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Dow 30 Profile: Alcoa
Necessity Is the Mother of Invention
Finding aluminum was an arduous task until the 1900s. Unlike silver or gold, this metal is not found in its basic form, but instead is found in ore compounds (typically potassium aluminum sulfate or aluminum oxide). Pure aluminum was rare during the early 1800s, leading it to be highly sought after. Napoleon, Emperor of France, used to give honored guests aluminum utensils, while others had to settle for gold. In subsequent decades, a few individuals attempted to develop methods to extract the product. But the real breakthrough occurred in 1886 when Charles Martin Hall (Ohio, United States) and Paul Heroult (France) separately invented comparable solutions for the extraction of aluminum from bauxite ore by electrolysis.
In spite of Hall’s groundbreaking discovery, initial attempts to lure investors failed. In 1888, his fortunes took a turn for the better after a meeting with Alfred E. Hunt, a metallurgist from Pittsburgh. Hunt and a small group of investors agreed to invest $20,000. With the arrangement, the Pittsburgh Reduction Company was founded and led by Hunt. The producer’s name was changed to Aluminum Company of America in 1907, and shortened to Alcoa (AA - Free Alcoa Stock Report) in 1999.
Ups And Downs of The 20th Century
In the early 1890s, President Benjamin Harrison felt strongly that American industries needed to be protected led to the implementation of numerous tariffs during the next several years. Such sentiment was conducive for Alcoa, which subsequently benefited from the rise of the automobile industry in 1900 and World War I, in 1914-1918. In all, Alcoa’s annual production grew from 110 million pounds to more than 150 million pounds between 1915 and 1918. While the war’s conclusion in 1918 led to a decline in demand, the use of aluminum in commercial markets eventually picked-up the slack.
Surging exports encouraged expansion overseas. Thus, Alcoa spent much of the 1920s acquiring assets in Canada and Western Europe. By 1928, it controlled over half of the world’s capacity: 90,000 tons in the United States., 45,000 in Canada, and 15,000 in Europe. This accelerated growth, though, came at a steep price. Efficiency fell by the wayside. In fact, the company eventually decided to divest many of the same assets it had accumulated, spinning off its foreign operations as Aluminum Limited (later renamed Alcan).
The Great Depression, whose most difficult years extended from 1929 to 1937, ravaged Alcoa. Plummeting demand for aluminum led to a precipitous decline in company sales, from a peak of $34 million to roughly $11 million in 1932. Just when conditions could not appear to get worse, the company became the subject of a Justice Department investigation (see below). The conclusion of World War II in 1945 would mark a decade-long run in which competitors would outshine Alcoa.
During the 1960s, the company shifted more deeply into new initiatives, including fabrication. The decision proved to be advantageous. In 1961, Alcoa entered the beverage business, developing the Easy-Open aluminum technology. The product garnered a major share of the canned beer market within a few years, enabling this Pittsburgh-based producer to post a record profit. A growing cash hoard encouraged the company to again acquire assets around the world, this time in South America, Europe, and Africa.
The 1973 oil crisis and the ensuing embargo led to a precipitous increase in energy costs, making the production of aluminum, which requires massive amounts of electricity, untenable. Additionally, economic factors in the United States led the Federal Reserve Board to hike interest rates. In all, these conditions led management to temper expansion plans and focus on deleveraging efforts during the 1970s. Philosophical differences between CEO Charles Parry and Alcoa’s board of directors led to a lost decade during the 1980s.
Eventually, the company replaced Mr. Parry with the former president of International Paper Company, Paul O’Neil, in 1987. Instantly, Mr. O’Neil refocused the company on core aluminum activities. During the next 14 years, Alcoa made strides by establishing and maintaining efficiency. In particular, it modernized plants, paid down debt, and linked global operations and facilitated the exchange of information and ideas. As the beverage industry sought to boost profits by utilizing plastic bottles, Mr O’Neil worked to sell the auto industry on the benefits of aluminum. This was not an easy task since steel was cheaper. Nevertheless, with fuel efficiency standards on the rise, car companies slowly came around.
A Victim of Its Own Success
Martin Hall’s patented process of producing commercial quantities allowed Alcoa to become a dominant player. In fact, for many years, the company was the only aluminum producer in the United States. In order to maintain the upper hand, it acquired the land rights to build and own hydroelectric facilities in the United States and Canada and purchased exclusivity to all bauxite ore (key source of aluminum) mines in the United States. Alcoa also helped create new end markets. By promoting additional uses, the company was able to generate economies of scale. Alcoa’s sheer size deterred other entities from producing new aluminum, instead leading them to focus on collecting and recycling the material.
