Back in April when Alcoa (NYSE:AA) posted a quarterly loss due to a huge one-time charge following closures of high-cost plants and weak aluminum prices, the stock, in fact, moved higher. Investors' confidence in the American aluminum giant was not shaken as after excluding the one-time charge, the company's earnings beat Street estimates, driven by strong performance at its finished goods division, which caters to the aircraft and automobile industries. Moreover, the fact that Alcoa has shuttered high-cost aluminum smelters in Brazil, the U.S., and Australia to offset falling aluminum prices and has increased focus on low-cost smelting facilities, as in in Saudi Arabia, has provided further support for the stock.
Not surprisingly, I have been bullish on the company's prospects. And following the release of yet another strong quarterly earnings report recently, the bull case has grown even stronger. Also, the increased optimism is not just because of better-than-expected results. It is also because of the rising possibility of higher raw-aluminum prices in the second half of the year.
Indeed, over the course of the year, the demand-supply fundamentals have changed dramatically. As global aluminum smelters curtailed or cut their output to make the market fundamentally balanced, supplies and inventory levels have been squeezed. Moreover, Indonesia's decision to place a ban mineral ores exports has also contributed to the shortfall.
Consequently, aluminum prices, which were close to $1,750 per ton at the beginning of the year, have been hovering near $1,900 per ton lately, having touched as high as $1,930 per ton last week on the London Metal Exchange (LME).
Strong second-quarter results
Last week, Alcoa posted better-than-expected fiscal second-quarter results. The bottom-line was boosted by solid performance from the company's aircraft and auto parts making unit and strengthening traditional aluminum smelting business.
With production cuts expected to be maintained amid accelerating pace for the global economy, the aluminum market is likely to go through a wider-than-expected demand-supply deficit. The changing scenario would help Alcoa strengthen its margin given that its smelting business is the major revenue generator.
Building further confidence on the aluminum giant is its growing revenue from value-added finished product business, which was further strengthened following a recent acquisition of UK based aerospace parts maker, Firth Rixson Ltd for $2.85 billion.
Years of supply glut, massive stockpiles of the metal at the LME warehouses (more than 5 million tons), along with huge inventory levels (estimated between 10 million tons and 15 million tons) lying with secondary sources globally in the backdrop of fragile demand have forced smelters to cut output since the middle of 2013. All major aluminum smelters, including Alcoa, Rio Tinto (NYSE:RIO), and the world's No. 1 aluminum smelter, Rusal, have been curtailing production since mid-2013.
Rusal estimated that aluminum producers (ex-China) slashed production capacity by approximately 1.2 million tons last year. Alcoa itself cut aluminum production in Brazil and announced closure of smelting facilities both in Australia and New York State.
These curtailments and production cuts helped smelters to create a deficit of 726,000 tons in 2013.
The production cuts by major aluminum smelters continued this year. Hence, it was widely expected that the aluminum market will continue to witness a deficit in 2014. The banks, however, differed over how wide the deficit could be. The most courageous forecast came from Barclays, which anticipated a deficit of 1.07 million tons. However, this forecast has turned out to be nearly accurate. Indeed, Alcoa during a conference call said that it expects a supply demand deficit of 930,000 tons up from April's forecast for 730,000 tons.
One of the key reasons why deficit will be widening this year is Indonesia's ban on mineral-ore exports. Between 2007 and 2013, Indonesia accounted for about 60% of the total bauxite supplies. As I pointed out earlier, citing CRU findings published on the Financial Times, China bought nearly two-thirds of Indonesia's bauxite exports all these years
But due to the export ban, China hasn't acquired any bauxite from Indonesia this year, which has helped widen the deficit.
Strengthening finished goods business
In order to ward off weakness in the raw aluminum market, Alcoa has been focusing lately on strengthening its high-margin downstream business. In the latest quarter, profit from this division, which makes products used by the auto and aircraft industry, increased 5.7% to $204 million. The company expects profits from this unit to rise by about 10% in the third quarter, year on year.
Demand from the aircraft industry has been very robust in the recent past, and the trend is likely to continue. That's why Alcoa's recent acquisition of jet-engine part maker, Firth Rixson has been touted as an excellent move by industry experts. Sales from Alcoa's downstream business, which currently accounts for about 17% of the total revenue, is expected to climb to 20% of the total as a result of this acquisition. Besides, the demand from the auto industry, which is substituting aluminum for steel to meet fuel standards, is also expected to remain strong.
Varun Chandan Arora has no position in any stocks mentioned. The Motley Fool recommends General Motors. 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.