While aluminum giant Alcoa (NYSE:AA) has been grappling with weak prices, the company has benefited from strong performance in its value-added businesses. Indeed, the downstream business has seen strong demand from industries such as aerospace and auto. This is one of the major reasons why the outlook for Alcoa has improved even though its upstream business continues to face challenges.
There are some concerns when it comes to the value-added businesses as well, however. Although the demand and outlook for aluminum products from the U.S. auto market is very strong, manufacturers in overseas market, especially in the fast-growing region of Asia, are reluctant to use lighter metal due to higher costs.
Struggling aluminum industry but solid demand for downstream products
The aluminum industry is facing significant challenges due to a huge imbalance between demand and supply. This has prompted producers such as Alcoa to even cut their production. However, the production cuts have been more than offset by rising production in the Middle East and China, which is why aluminum prices have failed to reach $2,000 per ton.
While Alcoa's upstream business remains under pressure, its downstream business has been one bright area for the company.
Thanks to increasing use of aluminum by the U.S. automakers such as Ford Motor (NYSE:F) and General Motors (NYSE:GM), Alcoa is seeing higher demand for its fasteners, drive shafts, sheets, and forged wheels, which are used in vehicles.
Ford's latest F-150 pickup, which is the first high volume vehicle and made from an all-aluminum body, has been a success. The automaker has sold more half a million F-150 trucks since it introduced this model in 2011.
Ford's bigger rival (and America's leading automaker) General Motors is also making concerted efforts to introduce large pickups made of an all-aluminum body by the end of 2018 amid growing pressure to meet fuel efficiency standards from federal authorities. Earlier this year, GM entered in a supply contract with both Alcoa and another major aluminum producer, Novelis, a subsidiary of India's Hindalco, for the aluminum sheets required for its pickups.
Not surprisingly, the U.S. market for aluminum sheet used in pickups is on pace to increase by a factor of five from 2012 levels by the end of this year. Reuters, citing one independent industry analyst, reported that the total demand for aluminum sheet from the U.S. auto industry is expected to touch 1 billion pounds in 2014, up from under 200 million pounds in 2012. By 2025, it is likely to hit between 3.2 billion and 6.4 billion pounds.
Alcoa expects aluminum use in auto parts to double in 2025 from the current level even as it anticipates value-added sheet products delivered to auto OEMs to increase fourfold by the end of next year and tenfold by 2025.
Anticipating higher demand for aluminum products from the U.S. auto industry, companies have been building aluminum plants both in the U.S. and abroad. While Alcoa is spending $575 million to expand aluminum plants (for auto) in Iowa and Tennessee, Novelis is investing $550 million to upgrade its plants both in China and Germany.
Will Asia spoil the party?
While the auto industry is expected to be a key growth driver for Alcoa, there are some worrying signs. The Asian auto market, which is expected to be the key growth driver for auto production till 2020, is expected to stick with steel due to the lower margins and higher costs associated with aluminum.
Although using aluminum results in 10% reduction in weight, thus improving fuel efficiency by 7%, using the lighter metal also makes manufacturing three times more expensive.
According to a report from Bernstein Research, automakers in Asia are expected to continue using steel as their main material as switching to the lighter metal is a costlier process.
The report says that Chinese auto production is expected to grow by 65% between 2012 and 2020 to 230 million vehicles, while the South Asian market is likely to grow by 48% in the same period. However, weaker margins will keep manufacturers reluctant to use aluminum. The report also notes that emissions standards in this region are not as strict as in the U.S. or the EU; even if they move toward higher-quality materials, the shift will more likely be toward higher-quality steel rather than aluminum.
While the downstream business has improved the outlook for Alcoa, Asia could cause some concerns for the company.
Varun Chandan Arora has no position in any stocks mentioned. The Motley Fool recommends Ford and General Motors. The Motley Fool owns shares of Ford. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.