This success, however, did not go unnoticed. As far back as 1912, the United States Justice Department declared its belief that Alcoa had violated the Sherman Anti-Trust Act on three counts: making restrictive covenants, engaging in alleged acts of unfair competition, and participating in foreign cartels. The government filed a suit against Alcoa in 1937, declaring over 100 violations of antitrust law.
Eight years later, the lower court found Alcoa innocent of all anti-competitive behavior. The appeals court somewhat agreed, determining that the prosecution failed to find any specific actions that were illegal. But the ruling prohibited Alcoa from bidding for government-owed aluminum plants, which were no longer needed once World War II ended. With the sale of these assets to competitors, the company’s market share dwindled from a high of 90% earlier in the decade, to 51% by 1950.
In light of the strategic role it played during both World Wars, antitrust authorities let Alcoa go with a slap on the wrist. When allied command realized that Germany had developed Duralium, a copper, aluminum, magnesium alloy with extraordinary strength, the United States government turned to the company for help. Alcoa then developed a comparable product, 17S alloy. In fact, a well-earned reputation led the Germans to hatch a plan during World War II to bomb many of the producer’s manufacturing plants in the United States.
This Aluminum Giant’s Business Model
Today Alcoa is a world leader in the manufacture of aluminum and non-aluminum products for aircraft, automobile, commercial transportation, packaging, building and construction, oil and gas, defense and industrial applications. It operates four segments: Aluminia, Primary Metals, Flat-Rolled Products, and Engineered Products.
The Aluminia unit (known as upstream operations) consists of the company’s worldwide aluminia system, including the mining of bauxite. During 2011, more than half of the unit’s production was sold to customers who process the material into industrial chemical products, while the remainder is consumed internally. The unit’s sales (14 % of 2011 totals) typically fluctuate sharply in tandem with aluminum prices.
Primary Metals (also part of upstream operations) operates the producer’s smelter system. It uses aluminia to make aluminum for the company’s fabricating business, with the remainder being sold to traders and commodity markets. In 2011, the segment accounted for 33% of sales. The Flat-Rolled Products unit (known as the midstream unit, 31% of sales) manufactures aluminum plate and sheet. It includes rigid container sheet, which is sold to customers in the packaging and consumer market and is used to produce aluminum beverage cans.
Engineered Products and Solutions (downstream, 22% of sales) make aluminum and titanium alloys for the aerospace, automotive, commercial transportation, and power generation markets. It typically represents Alcoa’s most stable source of revenue, with operating margins exceeding that of the aforementioned businesses.
The aluminum-making process remains a capital-intensive business. In the same vein, Alcoa is expending considerable resources to secure assets while expanding in Brazil, Russia, and China. These steps, together with the finalization of numerous long-term power agreements (primarily for renewable energy) suggest increasing efficiency in the years ahead.
An Option for the Risk Tolerant
Shares of this Dow-30 component may well pique the interest of investors seeking growth. In the long term, demographic trends suggest that aluminum should regain its shine. Indeed, the metal’s unique properties appeal to a plethora of industrial uses, indicating prices should firm as the economy improves.
One caveat: aluminum is affected by a number of micro- and macroeconomic factors. Accordingly, the issue has a relatively high Beta of 1.45, suggesting above-average risk. While the company has typically possessed the financial wherewithal to support operations and capital expenditures, recent economic turmoil led Alcoa to trim its annual dividend, and the yield remains below average.
The Next One Hundred Years
Alcoa’s first 100 years of operations were greatly influenced by wide fluctuations in aluminum prices. The next century will largely be determined by the company’s response to aluminum’s growing usage in key end markets, in turn, mitigating the effects of spot prices on operations. During the next ten years alone, demand for the metal is on pace to double as demographic trends and urbanization in emerging markets forge ahead. Meanwhile, aluminum consumption should remain strong in developed economies.
Transportation has emerged as the most important market for aluminum, with automotive uses leading the way. Vehicle manufacturers are utilizing greater quantities of the metal in order to increase fuel efficiency and curtail emissions. With the passage of more-stringent legislation, aluminum will likely prove instrumental. The metal’s consumption in container and packaging markets appears poised for gains, too, along with the production of beverage cans, food containers, household and industrial foil. We expect demand from building and construction industries to advance as the shiny metal’s use in residential, commercial, and industrial bases bounces back, too. Lastly, prospects in the aerospace industry appear bright, thanks to aluminum’s unique thermal properties.
At the time of this article’s writing, the author did not have positions in any of the companies mentioned.