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The recent oversupply of primary and fabricated aluminum is driving down the revenue of aluminum producers resulting in lower industrial profits. In September and November of 2013, the prices fell to their lowest level since 2010. The graph below shows the historical prices of aluminum on the London Metal Exchange "LME".

(click to enlarge)

Source: London Metal Exchange

The declining trend in prices has also affected Alcoa's (AA) revenue growth. Alcoa is the world's leading producer of primary and fabricated aluminum as well as the world's largest miner of bauxite and refiner of alumina. The company's operations consist of four worldwide reportable segments: alumina, primary metals, global rolled products and engineered products and solutions.

Its revenues are dependent upon the outlook of aerospace, automotive, packaging, building and construction,commercial transportation, consumer electronics and industrial markets.

Results of Operations

Alcoa's sales declined by 1% during the third quarter of 2013 and by 2% during the first nine months of 2013 mainly due to low aluminum volumes, a decrease in metal prices and lower London Metal Exchange prices. This was partially offset by higher volumes in alumina. The alumina and engineered products and solutions segments experienced an improvement in sales while the primary metals and global rolled products segments experienced a decline in sales.

However, net earnings in the third quarter of 2013 improved compared to third quarter results of 2012 and were driven by net productivity improvements, higher volumes in midstream and downstream segments and the absence of charges for three environmental remediation matters and a civil litigation matter.

Alcoa's interest expense decreased by 13% in the third quarter and by 8% during the first three quarters of 2013 due to a lower average debt level. The reduction in the debt level occurred as a result of the repayment of a portion of the long term debt in June 2013 and lower short term credit facilities and commercial paper.

As a result, the company's debt-to-equity ratio improved in the first three quarters of 2013. The debt-to-equity ratio was 0.649 on Sep 30, 2013 as compared to 0.669 on Dec 31, 2012.The ratio is lower than the industry average of 0.7 indicating that Alcoa has a better debt profile than other players in the market.

The higher operating results and the lower pension contributions resulted in an improvement in operating cash flows during the first nine months of 2013. The operating cash flows increased by almost 17% on a yearly basis.

However, the company's liquidity position weakened in these nine months as its working capital and current ratio declined. The main driving forces behind the weaker liquidity were the reduction in cash and cash equivalents and increase in accounts payable and current portion of long term debt.

Forecasted Aluminum Prices

The aluminum prices do not seem to be improving in the future especially since the supply will remain excessive. The prices for aluminum are predicted to decrease further and reach $1,838 per ton from an average of $1,867 per ton in 2012.

This decrease would cause Alcoa's revenues to reflect negative growth in future. The negative effect of prices could be offset by an increase in the demand for aluminum products. To check Alcoa's products demand let's have a look at the future outlook of each sector from where Alcoa's generates its revenues.

Building and Construction Sector

In the U.S. construction sector, a growth of 12% is expected in the residential construction segment while a 5% growth is expected in the commercial construction segment in 2014. Since Alcoa generates more than 50% of its revenues from the U.S. a growth in any of the U.S. sectors will significantly improve the company's revenues.

The company is expanding its operations to Saudi Arabia which has the largest construction sector in the Middle East and is considered the "construction safe haven". The growth of building and construction is forecasted to increase significantly as a percentage of GDP over the next three years due to many ongoing projects including the construction and expansion of airports in four cities, building of rail network, expansion of the Holy Grand Mosque in Makkah, as well as university and refinery building schemes.

Alcoa is on its way to building to approximately 100,000 metric tons of a wide range of products using aluminum in Saudi Arabia and the expected growth in the building and construction sector would considerably increase the demand for these products.

On the other hand, the construction sectors in Europe and China are not expected to experience impressive growth next year.

Automotive Sector

The outlook for the global automotive industry remains positive for the next 12-18 months due to a notable growth in the Chinese and U.S. markets. The demand for light vehicles is projected to rise in Brazil and Russia as well.

Aerospace and Commercial Transportation Sector

The growth in the commercial aircraft manufacturing industry is expected to reach record levels due to increased production rate, the introduction of the next generation of aircraft, growing travel demand and increased security requirements in emerging markets. The industry's backlog is projected to grow continuously resulting in higher demand for Alcoa's products.

Consumer Electronics Sector

The future outlook for global consumers is positive due to the growing convergence of communication, information and entertainment. The industry is expected to grow at a CAGR of over 10% during 2012 to 2015.The U.S, the UK, China, India, Japan, Germany, South Korea and Taiwan are considered to be the largest consumer electronics countries.

Packaging Sector

Like all of the aforementioned sectors, the global packaging sector also expects to experience positive growth of around 3% during 2014. The Asia Pacific region is projected to become the world's largest packaging market by 2014.

Forecasted Cost of Goods Sold and Expenses

Now let us examine the company's expected increase/decrease in its costs and expenses.

Alcoa's operations use substantial amounts of energy. Energy prices are expected to rise in 2014 and this would adversely affect the company's profits. Electricity prices are projected to increase by 1.4% and natural gas prices excepted to rise by 9.6%. The prices for caustic soda, an important raw material in the company's production process, are also expected to slightly rise in the future due to tight supply and increasing energy prices.

However, this increase in costs would be offset by an expected decline in coal and fuel oil prices in 2014. The decrease in fuel oil prices would also reduce Alcoa's future freight and transportation costs. Therefore, the cost of goods sold is projected to remain almost the same in 2014 with no significant changes.

Final Takeaway

Although, aluminum prices will decline in the future the strong expected growth in the building and construction, automotive, commercial transport and aerospace, consumer electronics and packaging sectors will create strong demand for Alcoa's products. The company's new joint venture in Saudi Arabia will add considerable revenues to its income statement due to the country's potentially fruitful construction and transportation sectors.

The company's cost of goods sold and general expenses are not likely to increase next year due to lower fuel oil and coal prices. The increased revenues with stable margins would result in an improvement in the company's profits. Given the positive outlook, I suggest buying into the stock.

Source: Alcoa: Ready To Shine Brighter Than The Metal Itself