Alcoa's Upstream Value Not Shaken by Economic Uncertainty

 

 

Earnings at Alcoa's alumina and primary metal segments--its upstream businesses--don't depend as much on end market consumption as the downstream businesses. Alumina is perpetually in short supply relative to aluminum capacity, and Alcoa always can sell any excess aluminum output to the London Metal Exchange warehouses, particularly with today's high premiums and easy financing. The key is whether the LME price of aluminum is high enough to make production attractive. While the LME price ultimately should be a function of demand, we find that in the short term it tracks global economic sentiment more closely than actual production and consumption patterns. Warehouse inventories have been declining this year, suggesting that demand is still strong. We expect global aluminum consumption growth to be in the double digits for 2011.

 

 

Only Alcoa's highest-cost smelters are sitting idle--about 14% of total capacity--and they are still far more cost-efficient than the marginal-cost supply that would be introduced from other players if demand and pricing improve enough to bring the market back to full capacity. The Deschambault smelter we visited in Quebec is one of Alcoa's lowest-cost smelters and is known as an operational benchmark for the company. It has never been idled and has increased its capacity to 260 thousand metric tons from 215 thousand since its 1992 startup through process improvements rather than capital-intensive investments. It also has successfully run its pots (steel containers used to produce aluminum) for close to nine years, much longer than the industry average of five to six years. The company plans to further improve the design of the plant to increase its capacity with minimal investment. Though Alcoa could lower production by as much 20% without idling Deschambault, it has never made economic sense to do so, even with the wild ride aluminum prices have taken in the past three years.

 

 

Petroleum coke and pitch together represent 13% of the cost to produce a ton of aluminum. The company has experienced some margin pressure from rising coke costs, but this doesn't compare to the squeeze from rising electricity costs, which represent more than 25% of cash costs. However, the Deschambault smelter runs on relatively inexpensive hydro power, and Alcoa has adjusted its smelting portfolio to concentrate on areas of lower energy prices (including Brazil and Iceland). Also, the company has secured 85% of its energy needs through 2025. Alumina is still the largest input cost, but Alcoa is able to source 100% of its needs internally as the world's largest alumina producer. Alcoa's primary metal segment is the only business unit that remains below its midcycle profitability average on a margin or per-tonnage basis, and it is the segment most dependent on the LME price. About 20% of its aluminum production feeds into Alcoa's downstream segments.

 

 

In alumina refining, fuel oil and natural gas each represent 14%-15% of the cost structure, with low natural gas prices partially offsetting the pinch from higher oil prices in the past two years. Caustic soda is another 10%-12%, and prices have steadily risen from their nadir in the fall of 2009. However, the largest tangible input cost for alumina production is the bauxite ore from which alumina is extracted and which Alcoa obtains from its own resources. Alumina traditionally was priced as a fixed percentage of the LME aluminum price, which we think has held down alumina prices as its supply/demand fundamentals always have been more favorable than aluminum's. The market is now slowly moving to delink alumina processing from aluminum. Alcoa sells about 60% of its alumina production and currently has about 20% of its alumina sales volume now tied to spot pricing. This percentage is expected to increase as contracts expire, and we think this trend will expand margins for Alcoa's alumina business.

 

 

The fate of the downstream businesses, flat-rolled products and engineered products and solutions, is not determined by aluminum prices. While these two segments tend to be lower-margin and have more volatility in shipping volume, both already have recovered to midcycle margins on profitable tuck-in acquisitions, better fixed-cost absorption, and productivity improvements. The company is on track this year to achieve close to half of its 2013 target of a $4.1 billion revenue increase for the downstream segments compared with 2010. While we think all end markets with the exception of aerospace should struggle in the near term, with particular weakness in Europe, consumption growth for aluminum should be higher than for steel or most of the other base metals in the next several years, with gains in new products, new applications, and new regions.

 

 

As Aluminum Goes, So Goes Alcoa's Stock Price

 

 

Aluminum prices are at a one-year low around $2,140 per metric ton, with a majority of the pullback occurring just in the past three months. In the absence of a major downturn in aluminum consumption, we think demand levels and input costs justify a reversal in this trend with the marginal cost of production below prevailing prices even at current supply levels.

 

 

Alcoa's stock price has reacted in a similar fashion, falling more than 40% since early July. However, with the exception of the price of aluminum, all other areas of Alcoa's business model and aluminum fundamentals appear strong. The company's capital spending is 40% below precrisis levels, despite heavy investment in the Saudi Arabia project, which is expected to be one of the lowest-cost, fully integrated aluminum complexes in the world. The company has sustained cost-reduction measures, with $441 million in additional cost-cutting completed thus far in 2011. The balance sheet has also recently improved, with the average debt maturity extended to more than 10 years. Looking outside Alcoa, global inventories have steadily declined to around 53 days of consumption compared with 59 a year ago, regional premiums remain strong, and we have yet to see signs of oversupply that we feared would get ahead of consumption growth. Aluminum demand depends on economic growth, and reduced forecasts for global GDP ultimately should affect consumption. However, in our view, a slower-growth scenario is more likely than the deep recession that we believe is being priced into the market. Strong backlogs and order entry in aerospace and further penetration in automotive should offset some of the weakening in commercial transportation and construction markets. As economic clarity develops, we anticipate that a rise in aluminum prices in 2012--we forecast a 10% increase from the 2011 average--will accompany continued slow volume growth and be an important catalyst for Alcoa's shares.