Aluminum Alert: China Stalls, Market Falls

This is not the same world you lived in just a few short months ago.

Over the summer, involuntary disruptions to aluminum production around the globe yielded reasonable assumptions of higher prices, as companies struggled to meet demand from China's industrial machine. But now that the financial crisis has devolved into a multitrillion-dollar fiasco, all those prior assumptions have gone out the window.

Unfortunately, recent revelations about weakening steel demand in China and elsewhere are taking their toll on aluminum's outlook. This week, Chinese aluminum giant Aluminum Corporation of China (NYSE:ACH), aka Chalco, announced further production cuts that will shutter 10% of the company's capacity and reduce China's production by about 5%. Let's take a comprehensive look at the fundamental picture.

Did he say "fundamentals?"
That word may appear meaningless in a spastic market gripped by fear and woe, but seasoned Fools know that once indiscriminate selling ceases, fundamentals will again rule the day. Now that the depth of this crisis has apparently knocked the wind out of even China's industrial revolution, the fundamentals for aluminum look pretty terrible in the near term.

Let's review the information emerging from around the world:

• Aluminum prices on the COMEX are off 33% from their July peak.
• In addition to Chalco's production cuts, China's second-largest smelter, Weiqiao Aluminum, has cut half of its production. Weiqiao's production costs were 25% above the alumina spot price in China.
• Chalco last week guided for a 50% reduction in earnings for the third quarter, while lowering spot alumina prices for the third time in five months.
• Mining conglomerate Rio Tinto (NYSE:RTP) issued a warning this week that China's demand for commodities is slowing.
• Aluminum stocks on the London Metal Exchange have risen to 1.46 million tons, equivalent to one month of pre-closure production in China.
• Russia's UC Rusal, the world's largest aluminum producer, estimates that 75% of producers in China, Europe, and the U.S. are operating at a loss in today's price environment.
• From the steel sector, we're hearing much the same story. ArcelorMittal (NYSE:MT), China's Baosteel, and Russia's Severstal have joined a growing list of companies cutting production thus far.
• Korean steelmaker POSCO (NYSE:PKX) warned of difficult times ahead, while Australian miner BHP Billiton (NYSE:BHP) downplayed concerns raised by smaller miners that China's iron ore stockpiles were quickly growing.

Fundamental value
Following the panic-driven sell-off within the aluminum sector, and among commodity equities at large, I believe that on a fundamental basis, the market's already priced a global slowdown into these stocks. Let's have a look at the scale of the damage to aluminum stocks thus far:

Data compiled from Motley Fool CAPS and Yahoo! Finance as of Oct. 21, 2008.

Thanks to a steady supply of disappointing news, recent panic selling, and presumed hedge fund liquidations, these stocks are trading as though the much-heralded BRIC countries were a mere fairy tale.

Throughout this protracted sell-off, the market's approach to valuing Chalco has continued to baffle frugal Fools. As with many Chinese ADRs, earnings data releases are delayed. In this case, the latest data we have was released in September and covers the six months ending June 30.

Diving into the balance sheet, we find that current assets -- including inventories, accounts receivable, and cash -- were RMB 36.95 billion ($5.4 billion), corresponding to $9.98 per ADR. Unless the company has hired Ben Bernanke and Hank Paulson to manage the balance sheet since midsummer, those assets look like a Foolish bargain at yesterday's close of $11.82 per ADR. Nearly 30% of the present share price was cash on hand. Chalco's price-to-book ratio of 0.68, as calculated from the same data set, provides further suggestion of deep value in these shares.

Fundamentally flabbergasted
The evidence points to a hard landing for the aluminum industry in the near term. But over the medium term, UC Rusal's management sees aluminum supply lagging demand, even in a worst-case scenario. I believe that China and the remaining BRICs will be crucial catalysts for any resumption of growth we may see in the wake of this calamity. On the other hand, as enticing as the values in this sector may be, they mean little until fundamentals come back into play. Fools need to watch these industries carefully for renewed signs of industrial life in China and its BRIC brethren.

Further Foolishness:

• Balance sheets are your best friend.
• Did you catch a falling knife?
• It seems like yesterday we were talking shortages.