Almost 29% of South32 revenue after the presumptive BHP Billiton will consist of Australian aluminum mining assets. Along with company’s silver/zinc division, aluminum will be the largest singular driver of investor returns. If you have been reading me for a while, you may wonder why I would have any kind of interest in this type of business at all, given my sharp disdain for Alcoa’s business model that I have covered in years past.
The summary of my writings on Alcoa previously have been something like this: Alcoa tends to be a troublesome cyclical to attach a buy-and-hold attitude towards because the (1) prices of aluminum is highly volatile and (2) the costs of running the business are quite high. In other words, Alcoa investors are likely to see higher fluctuations in stock price and lower stock market gains than someone investing in an S&P 500 Index Fund, accepting higher fluctuations in profit for lower long-term returns because the good times of high prices in the American aluminum industry have not offset the high costs of ordinary and bad times when the price of aluminum is low.
There are factors that can both confirm and rebut this general tendency:
1. Paying a high price for aluminum assets is not something you can “grow out of.” It is a mistake with consequences. Someone that paid a high price of $30 per share for Alcoa in September 1999 would have compounded his money at a rate of NEGATIVE 4.02% annually since then (even assuming dividend reinvestment). Yeah, you got some nice dividends along the way (Alcoa paid out $0.68 per share before the financial crisis) but the justified plunge in aluminum prices since then has been so substantial that investors have waited almost a generation for the privilege of losing half their money.
This isn’t like Disney where you could pay over 30x earnings in 1999 and still see your wealth compound at 10.6% annually from that point onward even though you overpaid. Disney can easily produce more and raise the price of its goods at a price above inflation, whereas Alcoa doesn’t have that price-raising power and it shows.
2. Of course, there is a flip side to this. Buying Alcoa when the shares are on sale still works out well. Someone who bought shares of Alcoa during the bear market in aluminum prices in 1973 would have seen his shares compound at 7.5% annually since then. This is still about two percentage points per year below the S&P 500, but I still see it as a miraculous testament to Benjamin Graham’s margin of safety principle that someone who invested $50,000 into shares of Alcoa in 1973 would have one million dollars of Alcoa stock in 2015. Alcoa endured dividend cuts, severe declines in the profitability of its operations, is currently trading at a low point of the business cycle, and still created wealth. It is four decades later, and yet the low starting price in 1973 provided so much safety that an investor still moved his economic life significantly forward despite buying an asset in an industry that would go on to suffer from significant and extended declines in the price of aluminum.
3. Not all operators in an industry are the same. You know that I’m no fan of airlines industry investments because there are many structural reasons why bankruptcy is an inevitability for most of the companies in the industry. Yet, if I am going to be intellectually honest, I must also concede that Southwest Airlines has kept costs substantially lower than its peers and found innovative route policies to make a profit such that investors have compounded their wealth at 17% annually since 1980. Surrounded by peers that have gone bankrupt, investors in Southwest have seen $25,000 grow into over $6 million over the past 35 years.
While the assets of South32 are neither great nor bad—this isn’t a company you would normally seek out in the ordinary course of events for buy-and-hold investing—it is nevertheless intriguing because it comes in the form of a lottery ticket attached to long-term investors in the higher-quality BHP Billiton parent company at a time when the valuations are cheap, the results of high returns from dividend reinvestment are promising, and South32 is not married to the aluminum industry because it has about 70% of its profits coming from other commodities so the possibility of itself morphing into another company are plausible in a way that is not the case with someone buying shares of Alcoa.
When you study the Worsley Alumina operations in Western Australia, you will see that the operations have a resource life of 63 years and a reserve life of 17 years. The operating costs at Worsley (which will be part of South 32 after the spinoff) are $272/t compared to the figures of over $350/t that is more common in the industry. Being the low-cost producer is something you should insist upon if you are dealing with investments in an industry that has more headwinds than tailwinds. This is useful to know because it lets you know that Worsley Alumina can make a profit—it pays $272/t while selling its aluminum it an average price of $330/t. The risk is that these costs are generally fixed—if the cost falls below $272/t, Worsley will operate at a loss. If aluminum prices rise, you’ll see inflated profits get reported.
If someone were starting a portfolio and looking for that ideal building block to be the foundation of future wealth, you would not look to South32. You would look to companies like Nestle, Coca-Cola, Johnson & Johnson, Colgate-Palmolive, and Procter & Gamble. That said, the attendant circumstances surrounding South32 make this opportunity interesting for those with already diversified portfolios seeking high income at an undervaluation that comes with the risk of short-term volatility and uncertain near-term prices of commodities. You get to buy BHP Billiton at a lower than usual price with a dividend that will not be adjusted downward despite spinning off 15% of its assets, and the South32 spinoff has the potential to be an intriguing long-term asset depending on which commodity division gets the focus of management’s attention with the 60% of retained profits.
Originally posted 2015-03-19 17:00:16.