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Prepare For Collapse In Aluminum Prices

Issued at 2015-07-10



Memo To Alcoa: Prepare For Collapse In Aluminum Prices.

Summary
 

 Aluminum is due for a sharp price correction with the market being very much over supplied.
 

  • The Alcoa business model is heavily weighted towards upstream operations.
  • Investors should consider selling out of Alcoa's stock to avoid deepening losses.

On April 8, Alcoa (NYSE: AA) kicked off the first-quarter earnings season with an earnings beat, tallying up $195 million in Q1 net income off $5.8 billion in total net sales. The bottom line results did include $177 million in restructuring charges. Without these charges, Alcoa would have taken down $372 million in net income, or 29 cents in earnings per share (EPS). A consensus estimate from Thomson Reuters had analysts expecting Alcoa to come in at a Q1 EPS of 26 cents.

The excitement concerning the earnings beat, however, largely overshadowed the fact that revenue growth has stagnated at Alcoa over the past year. If anything, Alcoa's bottom line performance has been more so a function of cost cutting, instead of any real results from recent efforts to transform the company into a purveyor of finished goods. Going forward, Alcoa shareholders may be further exposed to the very real risk that the aluminum market could collapse over the next year.

Oversupply in Aluminum

Various reports have already indicated that aluminum is now piling up at warehouses both near the London Metal Exchange (LME) and in Detroit. Various investment houses and institutional investors went heavy into aluminum last year to leverage contango and turn profits. Contango refers to the spread between immediate spot and forward delivery prices for aluminum. At the time, expanding aluminum storage and transportation premiums went hand in hand with contango.

The federal funds rate has remained at zero since Q4 2008 amid the depths of a housing bust and financial crisis. In response, institutional investors have helped themselves to massive amounts of liquidity, while also remaining desperate for yield. Much of this liquidity did work itself into the aluminum market, with Goldman Sachs (NYSE: GS) actually emerging as a major player in Detroit commercial real estate and formerly abandoned warehouses.

Instead of carrying bonds at negative real return, investment houses have been purchasing aluminum at spot prices and warehousing the metal with the intent of locking in a profitable sales price above the carrying costs at a future date. This aluminum carry trade will self destruct, of course, if the market were to be thrown into backwardation when spot prices are actually less than futures prices.

Meanwhile, China has emerged as the Saudi Arabia of aluminum, with producers shipping out semi-finished products in order to bypass paying 15% export taxes upon the raw metal. A semi-finished product, such as a door handle, can simply be melted down and recast within the destination country. Last May, China produced 2.7 million metric tons of aluminum, which then suddenly accounted for more than half of global aluminum supply. Last year, the Chinese produced 27.5 million metric tons of aluminum, which was an estimated 8% increase above 2013.

Andy Home, in writing for Reuters, recently described the aluminum market as "unchartered territory," before admitting that he himself had little to no idea as to how much aluminum was actually "out there." For 2015, the global supply of aluminum will likely exceed consumption by several million metric tons. If so, aluminum spot prices may collapse beneath $1,500 per metric ton by the end of 2015. Aluminum prices were approaching $2,100 per metric ton last fall.

Alcoa Heavily Weighted Upstream

Alcoa is the largest aluminum company in North America and a vertically integrated enterprise that mines bauxite, produces alumina, smelts alumina into aluminum, and wholesales finished goods, primarily used within the construction, automotive, and aerospace industries. Alcoa even generates roughly 20% of its own energy. Energy, of course, accounts for the majority of cost of goods sold in aluminum. Persistently weak oil and natural gas prices, however, will help trigger an aluminum supply glut, which would be more so detrimental to Alcoa.

Alcoa now categorizes its businesses according to Alumina, Primary Metals, Global Rolled Products, and Engineered Products and Solutions operating segments. Taken together, Alumina, Primary Metals, and Global Rolled Products generated $442 million in after tax operating income off $4.1 billion in Q1 2015 third-party sales. For the sake of comparison, Global Rolled Products accounted for $1.7 billion in sales and $191 million in after-tax operating income at Alcoa.

Alcoa excludes interest expenses, non-controlling interests, corporate expenses, and restructuring charges from its after-tax operating income. Again, Alcoa took $161 million in Q1 2015 restructuring charges, which was a $160 million year-over-year improvement. Alcoa has worked to shut down and sell off roughly 2 million metric tons in capacity over the past decade. Respective quarterly production of alumina and aluminum at Alcoa shrank by 239,000 and 128,000 metric tons last year.

In any event, Engineered Products and Solutions generated the majority of profits at Alcoa last quarter and will continue to do so into the near future. Alcoa has largely built out this specialized business through acquisitions by buying out TITAL, RTI International Metals, and Fifth Rixson over the past two years to break into the titanium and aerospace structural casting markets. These recent investments, however, will prove too little and too late to grow real shareholder value. Alcoa is still heavily weighted towards its upstream operations.

The Bottom Line

Aluminum, as a raw material, will prove to be an albatross at Alcoa, especially with prices entering secular decline. Last quarter, Alcoa Primary Metals realized average prices of $2,420 per aluminum metric ton, while spending $2,216 to produce one metric ton of aluminum. For 2015, Primary Metals realized price versus cost spread is likely to shrink beneath $50 per metric ton at Alcoa.

Alcoa closed out 2014 with $23.9 billion in sales and $268 million in net income on the books through what was a relative boom year for aluminum. Going forward, Alcoa's annual profits may decline by $175 million, with every $100 aluminum spot price drop at the LME. As such, Alcoa may take a $600 million loss through 2015, if quoted LME aluminum spot prices were to settle beneath $1,500 per metric ton throughout the remaining balance of the year.

On July 2, Alcoa last traded hands at $11.10 per share. At these levels, Wall Street traders are valuing Alcoa at a gaudy 53x trailing earnings (21 cents in 2014 EPS). Long-term investors should consider immediately selling out of this stock to avoid further losses. For the year, Alcoa's shares are already 37.5% off their $17.75 high.


Source: http://seekingalpha.com/



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