Another Buying Opportunity in Alcoa

gcopley
Print Friendly
Share on LinkedIn0Tweet about this on Twitter0Share on Facebook0

SEE LAST PAGE OF THIS REPORT FOR IMPORTANT DISCLOSURES

Graham Copley / Nick Lipinski

203.901.1629/203.989.0412

gcopley@/nlipinski@ssrllc.com

January 20th, 2015

Another Buying Opportunity in Alcoa

  • Concerns about global growth are leading to negative GDP revisions and a widespread market selloff with particular sensitivity seen in commodity related stocks, AA included. The commodity space is also not helped by a coincident, but understandable strengthening of the dollar which is a further negative for companies with significant non-US exposure.
  • Notwithstanding these major headwinds, we view the dip in AA as another buying opportunity (albeit one with near-term risk). The portfolio mix shift has been well thought through and greatly improved the earnings power of the company. Moreover, the underlying growth rate for aluminum remains very robust, despite weaker global GDP, and demand is quickly catching up with supply.
  • Short term, aluminum pricing has reversed most of the gains from early 2014 – LME prices currently stand roughly equal to where they ended 2013. However, while LME inventories remain elevated they are off their highs, suggesting that speculators are either taking some profit or cutting some loses.
  • Another short term concern: December saw a surge of Chinese exports, possibly suggesting slowing growth in the country, but possibly just a shipment timing issue. The export surge may also be a signal of strong growth outside China and may be a positive indicator, though this is unlikely.
  • We remain focused on strong growth in the auto and aircraft spaces and should lower oil result in an upside surprise in growth in 2H 2015, the world will run out of aluminum before it runs out of any other base metal. Alcoa remains below “normal” value in our model, and earnings should continue to come in above estimates (as seen recently.) We still believe that the stock could double from these levels.

Exhibit 1

Source: Capital IQ, SSR Analysis

Overview

As the world of commodities collapses, Alcoa has taken a bit of a breather and come off its highs. We see this as opportunity to jump on a train that has temporarily slowed but still has much further to go. The story remains intact and the company has outperformed our expectations so far in terms of portfolio improvements and earnings growth. Aluminum pricing has taken a negative turn over the last few months, both because of expected economic weakness and because of the strength of the dollar. However, underlying demand growth remains high in the auto and aircraft sectors and will recover quickly in commercial construction if lower energy prices result in better more general growth a couple of quarters from now.

Near-term there are some interesting inventory/trade moves that could be cause for short term concern. First, LME inventory data suggests a meaningful sell down for the first time in 5 years. This is most likely a reaction to the higher prices of early to mid-2014, but it may also be a sign of better demand and a need for those inventories. The trade data may be more negative. Chinese exports appear to have spiked in December by more than 35% versus November and 80% versus the prior year. This may be partly a shipment timing issue, but it is more likely a slower domestic demand issue, resulting in greater surpluses. It coincided with a very weak period for pricing and, if exports continue at this rate, we will likely see more declines in international pricing before we see a recovery – on this basis AA could get cheaper before it recovers.

Valuation remains very interesting as the company remains cheap, despite its very strong earnings momentum and positive revisions. The chart in Exhibit 2 shows a pattern of positive earnings surprises and a skeptical sell side (or a sell side which in aggregate is struggling to understand the drivers of AAs earnings). We also have a buy side that is more skeptical. In August, AA was trading at more than 25x 2015 earnings, while today the 2015 multiple is 12.9x.

Exhibit 2

Source: Capital IQ and SSR Analysis

The valuation chart in Exhibit 3 shows that the stock has become more interesting again – in our view suggesting an entry point, with the caveat that increased exports from China do add some near-term risk. Despite the higher earnings estimates and upside surprises, investors have become more skeptical over the last few months – Exhibit 4. We see this weakness and any near-term downside as a buying opportunity. Our “normal” value for the stock is around $18.3 per share today, but returns on capital are better than normal with base metal pricing much worse than normal so we believe that the upside well exceeds our “normal” value. We still think that the stock could double from here in 24 months.

Exhibit 3

Source: Capital IQ and SSR Analysis

Exhibit 4

Source: Capital IQ and SSR Analysis

Aluminum Pricing

As shown in Exhibit 5, pricing has given back most of its 2014 gains on the LME. This is not really a global demand issue, though it may be influenced by a China demand issue and drive to reduce Chinese inventories in Q4. Currency has played a part in the price decline as has a reduction in speculative inventories. Note that despite this decline, AA has managed to beat estimates for Q4 2014 and expectations for 2015 have risen.

Exhibit 5

Source: Capital IQ, SSR Analysis

Inventories – Producers Building and Speculators Cutting

In our early 2014 report on AA, we noted that producers were trimming inventories as speculators expanded theirs. We are seeing the reverse dynamic in recent months – Exhibit 6. There has been an upward trend in producer inventories in the recent months which may be a function of stronger demand and a desire to keep days of sales relatively flat. However, speculative inventories have tumbled by more than 20% in the last year (roughly 1 million tons – or 2% of global demand). This will have added some price pressure.

Exhibit 6

Source: IAI, Bloomberg, SSR Analysis

Chinese Exports – Significant, Volatile and Apparently Increasing

China’s position and influence over the global aluminum market is well depicted in Exhibit 7. Exports, mainly of aluminum products, have grown significantly over the last 12 years, as China has added capacity faster than it has grown domestic consumption and as Western manufacturers have outsourced aluminum parts/electrical goods etc. manufacture to China. 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 for several years. In Exhibit 8 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, perhaps what we are seeing in currently. This will, in our view put a cap on pricing for a while. China capacity is still 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.

The export spike in December is troubling, but we need to see more data before we draw too bleak a conclusion. It could be an over-estimate; or a desire to drop year end inventories; or a sign of much slower domestic demand; or a sign of much stronger global demand. Global consumption of Aluminum and Aluminum parts outside China is a little under 2.5 million tons per month and through 2012 and 2013, we have seen China satisfying around 12% of that demand. On an annualized basis that jumped to 20% in December if the trade stats are correct.

Exhibit 7

Source: Bloomberg, SSR Analysis

Exhibit 8

Source: Bloomberg

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

In this section we repeat what we wrote about demand previously with some updated charts – we still think that demand growth is key and will ultimately drive much better prices and margins for aluminum. AA in its recent conference call talked about expected Aluminum demand growth of 7% in 2015.

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, Chinese demand may catch up with Chinese 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 9 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 9

Source: Company Presentations

Aluminum demand in the US auto sector is expected to triple over the next decade, accelerating as tighter CAFE standards come into effect and primary consumption growth will be faster than overall growth – Exhibits 10 and 11. 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 10

Source: Company Presentations

Exhibit 11

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 2019 – Exhibits 12 and 13.

Exhibit 12

Source: Company Presentations

Exhibit 13

Source: Company Presentations

Demand growth of 6% per annum adds around 20 million tons to global demand by 2019. While China is still building, the 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 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 2016 and into 2017; and it is possible that both commodity and stock prices will begin to discount this if we get a rebound in glob al economic growth in 2H 2015. Global Aluminum demand by end market is summarized in Exhibit 14.

Exhibit 14

©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.

Print Friendly