giving DRH readers another opportunity to discover this sector in coming issues, so be sure to watch your email inbox for your next chance to profit.

Original article posted on Daily Resource Hunter