Chalco Appears Better Positioned for Recovery as Alcoa's Outlook Is Uncertain

A tough quarter for Alcoa

Results from Alcoa’s (AA) most recent quarter indicated that the company is faring no better than competitors and many other basic materials companies in the tough economic environment. During the most recent conference call, President and CEO, Klaus Kleinfeld expressed his surprise at the rapidly deteriorating economic conditions and, despite assurances that the company is well positioned for long-term growth, it could be understood that the more immediate future is uncertain for both the industry and the company.

Revenues in the third quarter declined to $7.2 billion from $7.6 billion in the second quarter but increased from $6.5 billion in the third quarter 2007. Net income fell approximately 50% to $268 million in Q3 from $546 million in Q2 and $555 in Q3 2007. Apart from the company’s Engineered and Product Solutions group, the other company divisions (alumina, primary metals, and flat-rolled products) experienced declines in revenues and net income.

Balance Sheet and Liquidity

The company’s balance sheet is good, with a debt-to-capital ratio of 0.36. Management mentioned that the company had previously been criticized for such a conservative level. However, management highlighted the current situation as evidence that the low level was a prudent choice. In January 2007 Alcoa issued notes that doubled the average life of debt outstanding while maintaining the weighted average price of 6.2%. Further, in July 2008 it issued additional notes, a transaction that extended the average debt life nearly one year (from 8.6 to 9.2 years) at a rate of 5.6%. Importantly, the short-term outlook for debt maturity is positive with less than $100 million coming due in 2009 and about $600 million in 2010. Despite the recent credit and liquidity concerns in the market, Alcoa has not had problems accessing the commercial paper market, and it has successfully issued CP for October, November, December, and January.

The drivers of growth are stalling

The overall macroeconomic picture for Alcoa has become bleak, with a particularly rapid deterioration in the third quarter 2008. Aluminum price on the London Metal Exchange (LME) declined almost $1,000/metric ton (mt) from a high of $3,271/mt. As of October 25, 2008, the price had declined further to $1,872/mt. The drop in price has been attributed to a significant weakening in the company’s end markets, a flight to liquidity during the financial crisis, subsequent inventory builds, and a strengthening US dollar. Further negatively affecting results was the continued high input prices. Of significant importance are caustic soda (up 88% yoy), calcined coke (up 110%), fuel oil (up 77%), and natural gas (up 47%). Energy accounts for about 40% of the cost of aluminum smelting. However, these costs are likely to moderate in the upcoming quarters.

As of the end of the most recent quarter, Alcoa’s revenues came from the following end markets: Packaging (25% of total revenues), Aerospace (23%), Automotive (12%), Building and construction (11%), Distribution (11%), Commercial transportation (8%), General industrials (7%), and Industrial gas turbines (4%). Alcoa has significant exposure to North America, with 55% of 2007 revenues arising from this geographic area. In addition, China, the biggest importer of aluminum has also experienced a slowdown in recent quarters, clocking in a GDP growth rate of 9% in Q3 2008. This is projected to decline further in 2009 and 2010.

North American auto production hit a 15-year low and dropped 14% yoy, while Class-A truck production was down 13% yoy. Given the decline in Big Three production of 23% yoy and the continued difficulties in which they find themselves, this industy will continue to have negative impacts on Alcoa’s results. In Europe, the company expects automotive production growth to be flat.

On the commercial transportation side, there was little demand for trailers as current inventory is sufficient to deal with demand due to economic slowdown. Additionally, Class-A truck production is down about 50% from the peak in 2006. Tighter emission standards should have resulted in additional demand. However, those investments have been pushed out. Commercial building and construction are now also seeing the effect of the credit crunch; architectural buildings – a leading indicator – hit new lows in 2008. The global aerospace market is showing some signs of resilience with new production up approximately 8%. Nevertheless, air travel miles have stagnated, and the number of planes idle is reaching levels seen after September 11, 2001. As a result, the demand for new planes and spare parts is falling.

Coupled with the decline in demand, speculators’ need for liquidity through sale of metals has resulted in a rapid rise in global inventories and exacerbated the price decline. At Q3 end, inventory levels were around all-time highs at almost 1,400,000 mt (seen previously in early 2004). September alone saw an increase in inventories of 200,000 mt and a monthly price decline of 10%, the largest monthly decline in 16 years.

Source: LME

As can be seen, the precipitous drop in aluminum prices has not previously been experienced, and the current level ($0.8509/lb as of October 25, 2008) is equivalent to levels seen in 2005.

