We initiated positions in two aluminum companies last fall, Alcoa (AA) and Norsk Hydro (OSL:NHY), that we saw as commercial opportunities or, as we like to call them, “3 to 1s”, i.e., 3x the perceived upside to its downside. The oversimplified and bigger picture view was that we saw the price of aluminum was at an inflation-adjusted low and the stock prices of these companies were down in kind, as can be seen in the following graphs.
As we studied the industry, we realized that almost half of aluminum smelters were operating below cash break-even…
…but the industry participants were acting rationally and closing capacity. Alcoa, alone, has already reduced its smelting capacity from ~4.5 to ~3.0 mm tons.9 With ~6% demand growth expected for the current decade, helped along by emerging markets and increased usage in the aerospace and auto industries, we kept researching.
We studied their competitive position, understanding relative strengths vis-a-vis competitors, customers and suppliers. We looked closely at Alcoa’s and Norsk Hydro’s businesses, financials, free cash flow, and the capabilities of their management teams (particularly their capital allocation decisions). We ultimately determined that these companies met our hurdles and represented a commercial opportunity. Our estimates of what might eventually happen look like this – although it may or may not play out this way or could but for different reasons than we think.
Talking about these two companies as if they’re synonymous does each a disservice. There are distinctions in business lines, geography and management. Norsk Hydro is more a pure play on the aluminum supply chain, while Alcoa has a hidden gem in its high-margin, high-return on capital Engineered Products Solutions business. However, we did feel that this abbreviated view would serve to illustrate how we decide what to work on and how we begin to understand a business and industry.
From Steven Romick (Trades, Portfolio)’s FPA Crescent Fund Second Quarter 2014 Commentary.
