Aluminum – Always Darkest Before the Dawn

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Graham Copley / Nick Lipinski

203.901.1629/203.989.0412

graham@/lipinski@sector-sovereign.com

April 2nd, 2013

Aluminum – Always Darkest Before the Dawn

 

  • We have been highlighting the attractive value in AA for a little under a year and we have been wrong, as the stock has consistently underperformed a rising market. What looked like a cheap stock a year ago looks even more attractive today.
  • The global oversupply of aluminum has kept pressure on prices, while supply complications rather than fundamental shortages have kept upward pressure on feedstocks. Profitability in the sector has been terrible, and despite rationalization of uncompetitive capacity, AA barely broke even in 2012.
  • But; demand is improving quickly, with positive absolute and substitution drivers in most key sectors: Aluminum pricing is at an all time low relative to steel and to crude oil (a proxy for plastic pricing). Moreover, CAFE and similar fuel efficiency standards will continue to drive more Aluminum into Auto manufacture; also construction (and electrical) related demand is improving.
  • Producers will add 20% to capacity over the next 5 years, but it is reasonable to expect demand growth in excess of 5% per annum over the same period. This would close the gap between demand and capacity significantly – driving pricing.
  • Buying AA at valuation lows as many as 5 times over the last 25 years has yielded very good returns – up to 100% – over very short periods. Few would suggest that we are not at a valuation low today.
  • This is a “risk on”, economically sensitive sector and the economic news is not getting worse anymore. Europe maybe, but the rest of the world more than offsets.

Exhibit 1

Source: Bloomberg, IHS and SSR Analysis

Overview

If you look at Aluminum pricing over any long period of history (Exhibit 2) you will notice very significant swings. This is a true commodity: one ton too much and the price falls, prompting inventory reductions and further price weakness. One ton too little and you get the reverse effect.

Exhibit 2

Source: Bloomberg

This is not particularly subtle, and understanding the incremental Aluminum demand caused by the specific substitution of aluminum in a particular car component for a particular model is probably a degree of accuracy that will not help predict the swings and may distract you from the bigger picture. This was the logic that caused us to highlight the attractiveness of AA a year ago when we first initiated coverage – this combined with an absolute and relative valuation that was in our view compelling. The risk with all of these very volatile and complex global stories is that you run the risk of catching the story early and while you wait it may get worse. This was clearly the case a year ago. Weaker than expected economic data through 2012 kept pressure on Aluminum prices and demand, and the stock fell sharply in March and April of 2012 and has since has been relatively flat while the market has rallied meaningfully (Exhibit 3). Over the last year Aluminum pricing has weakened incrementally relative to Steel and Crude Oil, but not to Copper.

Exhibit 3

Source: Capital IQ and SSR Analysis

However, simply reviewing the data today:

  • Demand was impacted by the economic slowdown, as it was for all commodities – this demand weakness drove a meaningful price decline as it did for most commodities.
  • Capacity expansion continued through the slowdown post 2008, though many future expansion plans have now been postponed or abandoned. However, at least a net of 20% will be added to global capacity in the next 5 years.
  • The industry today has operating rates close to 80% – not high enough to give sellers any pricing power.
  • But, demand growth is recovering and all of the indicators that matter would suggest it is accelerating.
    • Aluminum is cheap relative to steel and relative to plastics
    • Fuel efficiency standards tighten quite aggressively over the next few years, at a faster rate than in the past
    • The construction market is recovering – residential and commercial
    • Consumer spending is recovering
    • The global economy appears to have bottomed and while there are many conflicting signs from Europe, incremental weakness in Europe will not be enough to counter improvements elsewhere

While aluminum producers appear to have no pricing power today, industry consultants are calling for higher prices, the forward curve is positive and consensus estimates imply price and margin increases.

AAs stock is volatile and moves quickly

From the end of 1998, AA share price doubled in 12 months. It had another dramatic rise from September of 2000 to May of 2001. It also moved quickly off the lows in 2009 and was up 2.5x in less than a year. The point we are making here is that it moves quickly when it moves. Looking at our valuation model – AA has around 100% upside to reach what we would consider to be “normal” value – Exhibit 4 (one standard deviation for AA is around 23%, so the stock looks to be 47% of normal value today). This does not make any heroic assumptions about earnings, as we are using a declining return on capital trend as shown in Exhibit 5. This generates a current “normal” EPS of just under $1.00 per share – very much in line with 2014 consensus estimates today. Note that in Exhibit 5 our numerator uses forward earnings and so the last 12 months of return on capital calculations rely increasingly on consensus estimates for 2013/14.

Exhibit 4

Source: Capital IQ and SSR Analysis

Exhibit 5

Source: Capital IQ and SSR Analysis

Demand – Rosier, and better still with a recovering global economy

In Exhibit 6 we show broad demand categories for aluminum. Packaging is impacted by global consumer trends, but aluminum will benefit from its lower relative price versus plastics. In general global plastics prices are driven by the price of crude oil and so for the most part sit at all time highs (relative pricing is shown in Exhibit 7).The substitution of packaging materials between plastic and aluminum is limited as it is generally driven by consumer preference, but any company making a new packaging decision could be influenced by the relative attractiveness of aluminum today.

Exhibit 6

Exhibit 7

Source: Capital IQ and SSR Analysis

The transportation piece is growing already at a reasonable clip because of the lighter weight needs of the automobile fleet, but this will benefit further as the economy improves and auto sales increase globally. Moreover, while current aluminum prices are very depressed and we would not expect them to remain at current levels, so is steel. We have seen a slow and steady decline in aluminum prices relative to steel – Exhibit 8. Steel’s ability to compete with aluminum in the auto sector relies on the increased use of higher strength steels (allowing for weight reduction) and consequently, the grade of steel that aluminum is competing with in the auto space has a rising price relative to aluminum.

 

Exhibit 8

Source: Capital IQ and SSR Analysis

The other demand categories are for the most part driven by the strength of the global economy, which is showing signs of recovery following a couple of very weak years. There is a more bullish story in the construction sector, particularly in the US. Furthermore we still expect above trend demand growth in the electrical space given the discount in aluminum pricing relative to copper – Exhibit 9.

Exhibit 9

Source: Capital IQ and SSR Analysis

Risks

The most significant risk to the thesis is what happens in China. Over the last decade we have seen significant capacity additions in China and surpluses – moreover, there are plenty of new units under construction and in the planning phase. While much of the new 12 million metric tons of capacity assumed in our simple model is expected to come on line in China, there could be more. If you add up all of the announced capacity in China you get well above the 12 million metric tons assumed, but on the same basis you should have a lot more capacity today looking at announcements over the last 10 years. Not all got built in that timeframe and not all will get built going forward.

China is also a risk to the upside on two counts; first, the possibility that not all of the capacity we have assumed get built on schedule and second, domestic demand accelerates more quickly because of availability. China demand has proven to be supply driven in other areas with export surpluses often short term, while local demand steps up.

Another risk would be much slower growth in Auto demand than anticipated, although this is probably not as much of a risk over the next 3 to 4 years as it is beyond that. At a recent conference, IHS was touting a study that looks at driving trends in the 17-25 age group and suggesting that the newer driving generation may adopt auto ownership more slowly because of urban lifestyles, cost, improving public transport etc.

©2013, 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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