Alcoa – Making The Best Of A Bad Situation

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Graham Copley / Nick Lipinski

203.901.1629/203.989.0412

gcopley@/nlipinski@ssrllc.com

July 14th, 2015

Alcoa – Making The Best Of A Bad Situation

  • Despite declining Aluminum pricing – back to levels not seen in a couple of yearsAlcoa is managing to put up positive results. This suggests that the cost and restructuring actions that have been underway for the last few years are working.
  • There are a couple of ways to win with AA; the restructuring program is clearly delivering results and we would expect the RTI integration to result in more synergies. The company remains levered to an Aluminum cycle and demand continues to grow while capacity additions have stopped and marginal capacity is closing. We think the upside in AA is greater than any company in our coverage universe over the next 24 months.
  • Weaker China domestic demand and lower China production costs are likely behind the recent price decline, rather than additional capacity. Lower pricing is likely to result in further capacity closures both within China and outside China and AA has closed capacity for Alumina and Aluminum this year.
  • Another risk to Aluminum pricing has been the large buildup of speculative inventories since 2009, but these are falling – possibly contributing to the price decline and are now 35% below their peak. Inventories remain very high but are less of an overhang than they were.
  • Alcoa’s self-help moves are making a difference and while the company still remains levered to the base aluminum market, it is taking out higher cost capacity and building a high quality downstream portfolio. This is creating a more diversified portfolio but at the same time raising “trough” earnings.
  • We still believe that Aluminum will run short long before the other major commodities, partly because the surplus began earlier, but mostly because the underlying demand growth is stronger. AA offers leverage to the upside, but better downside protection because of its growing downstream portfolio.

Exhibit 1

Source: Capital IQ, SSR Analysis

Overview

It is very easy to be negative on Alcoa; Aluminum pricing has completely retraced its steps to the lows of 2013, despite the expected demand growth that we wrote about in
our earlier research
and despite a slowdown in new capacity adds and some significant old capacity closures. However, we are not discouraged, nor have we changed our view that Aluminum should be the first commodity that the World runs short of over the coming years. Demand growth for the base material remains very robust confirmed by Alcoa in the earnings release this week.

China is, as has been the case for a while, the problem, but this time for different reasons. Now it is slower demand domestically in the construction sector, coupled with lower costs as energy prices fall and Aluminum production costs fall. While we do not have good and consistent data on Chinese electricity costs, we only need to look at Australian export coal prices to get a feel for what is happening – Exhibit 2.

Exhibit 2

Source: Capital IQ, SSR Analysis

China has reduced imports of coal almost to zero as local coal production has increased and as alternative sources of electricity grow – such as wind and hydroelectric – but local coal prices will be competitive with import alternatives and will have shown the same trend. While electricity prices in China have been fixed, the lower generation costs are now beginning to be passed through and power intensive industries such as Aluminum and chlor-alkali are seeing a direct cost benefit, which is almost immediately being reflected in more intense competition and lower export pricing – the LME cash Aluminum price shows this well – Exhibit 3.

Exhibit 3

Source: Capital IQ, SSR Analysis

If we simply look at the ratio between the Australian export coal price and the price of Aluminum there appears to be much more margin in Aluminum today than the last time prices were this low – Exhibit 4 – which is a negative because it means that pricing could go lower still.

However, we are interested in the space because of a possible demand driven cyclical recovery, and lower Aluminum pricing should continue to stimulate demand growth, so while this may be a short term negative, we believe that it will help longer term

Exhibit 4

Source: Capital IQ, SSR Analysis

Despite these poor aluminum fundamentals, Alcoa is putting up better and better numbers, and while Q2 missed consensus expectations, in the context of where the base metal price moved, the results were good. If we look at AA’s numbers versus the base metal price – Exhibit 5 – the improvement is obvious; clearly there is a correlation, but EPS is improving relative to the base metal price.

