Wanna hear something kinda strange? The price of aluminum has jumped about 50% over the past two years, while the stock of the world's largest aluminum company, Alcoa (NYSE:AA), has dropped more than 20%. And it's not just Alcoa, either. While Canada's Alcan (NYSE:AL) and Aluminum Corporation of China (NYSE:ACH) have both done better than that, they're still in the hole relative to where they were two years ago.
Look at the fundamental picture for aluminum, and you'll see a lot to like. China continues to build like there's no tomorrow, the revival of commercial aerospace means Boeing (NYSE:BA) and Airbus need more aluminum, and a variety of manufacturers continue to look to replace steel with aluminum in their products.
Demand growth looks like it will outstrip production growth in 2006, meaning that relatively low aluminum inventories are going to get pared down even further. Making matters more interesting, aluminum is an exceptionally power-intensive metal to produce, and high operating costs are leading Alcoa, Alcan, and Norsk Hydro (NYSE:NHY) to shutter some smelters.
In an odd way, though, this could ultimately be good in the short run for the biggest players in the industry. The high cost of power, alumina (the substance smelted into aluminum), and other chemicals like caustic soda is going to make life very difficult for smaller smelters. Companies like BHP Billiton (NYSE:BHP) have already reported that China may have upwards of 2 million tons of capacity idled because the small producers can't operate profitably in this environment.
Accordingly, I think there's a case to be made that prices for aluminum could go up further in 2006. Couple that with the fact that Alcoa and Alcan are closing less profitable operations, and this next year could be a good one for profits.
There are some flies in the ointment, though -- namely the fact that the stocks are already up a fair bit from recent lows. What's more, idle capacity can come back online if prices get high enough -- possibly nipping profit growth in the bud.
All that said, I find myself wanting to like this sector -- if for no other reason than talk of rising aluminum prices might buoy the stocks. Still, when I put the numbers through my valuation models, I come away thinking that Alcan looks too expensive, Alcoa is close to fair value, and only Aluminum Corp. of China -- the riskiest of the lot -- looks potentially cheap. At a bare minimum, that at least suggests that caution is in order before plunking down hard-earned money on these stocks.
For more smelting-related Foolishness:
Fools, now is the time to open your hearts and wallets to worthy causes! Please support our five Foolish charities at www.foolanthropy.com.
Fool contributor Stephen Simpson has no financial interest in any stocks mentioned (that means he's neither long nor short the shares).
