“I am worried about new capacity in China” – “How do I improve my business”
Talk to any investor today about commodities, and improving demand in the US and perhaps a floor in European demand, and you will eventually hear the first half of the title of this short blog. Today we hear that Rio Tinto has abandoned plans to sell its Aluminum business because it cannot find a buyer, in recent weeks we have heard titanium dioxide producers talk about a meaningful turn in the market, and both Rockwood and now DuPont are talking about divestment, but Rockwood has been trying for a long while, and again you hear the same comment – what will new capacity in China do for the market?
There are a number of issues:
- How much capacity will be built in China? – the announced numbers in most industries look daunting – see our comments on coal to chemicals in research earlier in the year.
- What does slower Chinese growth mean? – historically, in commodities and basic materials, China has been a supply driven market – everything produced has been consumed.
- Answers to the first two questions lead to the key issue. How much surplus capacity will China have and for how long?
- And lastly, and just as important. How rational will Chinese producers be in the export markets?
Many commodity and material markets could do with some further consolidation, but who is going to pay up to acquire someone-else’s business if they cannot answer the questions above? Moreover, this issue is not going to resolve itself quickly as more and more forecasters are talking about longer-term slower growth. Data from China is very mixed and often hard to rationalize – today’s trade data would be a good example. Today we have also seen an analysis from the OECD talking about declines in economic growth in the BRIC countries.
China is not the low cost producer in almost every “commodity” like product, but they can still be disruptive in the global market when they seek to move production surpluses. Solar panels are a good example of how far things can go, but in this case China is a lower cost producer. Products like aluminum and steel are unlikely to see much more downside in price given that marginal producers are today already at break-even, but titanium dioxide could fall incrementally, as could basic plastics and chemicals. With slow global economic growth, the risk is that prices remain low for a multi-year period.
The answer for producers outside China is still further cost control and possible capacity rationalization – best achieved through consolidation. However, to make it work companies are going to have to get creative and be prepared to do things that do not generate immediate guaranteed shareholder value – simply because these avenues may not be available. Premium free and cashless combinations are likely the most logical way forward. DuPont can probably spin out its chemicals business, but if it could also scoop up a small competitor, or create a degree of integration in the process, that would be good. Rio Tinto may be able to exit the aluminum business if it was willing to take a share of a new company rather than cash as an initial move. It is much easier to put a relative price on businesses rather than an absolute price in circumstances like these.
We have been positive on AA this year based on valuation and on expected stronger demand growth for aluminum. The valuation story is even stronger than it was three months ago and demand data already looks promising, but the China issue is overwhelming and Rio’s announcement will not help. Things are going to have to change in the aluminum business and we still believe that AA is an interesting investment – it comes down to patience.