Exhibit 5

Source: Capital IQ, SSR Analysis

The improvements at AA are coming from better management of the base metal portfolio, including rationalization of both Alumina and Aluminum capacity, as well as the portfolio changes that the company is making by moving further downstream. The RTI acquisition is yet to close and this adds even more diversity and likely earnings stability to the portfolio. While the new portfolio should not be as cyclical, we would still expect earnings to move up meaningfully as Aluminum prices recover and we would expect the stock to recover meaningfully also. We still believe that Alcoa can be a $30 stock within the next 2 years and see the current pull back as a renewed opportunity to get involved. The obvious risk is that base metal prices could fall further, with lower China costs, but this will lead to further closures and could hasten the recovery.

Inventories Falling

One of our concerns when we first wrote on the subject 2 years ago was the high level of speculator inventory. While levels remain high, they are now well off their peak – Exhibit 6 – and the reduction in speculative inventories is down by 35% when we include the most recent data (LME inventories are available sooner than producer inventories) – Exhibit 7.

Exhibit 6

Source: Bloomberg, International Aluminum Institute, SSR Analysis

Exhibit 7

Source: Bloomberg, International Aluminum Institute, SSR Analysis

But China Exports Are Higher – Though This Is Not Necessarily a Bad Sign

China’s exports of Aluminum and Aluminum products continue to rise – Exhibit 8 – and to a degree this is driving the price weakness, with Chinese suppliers competing among themselves to gain share of the export market because of local surpluses and weaker domestic demand growth.

Exhibit 8

Source: Bloomberg, SSR Analysis

However, the world is absorbing this export volume, partly because of some smaller shutdowns outside China, but also because the world continues to see very strong demand growth. Alcoa expects this to be another 6.5% growth year for Aluminum. With an overall market, including recycle that is around 50 million tons a year, even if demand growth is only 5% we need 2.5 million tons of new supply a year. Put in this context, China’s YTD exports are up roughly 100 thousand metric tons per month versus 2014. China exports are meeting the growth needs of the market if one assumes that China itself is roughly 50% of the market. Meanwhile, China production is rising rapidly and should quickly approach available capacity.

But, The Market is Skeptical

Exhibit 9 shows Alcoa’s progression on our Skepticism Index over the past three years. The market is more skeptical towards Alcoa today than it was during the 2012-2013 period, when AA was an overlooked, deep-value play and the cheapest stock in our coverage. The apparent discount in the stock is again notable, but returns today are higher than they were at the last valuation low and skeptical peak. In other words, the market is essentially ignoring tangible evidence of the company’s capacity curtailments and portfolio moves upstream and is discounting Alcoa even more like a pure commodity aluminum producer than it did in the past.

Exhibit 9

Source: Capital IQ, SSR Analysis

Exhibit 10

Source: Capital IQ, SSR Analysis

This level of skepticism is not entirely unwarranted – the long term return on capital trend in Exhibit 11 shows successively lower peaks. Yet, given where we are in the aluminum cycle and AA’s current portfolio composition, current returns seem as likely to be a trough as a peak. Alcoa is clearly not being given the benefit of the doubt, however, and likely needs to demonstrate that its recent acquisitions can materially improve the return profile before we see a sustained move higher. Exhibit 12 looks at the relationship between AA’s return on capital and the ratio between Aluminum price and crude oil (as a very rough general proxy for Aluminum margin). The 2005 return on capital peak was caused by an Aluminum shortage. There is no shortage today, yet the lines are clearly diverging, an improvement that is being ignored in Alcoa’s valuation. Exhibit 13 is a repeat of Exhibit 1 – as we noted the last time Alcoa was this cheap, when the stock moves it tends to do so quickly.

Exhibit 11

Source: Capital IQ, SSR Analysis

Exhibit 12

Source: Capital IQ, SSR Analysis

Exhibit 13

Source: Capital IQ, SSR Analysis

©2015, SSR LLC, 1055 Washington Blvd, Stamford, CT 06901. All rights reserved. The information contained in this report has been obtained from sources believed to be reliable, and its accuracy and completeness is not guaranteed. No representation or warranty, express or implied, is made as to the fairness, accuracy, completeness or correctness of the information and opinions contained herein.  The views and other information provided are subject to change without notice.  This report is issued without regard to the specific investment objectives, financial situation or particular needs of any specific recipient and is not construed as a solicitation or an offer to buy or sell any securities or related financial instruments. Past performance is not necessarily a guide to future results.

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