Alcoa – Self Help Can Take You Only So Far – Now We Need Pricing

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Graham Copley / Nick Lipinski

203.901.1629/203.989.0412

gcopley@/nlipinski@ssrllc.com

April 21st, 2014

Alcoa – Self Help Can Take You Only So Far – Now We Need Pricing

  • Over the last 12 months Alcoa has done a lot to regain investor confidence, closing uncompetitive aluminum capacity, growing its downstream business through partnerships, and focusing on cost reduction. From its low in September 2013 the stock is up almost 80%.
  • This has happened in a period when aluminum prices have, until recently, continued to decline, and clearly Alcoa’s self-help program has convinced investors that the company is not a candidate for bankruptcy and has a future.
  • A year ago, we suggested that oversupply would persist but expected above trend growth in demand. This has been the case, with demand growing quickly mostly because of increased use in Autos and strong commercial Aircraft demand – both growth drivers should continue.
  • While Alcoa remains below “normal” value of $15 per share, current earnings do not support upside and while estimates for 2014 and 2015 would provide such support, Alcoa has not surprised on the upside versus early year estimates since 2006. Lower aluminum pricing has driven negative revisions, and AA has consistently topped the shorter term estimates.
  • We like the self-help strategy, and barring a more radical consolidation move, this is the only real way forward for the company. However, further upside in the stock needs positive revisions from here and that needs a turn in real aluminum pricing.
  • China oversupply (worse if China growth slows) and high speculative inventories should remain material drags on pricing for the next two years and consensus estimates have no meaningful pricing baked in. If demand growth remains in the 6+% range for the next several years, which we think is likely, the global supply/demand balance for aluminum could look very different and prices could be at peak levels 4-5 years from now.
  • For the moment we think that the easy money in AA has been made, but the stock can probably move to our fair value (+11%), unless there are earnings misses.

Exhibit 1

Source: Capital IQ, SSR Analysis

Overview

For a company that has seen its 2014 estimate cut in half over the last twelve months, Alcoa’s stock has done quite well. Outperforming well in the last quarter of 2013 and continuing its winning streak in to 2014. Alcoa’s quarterly earnings have surprised on the upside despite the broad negative revisions which have largely been due to ever weaker aluminum pricing. Alcoa’s cost controls and downstream expansions have been the drivers of the better than expected earnings and the main momentum behind the stock.

Alcoa and others have closed aluminum capacity in the last year in an attempt to combat the lower prices and bring the market back into balance, but the oversupply in China still overhangs the market and has kept downward pressure on pricing for most of the last 12 months. The recent posted price increase on the LME is likely not indicative of a stronger market, but rather only a reworking of how pricing is reported. A further overhang is the very high level of aluminum inventory globally, which continues to rise as speculators increase their bet that prices will be higher in the future, in an environment where the cost of carrying the inventory is very low. Liquidation of this inventory could result in further downward price pressure.

If we assume that Alcoa will remain on the same negative return on capital trend that it has seen for the last 30 years, we only have normalized earnings for the company of around $0.75 per share and a fair value of $15 per share. This time last year consensus estimates had the company recovering to its trend line return on capital within 12 months and that projection was wrong – today we have essentially the same forecast recovery 12 months out, albeit with a lower net capital base. If consensus is correct, we would expect to see the stock rise past fair value in anticipation of more momentum, but if we see further negative revisions or earnings shortfalls we struggle to see much further upside.

The cost reduction program and move downstream have been popular with the market, but unless earnings improve meaningfully, we are not sure that the popularity is sustainable. Real earnings improvements would come from higher metal pricing and despite the higher levels of demand, the supply overhang looks too large for the next couple of years.

Any material price improvement is likely to trigger supply reactions – increased exports from China and liquidation of speculative inventory. Consequently we could see some significant price volatility going forward. If this volatility is around a price level 10-15% higher than it is today, AA will see better earnings. If the volatility is around the average price of the last 6 months, AA will see little gain.

Longer-term, the current malaise in the industry will deter expansion – in part because producers do not have capital. If demand continues to grow at 6+%, we could have very different industry fundamentals by 2017/18. Alcoa may have much more upside in the 2016/17 time frame.

