Marcial: Alcoa Might Regain Its Luster

Commodities—and shares of companies that produce them—have turned cold after a sizzling runup in prices this year.

And so have the shares of Alcoa (AA), the world's largest integrated aluminum producer. It's no big surprise: Commodity prices are under pressure mainly because of the economic downturn, and the housing and auto industries—two major users of aluminum—remain embattled. So shares of Alcoa have tumbled, to 24 on Sept. 26, down from their 52-week high of 44.32 on May 19.

But this could be an opportune time, say some investment pros, to buy Alcoa's battered stock to capture what they expect will be robust gains over the long term.

Takeover Target?

Here's why: It's unlikely that commodity prices will keep going down. Once the economy starts showing signs of recovery, commodities will start snapping back. If Alcoa's stock continues to weaken, however, some bulls say it's more than likely the company will end up being gobbled up by a larger mining concern.

"Undoubtedly, the industry is actively in consolidation, and Alcoa is definitely one of those vulnerable to being taken over," says David Katz, chief investment officer at Matrix Asset Advisors, which has accumulated shares. For months now, he notes, the world's largest mining company, BHP Billiton (BHP) of Australia, and Britain's Rio Tinto (RTP), the world's second-largest aluminum producer, have been trying to acquire each other, with no success. And about 18 months ago rumors swirled that BHP and Rio Tinto were separately preparing to launch a bid for Alcoa. To avoid such a fate, Alcoa submitted an offer to buy Alcan, another major mining company. But Rio Tinto frustrated Alcoa by buying Alcan. Now, analysts say the prospects for more consolidation are strong.

Katz figures that based on fundamentals, the value of Alcoa is in the high 30s. But he puts the company's value in a buyout in the low to mid-40s, based on the projected increase in aluminum prices over the long term and the company's shift to lower-cost plants.

Less Volatility Ahead

Standard & Poor's analyst Leo Larkin, who rates Alcoa a buy, expects earnings will increase over the long term because of the industry's consolidation, generally rising prices, and reduced production costs. Larkin says aluminum prices hit bottom in 2002 and should move higher through 2009. So Alcoa's stock, at its current price, is "attractively valued," says Larkin.

He forecasts Alcoa will earn $2.53 a share in 2008 and $3.22 in 2009, vs. 2007's $2.96. The lower earnings in 2008, he says, are due to the weakness in residential construction and a decline in auto sales. But Larkin says the anticipated consolidation in the industry should result in a more disciplined pricing environment and less volatility in sales and profits over the course of the economic cycle. His 12-month price target for Alcoa shares is 42, based on his earnings forecasts. (S&P, like BusinessWeek, is a unit of The McGraw-Hill Companies (MHP).)

Brian MacArthur, an analyst at UBS (UBS) (which has done banking for Alcoa), also rates Alcoa a buy but with a higher 12-month price target of 46, based on his earnings projections of $2.93 a share on sales of $30.5 billion for 2008, $4.36 a share on $32.6 billion in sales in 2009, and $6.86 per share on $37.9 billion in sales in 2010.

Diversified Product Mix

"Alcoa is one of the most effectively managed mining companies in the world," says MacArthur, pointing to its highly competitive position in the industry, a diversified production mix, and "compelling processing technology potential." He notes that Alcoa's aluminum products are used in a wide variety of applications, including aircraft, automobiles, buildings, and packaging.

Right now, Wall Street is preoccupied with the credit crisis and the jarring shakeout in the financial sector, and little attention is being focused on the M&A front. But when the dust settles and Wall Street gets back on its feet, the search for deals will be under way again, and Alcoa, buttressed by its strong assets, should get fresh attention.

Unless otherwise noted, neither the sources cited in Gene Marcial's Stock Picks nor their firms hold positions in the stocks under discussion. Similarly, they have no investment banking or other financial relationships with them.

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