Alcoa Bid Fires Up Alcan

At the end of last week, the three-month London Metal Exchange price was around $2,830 a metric ton. Virga believes that will decline to an average of $2,615 this year and further in 2008. Inventories on the LME are edging higher compared to where they were at the beginning of February, but prices have remained steady, in sharp contrast to copper prices, which have rallied from around $5,300 a ton to more than $8,000.

The aluminum industry has only a handful of major players, meaning the market leader can create dominance by achieving economies of scale, thus shaking out the smaller producers over time, explains Bob Bruner, dean of the University of Virginia's Darden Graduate School of Business Administration.

Or put another way, the combined Alcoa and Alcan could have the power to discipline higher-cost producers, which are typically smaller in size, by from time to time flooding the market with additional metal output, he says.

It's a strategy that, Bruner adds, is technically illegal under U.S. and European Union law, but one which has been hard to prove historically, especially against producers of commodities. Bruner is also the author of the merger and acquisition tome Deals from Hell.

Still, he acknowledges that driving aluminum prices down to hurt modest-sized smelters would also weigh on Alcoa-Alcan in the short term. If such tactics were employed, investors should expect margins to get squeezed and the stock to stagnate, at best, he cautions.

Another problem for the combined entity will be escalating power costs, which have risen faster than metal prices, says Brian Hicks, co-manager of the (PSPFX Quote)Global Resources Fund at San Antonio-based U.S. Global Investors. Energy constitutes a major part of the expense of converting bauxite ore into aluminum.

"The companies are looking for ways to cut costs," he says. However, even with the projected $1 billion in savings, he's not tempted to add stock in Alcoa to his portfolio. With Alcoa trading at around 12 times next year's consensus earnings estimate of $3.11 a share, he thinks the stock is fairly valued, especially given that the company is at the top of the cycle.

Alcan fetches about 14.5 times next year's projected earnings of $5.56 and is also fairly valued, he says.

Hicks says there's the possibility that one of the large diversified miners, such as Rio Tinto (RTP Quote) or BHP (BHP Quote), could make a bigger bid for Alcan.