With the possible exception of dry bulk shipping, aluminum has truly stuck-out over the past couple of years as a noteworthy laggard among global industrial bellwether sectors.
As we watch fading recovery hopes slip into double-dip doldrums, this seems an appropriate moment to check the aluminum industry for signs of a pulse.
The patient's brief medical history
The world's aluminum industry has proven itself particularly allergic to economic malaise. A very ill-timed acquisition of Alcan by diversified miner Rio Tinto (NYSE: RTP) in 2007 nearly buried the miner in debt, and continues to account for much of rival BHP Billiton's (NYSE: BHP) easy outperformance. U.S. aluminum giant Alcoa (NYSE: AA) barely registered a pulse during the worst periods of 2009, but has certainly stabilized considerably in the interim. Even in China, where the heart of global industrial activity barely skipped a beat, Aluminum suffered a hard landing that pummeled shares of Aluminum Corporation of China (NYSE: ACH) (aka "Chalco").
The patient's status
As corroborated by the strong outperformance of Asian steelmaker POSCO (NYSE: PKX) over familiar U.S. counterparts, China's industrial machine has suffered nowhere near the same degree of general impairment as that of the United States as a result of this ongoing economic illness. That same relative strength is clearly visible in aluminum, where Chalco has handily outperformed each of its U.S. counterparts over the past two years.
Chalco reported with its earnings this week that China's capacity utilization at aluminum smelters through the first half of 2010 ran at 88.2%, which compares to a global average utilization rate of just 80.9%. Chalco observed a 114% increase in revenue for the first half of 2010, but costs remained a significant drag despite a concerted move upstream that yielded a 19.7% increase in produced volumes of self-mined ore. Gross margin for Chalco stood at only 6.3% for the first half.
Remarkably, all three of the U.S.-based Aluminum producers that I've been watching outperformed Chalco on the basis of gross margin during the first half of 2010. Alcoa led the field with a truly impressive gross margin of 18.4%; which represents a marked improvement over the 3.4% reported for the prior-year period. Alcoa's EBITDA margin of 14%, furthermore, was the highest mark the company has seen since the third quarter of 2008. As my colleague David Lee Smith reported last month, Alcoa managed these profitability gains even on the heels of a 1% drop in realized aluminum prices.
Even without the massive economies of scale that Alcoa and Chalco enjoy, U.S. producers Kaiser Aluminum (Nasdaq: KALU) and Century Aluminum (Nasdaq: CENX) both revealed gross margins of greater than 9% for the first half of 2010. Fools wondering how to make sense of this disparate cost structure between the U.S. and Asian aluminum producers are encouraged to consider one of the more important input costs for aluminum producers: energy. Electricity accounts for roughly 35% of aluminum smelting costs.
As China has dramatically increased its reliance upon imported coals for electricity generation, Chalco is certainly feeling the pinch from energy costs. In fact, Chalco explicitly stated its intention this week to seek strategic investments in coal and power companies in order to keep a better handle on smelting costs. In the U.S., meanwhile, persistently elevated coal stockpiles at utilities and cheap natural gas have combined to keep domestic electricity costs better contained.
The patient's prognosis
In the hospital, only doctors deliver their prognoses. Here in the investment ward, however, we keep our stethoscopes pressed to the chests of our patients to hear their own views of their predicament. In the case of major aluminum producers, the patients do not offer much of a consensus. Let's consider the following recent outlook-related commentary from the four following aluminum producers:
- Chalco: "In the second half of 2010, the European debt crisis, the policy shift in the PRC real estate industry and the US dollars rally had raised concerns on the global economic recovery, which led to a lackluster demand. Added to the surplus aluminum production capacity, aluminum price will remain volatile."
- Century Aluminum: "Despite some signs of moderation recently, economic growth in China and other developing regions has continued largely apace, and the physical availability of metal remains constrained in most regions. At the same time, we are closely watching the global financial and capital markets and assessing the risk that recent dislocations could dampen the economic recovery. Within this complex framework, we are managing the company, both existing operations and our growth projects, with reasonable caution."
- Alcoa: "Prospects for Alcoa and aluminum continue to be excellent. Aluminum is traditionally a backbone of growing economies and is penetrating new applications every day. Alcoa has enviable positions in bauxite, alumina and aluminum and our investments will move us further down the cost curve. Meanwhile, our mid- and downstream businesses continue to improve margins."
- Kaiser Aluminum: "We foresee strong long-term growth in demand for our aerospace and automotive applications, and we have yet to fully realize the benefits of significant capital investments throughout our manufacturing platform."
Whether a Fool is more likely to heed the cautionary tone conveyed by the first two comments above, or those notably more upbeat predictions from Alcoa and Kaiser, one's expectations for sustainable recovery within the aluminum industry must be inextricably linked to one's outlook for broader economic recovery overall. I can praise the relative cost efficiency of domestic aluminum producers over China's leading rival until the cows come home, but bottom lines can simply not be insulated from any wholesale resumption of demand disruption.
On the other hand, with Alcoa shares presently languishing near $10 -- even as margins improve and profits return -- one could easily argue that Alcoa represents one of the lower-risk options available for Fools to gain exposure to a time-tested industrial behemoth within an industry that is not waning in strategic significance.
These are not easy calls to make at this particular juncture, and I invite fellow Fools to please chime in with their own outlooks for this important bellwether sector. My own tendency is to await the possibility of still-superior entry points as global demand dislocations rear their head once more. I am placing Alcoa on my watchlist at Motley Fool CAPS, and I invite you to do the same.
