A decline in aluminum prices have negatively affected margins of the companies like Alcoa Inc. (NYSE:AA), Aluminum Corporation of China Limited (NYSE:ACH) and Alumina Ltd. (AWC). Alcoa is amongst the 70% of aluminum companies that are managing to report profits. The rising demand of aluminum could possibly mean a potential return on investments. The question is if the growth in auto sector will prove to be a catalyst for Alcoa's growth? However, a drawback prevails as the commodity prices decline and the industry suffers.
Alcoa outperformed the industry during the trailing twelve months. Its profit margins and management efficiency ratios were better than the industry results. During the last 12 months, the company's operating margin was 2.9%, higher than the industry average of 2.3%. Moreover, the company's net margin was 1.3% while the industry reported a negative net margin over the trailing twelve months. The company's financial leverage is 2.99, which is lower relative to the industry average of 3.34. Despite having a lower financial leverage, the company's ROE was higher than the industry average owing to a higher net margin.
Aluminum supply & demand balance
Aluminum price depends upon the balance of supply and demand. Aluminum has excellent long-term growth opportunities in various markets. The demand for aluminum will grow in the key growth regions such as China, India and the developed markets. There has been a significant demand & supply mismatch since the beginning of the fiscal year 2008. However, the company has revised its deficit forecast for the fiscal year 2013. Therefore, I believe that the price of aluminum will increase in the near future owing to a less supply and more demand for aluminum in the future.
Moreover, car makers are using record amounts of aluminum in order to replace heavier steel. I believe it is a big relief for aluminum producers who were confronting the problem of excess supply and depressed price. Aluminum content usage is increasing in vehicles by about 5% a year. Growth is expected to accelerate over the next decade as drivers seek improved fuel economy and lower emissions.
Increase in the car usage of aluminum "fuel strong growth in demand for the light metal and we forecast that total consumption of primary aluminum will expand by a compound annual growth rate of 5.9% over the coming 5 years," said Charlie Durant, senior analyst at London-based metals analysis company CRU. Therefore, I can conclude that the high demand for aluminum in the coming years will ease the pressure on aluminum prices.
Aluminum price will not reach the 2008 peak level of $3,317 a ton. The average price for aluminum was $2,200 in the last five years. Aluminum price slumped about 5% in 2012 while producers reduced the global output about 3%, from January through November in FY12. Aluminum contracts on the London Metal Exchange show that the aluminum price would reach at $2,530 by the middle of 2015 and $2,700 by 2022. Therefore, Morgan Stanley estimates a gain of 29% in the aluminum price until 2018.
Engineered Products & Solutions
Revenue is up 5% YoY in this segment, which is primarily attributable to strong share gains across all markets. Short-term outlook of this segment is not good. Aerospace will be impacted by engine market inventory realignment and the lower U.S defense spare parts demand in the near future. However, in the long run, aerospace is expected to witness a strong demand. Aerospace segment is expected to grow at a CAGR of 8% until 2015.
Automotive is expected to witness a strong growth in the years to come. In North America, auto sheet is expected to grow at a CAGR of 30-35% by the end of 2015. Therefore, revenue from auto sheet is expected to increase by 3.6 times until 2015. As shown in the following graph, the demand for auto sheet is expected to jump tremendously by 2025.
SOURCE: Q3 Earnings Presentation
Non-residential construction will continue to grow gradually in North America, which will also increase the demand for Engineered Products & Solutions. However, the weakened European market will somewhat offset the demand for the products of this segment.
Global Rolled Products
Performance of Global Rolled Products worsened in the third quarter on year-over-year basis. Auto and packaging demand remained strong; however, the unfavorable volumes and prices negatively affected the results.
Auto demand is expected to remain strong in the fourth quarter. However, price pressures in China and Europe, along with a decline in the demand for Brazing, will negatively affect the results. The after tax operating income from this segment is expected to decline by 25%, assuming flat metal price and FX rates.
Year-on-year, performance of this segment was better in the third quarter. Despite lower metal prices, the company posted decent margins in this segment owing to the productivity gain, non recurring power plant outages and the favorable impact of FX.
The company will continue its plan to curtail the cost in order to magnify the profit margins. Productivity improvement is expected to continue in the future. Therefore, I believe that the company will be able to post decent results from this segment.
Year-on-year, after tax operating income of this segment was also higher in the third quarter. Better results were mainly driven by favorable impact of foreign exchange rates, strong productivity savings and sales at Alumina Price Index-based pricing, despite lower London Metal Exchange (LME) - based prices. Productivity improvements and shipment volume will mainly drive the higher margins for this segment in the near future.
The company increased deficit forecast (more supply than demand) from 315,000 mt to 400,000 mt. The aluminum price is also expected to increase in the future owing to an increased demand for aluminum.
At the current aluminum price, more than 30% of the companies are not making profits. However, Alcoa is amongst the companies that are posting decent margins relative to their peers even in this low pricing environment. Therefore, I would recommend buying the stock.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.