Automakers' Shift To Aluminum Boosts Alcoa's Outlook

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 |  About: Alcoa, Inc. (AA), Includes: KALU
by: Alpha World

Summary

Alcoa shares have gained more than 50% so far this year.

Alcoa is benefiting primarily from strong demand for its value added products.

As the auto industry shifts to aluminum, the outlook for Alcoa’s downstream business has improved even more.

Although Alcoa has posted substantial gains in the past year, there is further upside potential in the stock.

It has been a phenomenal year for shares of aluminum giant Alcoa Inc. (NYSE:AA). Year-to-date, the company's shares have gained more than 54%, even as the S&P 500 has posted gains of just a little over 5%. The gains have been driven by Alcoa's improving outlook. Indeed, the aluminum giant struggled over the years as lower prices due to a supply glut negatively impacted its upstream business. As a result, Alcoa has been restructuring its upstream segment by closing high-cost smelters. While this has certainly improved Alcoa's outlook, the company's prospects have been primarily boosted by strong performance in its value-added or downstream business.

Alcoa's downstream business is benefiting from strong demand from the auto and aerospace industries. Kaiser Aluminum Corp. (NASDAQ:KALU) is also benefiting from this trend. Not surprisingly, Kaiser shares have also done well so far this year, outperforming the S&P 500. More importantly, the strong performance of the downstream business will continue going forward as the auto industry braces for a change.

Auto Industry Braces for a Change

As Ford Motor Company (NYSE:F) draws closer to introduce its much-awaited F-150 all-aluminum pickup truck series by the end of this year, there is growing anticipation in the market about how the new product will perform.

Ford, however, seems to be fairly positive about its new product launch. Last week, dealers began taking orders for the all-aluminum F-series pickup trucks. And interestingly, even before the new models hit the market, the automaker has announced an increase in prices. Ford informed its dealers recently that the retail prices of the entry-level models of its latest product will cost $360 more. The high-line luxury versions, meanwhile, will cost $3,615 more.

Ford's confidence stems from the fact that more and more truck buyers in America now look for fuel-economy vehicles amid mounting pressure from the federal authorities to meet fuel-efficiency standards. Indeed, Ford's internal study shows that 80% of truck buyers want automobile makers to use aluminum as it does not corrode or dent. Ford expects to manufacture more than 700,000 F-150 all-aluminum pickup trucks annually based on this research.

Reuters, citing an independent automobile consultant, reported earlier this year that the U.S. automobile industry's demand for aluminum sheets is likely to rise from 200 million pounds in 2012 to 1 billion pounds this year. By 2025 the demand is likely to be between 3.2 billion pounds and 6.4 billion pounds.

Not surprisingly, America's leading automaker, General Motors Company (NYSE:GM) is also switching to an all-aluminum body for its next-generation large pickup trucks, which are expected to hit the market by mid-2018.

Fiat Chrysler might also build its next-generation Ram pickups from aluminum in 2017 if Ford's upcoming F-150 turns out to be a huge success.

A report published recently by Ducker Worldwide shows that by 2025, 18% of the total vehicles on the roads will have all-aluminum bodies, compared to less than 1% at present. The study also adds that by 2025, more than 75% of the pickup trucks and 20% big-sized sedans and SUVs build in North America will be all-aluminum bodied.

What This Means For Alcoa

The changing auto industry landscape suggests that the demand for fabricated aluminum is expected to rise significantly in coming years as automakers look to make bodies from the lighter metal instead of steel. This is a very positive development for Alcoa, which is increasing its focus on its downstream business. It also makes Alcoa a very good long-term bet.

Alcoa's downstream segment, which manufactures products used by the automobile and aircraft industry, saw profits jump 5.7% to $204 million for the fiscal second quarter of the year. Alcoa, which is slated to announce its third quarter results in October, expects profit from the downstream business to rise by 10% on a year-over-year basis.

Kaiser Aluminum recently posted a solid growth in automotive extrusions segment for the second quarter of the fiscal year 2014. The Foothill Ranch, California-based company, which generated a record profit for a second successive quarter, is also confident about its outlook in the mid-to long-term.

In a recent conference call, Kaiser's President, CEO and Chairman, Jack A. Hockema said that he anticipates "full benefits from strong secular demand fundamentals for (our) aerospace and automotive extrusion applications."

Between Alcoa and Kaiser though, I would prefer Alcoa, given the company's diversified operations. Alcoa not only stands to benefit from strong demand for its value added products, but also from restructuring of its upstream business. Indeed, Alcoa's second-quarter profit beat expectations, thanks to the solid performance of its smelting business. Not surprisingly, Alcoa's gains have outpaced Kaiser's this year.

The big question for investors is whether there is further upside potential in Alcoa, given that the stock has already gained nearly 100% in the past year. In my opinion, the stock may have more room to run. Despite the gains in the past year or so, Alcoa shares are still trading well below the levels they traded at prior to financial crisis. In fact, Alcoa missed out on the rally in the S&P 500 that began in March 2009. Given the company's improving business outlook, I think this is still a good time to go long on the stock.

Disclosure: The author has no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.