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Optimism Around Alcoa May Be Excessive

By Vladimir Zernov – Mar 7, 2014 at 12:21PM

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Alcoa's shares have recently been on the rise, but the headwinds remain for its biggest segment by revenue.

So far this year, Alcoa (AA) outperformed general market, rising 14% year-to-date. Its shares demonstrated strength despite the soft fourth-quarter report, which came in below analysts' expectations and brought $1.7 billion of non-cash goodwill impairment tied to legacy smelting acquisitions. The rise in share price reflected investors' optimism about the company's future. However, it does not look like this year will bring dramatic improvements for one of the world's leaders in aluminum production.

Aluminum prices remain soft
The prices that aluminum producers get for their output are formed by adding a premium to the benchmark London Metal Exchange (LME) price. According to Metal Bulletin, this premium has recently risen to $285-$310 per ton. For example, Alcoa's average realized price was $2243 per ton in 2013, while LME prices were substantially lower.

The problem is that Alcoa's cash cost for producing a ton of aluminum was $2201 per ton. Cash costs are not the only expense that a company has to take in order to produce aluminum. As a result, Alcoa's after-tax operating loss for its aluminum segment was $20 million last year.

The Aluminum segment had the biggest share of the revenue mix in 2013, so its profitability remained crucial for company's results. Alcoa's shares reacted positively on the news that the LME has recently decided to alter warehousing rules to speed up withdrawals.  Investors likely hope that these rules will drive premiums higher. However, according to one of the world's leading aluminum producers, Rusal, these rules, which take effect in April 1, are likely to move aluminum volumes to unofficial storage sites rather than decrease waiting times. If this happens, premiums are likely to remain at current levels.

Alcoa is projecting a 7% growth in global consumption of primary aluminum this year. At the same time, supply is rising too. For example, Rio Tinto (RIO 1.17%) grew its aluminum production by 7% in 2013. Though, there are certain hopes that the supply growth will finally be curtailed. Rio Tinto expects no growth in its aluminum production in 2014, while Rusal is reducing its primary aluminum capacity by closing six smelters.

Big support from the automotive market is unlikely in the near term
While Alcoa's primary aluminum business continues to struggle, its Engineered Products and Solutions segment brought the lion's share of its after-tax operating income in 2013. This segment consists of downstream operations that make products for aerospace, automotive and construction industries.

Alcoa stated that it expected demand for aluminum to produce cars would double by 2025. So far, this optimism looks premature, as aluminum-heavy vehicles just began to hit the roads. Kaiser Aluminum (KALU -1.66%) stated that it expected North American car builds to increase approximately 4% in 2014. Kaiser Aluminum benefits from its focus on value-add products, as it has no primary aluminum operations.

For one more note on the market, the latest housing starts report came below expectations, although it is clear that the report was affected by the harsh weather. Still though, the building permits levels missed expectations as well. It is too early to say whether this slowdown is the beginning of a trend, but this is worrying news for suppliers of the housing industry like Alcoa.

Bottom line
Alcoa's shares have been rising on optimism about the future of aluminum in the auto industry and the new LME rules. However, as the company trades at more than 20 times its future earnings, the market could have become excessively optimistic. Alcoa continues to face significant headwinds on its biggest segment by revenue, and those headwinds are unlikely to disappear in the near term.

Chinese demand is also a big automotive trend to keep an eye on

Vladimir Zernov has no position in any stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. 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.

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