Alcoa: Don't Lose Hope

| About: Alcoa, Inc. (AA)

Summary

Alcoa posted a weak bottom line performance earlier this week due to low aluminum pricing, but investors should focus on the bright long-term prospects of the market.

The price of aluminum should improve going forward due to production cuts in China, where 75% of alumina refining and 70% of aluminum smelting capacity are currently cash negative.

Alcoa will also benefit from an increase in aluminum demand going forward as it is estimated that consumption will rise 5% globally and 6% in China.

Due to an increase in demand and lower supply, the aluminum market will move into a deficit, thereby leading to an improvement in pricing.

Alcoa has managed to keep its bottom line in good shape despite the pricing weakness, which is why an improvement in aluminum pricing will lead to further bottom-line improvements.

Though Alcoa's (NYSE:AA) latest results that were released earlier this week weren't that great due to weak sales and a tepid outlook for the aerospace sector, there has been no negative impact on the share price. Since releasing its results on April 11, Alcoa shares have gained over 4%. This does not surprise me since Alcoa's long-term prospects are still intact and the company is taking the right steps to improve its efficiency.

As such, in this article, we will take a look at the reasons why investors should ignore the top line weakness in Alcoa's latest results and remain invested in the stock for the long run.

Doing well despite adversity

Even though Alcoa faltered last quarter as far as its top line performance was concerned, the company posted a strong bottom line with a positive surprise of 250%. In fact, Alcoa has posted really strong bottom line performances over the last two quarters. For instance, last quarter, Alcoa's earnings came in at $0.07 per share, up 75% sequentially, despite a drop of 5.6% in revenue.

Moreover, Alcoa has managed to improve its bottom line despite a drop in the average realized price of aluminum, which was down 0.33% sequentially and 26% year-over-year in the previous quarter. Now, looking ahead, it won't be surprising if Alcoa is able to keep up its strong earnings performance since the price of aluminum is anticipated to get better on the back of positive demand and supply dynamics.

Why aluminum prices will get better

According to data released by the International Aluminum Institute, China's alumina production in the first quarter of the year stood at 4,852 thousand metric tonnes. This represents a drop of 66% from a total of 14,277 thousand metric tonnes of alumina produced in the year-ago period. As a result of this decline in Chinese aluminum production, global alumina production has dropped approximately 52% in the first quarter of 2016 as compared to last year.

This is a welcome sign for aluminum producers such as Alcoa, Norsk Hydro (OTCQX:NHYDY), Rio Tinto (NYSE:RIO), and Century Aluminum (NASDAQ:CENX) as the reduction of 14,565 thousand metric tonnes of aluminum production will move the aluminum market into a deficit in 2016 after almost a decade of surplus. In fact, Alcoa forecasts a deficit of 1.1 million metric tons in the aluminum market this year, with the rest of the world in deficit by nearly 2 million metric tons and China in surplus for 2016.

More importantly, it won't be surprising if China's aluminum production also moves into a deficit since 75% of China's alumina refining and 70% of aluminum smelting capacity are currently cash negative. As such, China's smelters should ideally cut production going forward. In fact, last year, aluminum capacity worth 5 million tons was shut down in China and the trend of shutting down capacity is likely to continue going forward as a majority of Chinese aluminum production is inefficient at current levels.

On the other hand, Alcoa expects global demand for aluminum to increase 5% this year, including a 6% year-over-year increase in Chinese aluminum demand. In fact, the company expects global consumption of aluminum to reach 59.7 million metric tons this year, which will play an important role in improving the demand-supply dynamics of the market.

As a result of a cut-down in Chinese aluminum production and higher demand, the deficit in the aluminum market will increase further going forward, leading to an improvement in prices. For instance, the World Bank projects aluminum prices to rise from $1,550 per metric ton in 2016 to $1,811 per metric ton in 2020. Similarly, the IMF anticipates aluminum prices to increase to $1,694 per metric ton in 2020 from $1,477 per metric ton this year, as shown in the charts below.

Source: Knoema

Conclusion

Alcoa has done impressively in difficult times for the aluminum market, keeping its bottom line in good shape despite the weakness in aluminum pricing. As discussed above, the price of aluminum should improve in the long run and this will prove to be a tailwind for Alcoa as it will be able to improve its margin profile. As such, investors should look at the long-term prospects of the aluminum market and remain invested in Alcoa since an improvement in the end market will lead to upside in the long run.

Disclosure: I/we 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.