Aluminum Pricing – Near Term LME Improvement Unlikely To Be Meaningful

As shown in Exhibit 2, pricing is indicated higher on the LME. This is not regarded as a meaningful improvement in returns for sellers and is more a function of a change in reporting. However, any real increase is expected to be met with increased supply from China, and possibly some from inventory, so we do not feel comfortable calling for any sort of sustained pricing recovery yet.

Exhibit 2

Source: Capital IQ, SSR Analysis

Inventories – Producers Cutting and Speculators Building

Inventories are a real issue for aluminum because, as shown in Exhibit 3, while producers are cutting inventories in an attempt to control every aspect of costs, in a low price environment, speculators continue to build inventory in anticipation of higher prices longer-term. Some of the LME inventory is backing securities such as ETF’s, but this is a very small portion and most is simply a buy and hold strategy against future gains. This is partly made possible because of the very low cost of borrowing today, and as aluminum prices fall, inventories increase. When aluminum prices increase there will inevitably be trigger points at which this inventory will get released and while it is unlikely that a 10% price increase will trigger anything, it is almost impossible to know the expectations and the financial conditions of the holders and what would cause them to sell. Regardless, we would expect higher prices to result in a rundown of inventory and supply pressure if it happens in the next 2 to 3 years.

Exhibit 3

Source: IAI, Bloomberg SSR Analysis

Chinese Exports – Significant and Volatile

China’s representation in the global aluminum market is well depicted in Exhibit 4. Exports have grown significantly over the last 12 years, as China has added capacity faster than it has grown domestic demand. At a recent average of around 300,000 tons per month, China’s exports account for around 7.5% of global monthly aluminum demand, or around 14% of non-China demand. China also imports aluminum but the export is significant and has been a drag on global prices. In Exhibit 5 we show a shorter time frame to illustrate the volatility (ignore the extreme volatility in February, which is a function of the Chinese New Year). China is not an exporter at any price and at extreme lows in the spot market we have seen China back away from exports. The negative of this is that China can and will likely increase exports if global pricing improves. This will, in our view put a cap on pricing for a while. China has more than 25 million tons of capacity today, according to IHS, versus demand of around 22 million tons, and capacity is expected to grow to 28-29 million tons by 2018. Without very strong near-term domestic demand growth China will continue to be a player in the global market at a minimum for the next 18 – 24 months – see next section on demand growth. Our view today is China has as much of a chance of growth surprising on the downside as on the upside.

Exhibit 4

Source: Bloomberg

Exhibit 5

Source: Bloomberg

But, The Bright Spot Is Still Demand Growth – We Could Run Out Of Aluminum!

Aluminum demand has grown at more than 6% for the last three years and consensus is coming around to the idea that it can continue to grow at this rate with China leading the way. If China continues on its current demand path, which is debatable, China demand may catch up with China capacity in a few years, getting rid of the capacity overhang. Demand growth of 7.5% per annum in China (below recent growth rates) would put 2018 demand at more than 30 million tons versus expected capacity of 28-29 million tons.

The projection in Exhibit 6 shows a summary of a number of corporate presentations around demand growth, and we do not think that the assumptions are that crazy – demand growth is very robust and has some very strong drivers, such as Autos and Aircraft.

Exhibit 6

Source: Company Presentations

Aluminum demand in the US Auto sector is expected to double from 2012 to 2025, accelerating as tighter CAFE standards come into effect and primary consumption growth will be faster than overall growth – Exhibits 7 and 8. Fuel standards in the US are not unique and auto manufacturers in other countries are moving the same way – in some cases faster than the US.

Exhibit 7

Source: Company Presentations

Exhibit 8

Source: Company Presentations

Commercial jet deliveries have been very strong for the last few years and the expectation is that the number of jets delivered will grow through 2016 – Exhibits 9 and 10.

Exhibit 9

Source: Company Presentations

Exhibit 10

Source: Company Presentations

Demand growth of 6% per annum adds around 20 million tons of demand globally by 2019. While China is still building, the very low prices that have prevailed for the last couple of years have curtailed other plans and caused plant closures rather than expansions. While we are unlikely to run short of supply in 2014, 2015 and probably 2016, because of current and expected capacity and because of inventory, things could get a lot more interesting as we go through the second half of this decade. Aluminum demand growth by end market is summarized in Exhibit 11.

Exhibit 11

©2014, 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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