Short-term outlook is bleak but long-term outlook remains solid

Alcoa management is cautious in the short term. It has curtailed capital expenditures (and halted production at certain facilities, most notably aluminum production at the Rockdale Smelter in Texas) except for several projects that are expected to be completed shortly, including Brazilian projects (Juruti Bauxite Mine Development and Sao Luis Alumina Refinery Expansion, which are expected to provide $80 million in incremental EBITDA in 2010) and an Icelandic project (Fjardaal, which is expected to provide $170 million in incremental EBITDA in 2010). The company has decided to suspend share buybacks and instead focus on strengthening its liquidity position.

Alcoa management projected that at an LME aluminum price of $2,200/mt, the cost of approximately one-third of global aluminum production exceeded the market price. United Co. Rusal has said that about 75% of producers are unprofitable at a price below $2,500/mt. Regardless of the exact number, it is clear that with a continued decline (or continued low levels) in aluminum price, companies with a higher cost structure and less financial strength will eventually fail. The result will be fewer players in the industry. As the biggest player in the U.S. and with its financial strength ($831 million cash on hand as of Q3 2008), Alcoa will be able to cope with the poor short-term outlook and position itself well for the longer term.

The long term trends for the aluminum industry are still intact. Aluminum is affected by cyclicality but as the global economy eventually recovers, the demand for metals will continue its upward trend. According to Alcoa management, a 6% CAGR in world aluminum consumption is expected from 2007 to 2017. However, the profitability of Alcoa and other industry players will depend on their ability to prevent continued inventory build-up and a significant decline in price.

Because of its strength, one pound of aluminum can replace three pounds of steel, making aluminum the preferred choice in the automotive industry. With the troubles in Detroit, Alcoa is expanding its presence in Asia, particularly in China, where it has invested more than $700 million since 1993. While the trend in the automotive sector is favorable, the opposite is the case in the aerospace end market, which accounts for 23% of revenues. Here, there has been a recent increased use in carbon fiber composite materials, which are lighter than aluminum, stronger than steel, and easier to assemble. Airplane manufacturers have announced plans to build models composed of 20% aluminum by weight, a marked decrease from earlier 50%. A key driver of growth remains China, accounting for approximately one-third of aluminum demand in 2007 and expected to account for almost one-half in 2017.

Alcoa vs. Chalco

Aluminum Corporation of China (ACH) is faced with identical problems as the rest of the industry. High input costs, particularly energy, and falling spot prices affect the company. In fact, although energy costs are lower in China, the government announced in June 2008 that it was raising power tariffs 70% for industrial users during peak hours. This, coupled with the fact that energy supply is not as reliable in China as in the U.S. has serious negative impacts on Chalco. Additionally, Deutsche Bank estimated that the production costs for alumina, Chalco’s main product, increased by 24% between January and April 2008 due primarily to the rising cost of bauxite.

Chalco is the largest alumina producer and among the largest primary-aluminum producers in China. It accounts for 39.2% of alumina consumption and 22.5% of primary aluminum consumption in China. The company has made significant acquisitions and achieved great strides in transforming itself into an integrated aluminum company. With the support of the Chinese government, which has closed many smaller and inefficient producers in recent years, Chalco has been able to acquire many of these businesses at a discount. In fact, with its large and growing presence in China, Chalco is significantly better positioned to take advantage of the China growth story as the global economy recovers.

	Alcoa	Chalco
Price (as of October 25, 2008)	9.41	8.08
P/E (ttm)	3.9	2.7
P/B	0.5	0.5
P/CF	4.0	3.1
Total Debt/equity	67%	39%
Cash per share	1.04	2.11
Dividend yield	7.23%	4.67%
Operating margin (ttm)	8.0%	19.6%
Net profit margin (ttm)	6.8%	15.3%

At a price of 8.08 (as of October 25, 2008), Chalco is trading at historically low P/E, P/B, and P/CF ratios (for period where data is available – dating back to 2001). As can be seen in the table above, Chalco is cheaper than Alcoa and has also been able to maintain higher margins in the trailing twelve-month period as well as every year since 2001. In addition, it has a lower total debt/equity ratio and more cash per share. Both companies provide a generous dividend. Alcoa does, however, have a higher dividend yield, but it is possible that both Alcoa and Chalco will cut their dividend if current economic conditions continue or deteriorate further.

Chalco appears to present a more attractive investment opportunity

Alcoa and Chalco are among the dominant players in the industry. The current economic environment has severely affected all aluminum producers, and this has been reflected in their stock prices. Those producers that do not have strong financial positions and/or high cost structures will be negatively affected to a greater extent. Nevertheless, the long-term story for aluminum remains convincing.

Despite the issue of energy costs, Chalco does seem to be more attractive based on current valuation, its strong position in the Chinese market, and its integrated and global expansion potential. Nevertheless, the decision to buy Chalco should be based on a long-term view that eventually the global economy will improve and the demand for aluminum will recover from current levels.

Disclosure: None.