For years, aluminum giant Alcoa (NYSE: AA ) failed to benefit from the broader economy's recovery, performing so poorly that the Dow Jones Industrials (DJINDICES: ^DJI ) expelled the company from its ranks in 2013. Since then, though, Alcoa shares have rocketed higher on signs of budding strength and hopes for better times ahead. Nevertheless, the company faces a number of challenges, and there are several reasons to believe Alcoa stock could give back some of its hard-fought gains from over the past year. Let's look at three of them.
1. Gains in natural gas prices could put pressure on margins
One challenge of aluminum production is that it's extremely energy-intensive. Although recycling aluminum scrap saves energy, many key customers require primary aluminum production to address quality and consistency concerns. In particular, converting bauxite to alumina requires substantial use of natural gas, while further conversion involves smelting, which employs significant amounts of electricity.
Low natural gas prices in recent years have helped Alcoa keep its productions costs low and minimized the impact of low aluminum prices on its profit margin. Yet natural gas has already rebounded sharply from its lowest level two years ago, and further natural gas price increases could jeopardize Alcoa's future growth. In particular, the potential export of U.S. natural gas in the form of liquefied natural gas could lead to less dramatic price disparities around the world, taking away some of Alcoa's competitive advantage against its international rivals. Alcoa itself has lobbied against LNG exports, arguing that the resulting rise in U.S. natural gas prices would hurt its business and the businesses of other high-energy manufacturing companies. Yet as demand for gas rises, Alcoa will almost certain have to deal with higher costs in the future.
2. Reliance on aerospace and automotive industries leaves Alcoa vulnerable
Alcoa's transformation toward emphasizing its value-add products came at a perfect time for the company, as its primary customers have enjoyed strong fundamental conditions in their own industries. The resurgence in airlines' profitability has pushed demand for new aircraft to unprecedented levels, and airplane manufacturers enjoy huge order backlogs that have prompted them to seek ways to boost production levels. With Boeing (NYSE: BA ) expecting $5.2 trillion in industrywide aircraft sales over the next 20 years, Alcoa's strategic move to offer aluminum-based products and other lightweight materials such as titanium appears extremely well-timed. Similarly, automakers' sales have returned to levels not seen since before the financial crisis, and that has put companies in position to innovate; for example, Ford (NYSE: F ) is preparing to begin sales of its aluminum-intensive 2015 F-150 pickup truck.
Right now, the auto and aerospace industries appear to have sustainable growth prospects. Yet both industries are notoriously cyclical, going through booms and busts as consumers and industrial customers navigate changing economic conditions. Alcoa currently has most macroeconomic trends supporting its growth, but any change in those trends could lead investors to think twice about their expectations for the company.
3. Favorable competitive trends will reverse as aluminum industry recovers
Alcoa took a risk in putting itself in its current position, and so far, that effort has paid off. Major competitors like BHP Billiton (NYSE: BHP ) and Rio Tinto (NYSE: RIO ) have taken steps to reduce their exposure to aluminum, and their willingness to sell off assets at less than premium prices in part contributed to Alcoa's big share-price decline going into last year. Yet investors are counting on Alcoa's aluminum focus to boost its growth as the industry strengthens.
Still, Alcoa can't count on reaping all the success in aluminum for itself. If its turnaround continues to build momentum, BHP, Rio Tinto, and other players could well reverse course and challenge for a portion of what will then be a growing market. Alcoa would still claim its share of gains, and its competitive position would be stronger because of its more consistent long-term strategy. But in the long run, Alcoa's growth rate could be much slower than investors hope, and when shareholders realize that, the stock could give up some of its gains.
Alcoa deserves a lot of credit for its transformation, and even after its impressive share-price gains, the stock trades well below its levels from a decade ago. Yet Alcoa still faces the tough job of continuing its restructuring efforts while also fending off what's likely to become even more intense competition as industry conditions improve. Those pressures could easily force Alcoa shareholders to go through painful corrections in the stock even if the company is eventually successful in executing its long-term business strategy.
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