(11/12/14) Alcoa: Transition in Aluminum

Although my latest recommendation deviates from our usual focus on small-cap stocks, the rapidly growing EPS and special situation hook will convince you that this aluminum firm is an excellent buy, explains Tom Bishop, editor of BI Research.

Let’s start with the special situation aspect of Alcoa (AA). In two words, it’s about saving money. More specifically, it’s about fuel economy.

The biggest driver here is the lightweighting of vehicles (which is believed to still be in its infancy) going on in the auto industry to meet mpg standards mandated by the federal government to gradually increase average car efficiency to 54.5 mpg by 2025.

But frankly, it’s just plain mandated by any consumer’s desire to have the best mpg they can get for the car they want to save on gasoline bills and feel good about using less energy. As a rule of thumb, for every 3% reduction you make in a vehicle’s weight, you can improve fuel efficiency by 2%.

And using more aluminum in cars and trucks took center stage this year when Ford (F) announced that it was substituting an aluminum alloy for steel in the most popular pickup truck in America, the F-150. By going to an all-aluminum body, the F-150’s weight was reduced by over 700 pounds.

Alcoa is ready for the surge, having invested over $1 billion in 2013 alone on plants that produced aluminum for the auto industry. Another plant expansion in Tennessee to supply the auto industry is scheduled for startup in 2015.

And it’s not just the auto industry stoking demand here, but the airline industry as well. Aircraft manufacturers also desire to upgrade fleets to more energy efficient aircraft since fuel is their biggest expense.

Although this has been going on for years, the trend to more and more aluminum and aluminum alloy products like higher strength aluminum-lithium (Al-Li) in each plane is growing.

So, while sales may be growing at only 7% per year, what is going on here is that Alcoa is strategically increasing its proportion of higher margin, value-added products in its revenue stream. This is the most important point behind this recommendation.

So, how’s this working out? Well, in Q3 Alcoa reported very strong results, blowing away the consensus analyst EPS estimate of $0.23, reporting $0.31, up 181%, and a 35% earnings beat on a 7% increase in revenue to $6.2 billion.

That marks the third EPS surprise in a row exceeding 30% as Alcoa turns the ship around and gets it headed in the right direction. How’s that for a stodgy 125 year old company? So, this is a pretty interesting transformation going on here. I already own some shares and think you should consider Alcoa as well.