Is This Aluminum Maker Behind the Eight Ball?

Fani is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.

Alcoa (NYSE: AA) is definitely a big-time player in the aluminum business. But with global aluminum production going through the roof and aluminum prices touching rock-bottom levels, is there any room left for this 125-year-old top dog to shine?

Alcoa's five-year stock chart is the definition of a falling knife portraying the industry's woes, as well as the uphill battles yet to be fought:

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Should you ditch this stock right now or should you “be greedy even if others are fearful”? Let's find out.

A rocky road

For the most recent quarter, the company delivered earnings that topped analysts' average estimates, but its quarterly revenue failed to impress the Wall Street. Earnings, excluding special items, came in at $0.11, up by $0.01 on a year-over-year basis. Revenue rolled in at $5.8 billion marking a 3% drop compared to the same period in 2012.

Up until 2012, Alcoa's upstream businesses, which consist of its alumina and primary metals segment, made up nearly half of its total sales. Thus, it's no wonder that, over the past couple of years, falling realized prices for aluminum and alumina took a toll on its overall top-line growth:

For the quarter, the primary metals segment's after tax operating income (ATOI) – the No 1 metric Alcoa uses to evaluate each segment's performance – experienced a $29 million year-over-year lift reaching $39 million. But, if we dig a bit deeper, we'll find that primary metals' ATOI has nosedived from $488 million at the end of 2010 to $309 million for full-year 2012.

More importantly, Alcoa's margins are hanging by a thread. To its credit, the company has put the optimization of its profit-maximizing mechanisms on the front burner and has already set the wheels in motion to become more cost-competitive. Cost-reduction programs and profitability-improving strategies – such as converting more of the output from its cast houses to value-add products – should make its income statement picture-perfect. Yet, its trailing-twelve-month earnings excluding interest and taxes (EBIT) account for barely 1.8% of its sales, while, its net margin (TTM) is standing at somewhat above 1%.

Century Aluminum (NASDAQ: CENX), one of Alcoa's direct competitors, has also been going down quite a rocky road. This U.S.-based primary aluminum producer is a smaller player operating primarily in the U.S. and in Iceland.

Over the past five years, Century show its sales go downhill at a compound 6.7% rate. It struck an $8.3 million profit for the first calendar quarter, but that was largely because of a $15.7 million unrealized gain related to a LME-based contingent obligation. Shipments of primary aluminum remained relatively flat while its margins are in a much worse shape than Alcoa's.

Nevertheless, the company does not give up the fight so easily and continues to expand its operations as it remains upbeat on the market's long-term prospects. Earlier this month, it took the Sebree aluminum smelter off Rio Tinto's hands.

The industry's woes

Overall, industry players have been pulling their hair out trying to cope with aluminum's sluggish price.

In a recent report, the Boston Consulting Group points out that: “compared with other metals, aluminum entirely missed the “commodity super cycle””. During the past decade, primary aluminum's price scored only a 20% upturn. When measured up against iron ore's whopping 600% appreciation, words fail me! 

Since 2000, China's appetite for aluminum has grown by an annual rate of 16% representing today around 45% of global demand. At the same time, demand from the rest of the world remained pretty much stagnant. Yet, over the past six years, China's production capacity spiraled out of control leaving all other producers twisting in the wind. As of last year, worldwide aluminum production stood at slightly above 45 million metric tons, of which around 20 million were produced in China.

In turn, producers around the world are forced to reduce capacity at loss-making smelters. Recently, the Aluminum Corporation of China (NYSE: ACH), also known as Chalco, decided to shut down temporarily 380,000 tons of production capacity. But, still, is it enough to fix the demand-supply equation?

Given the fact that China is this commodity's biggest consumer, but since 2007, it has been, more or less, self-sufficient, oversupply will probably continue to be a hard nut to crack. At the moment, around 25 % of expected 2013 global consumption or 10-12 million metric tons are locked up in storage.

An unexpected twist?

Apparently, things are not going as planned in the world's No 2 economy. The Chinese government is cracking down on “easy money” while fears of a credit crunch are giving investors ants in their pants. The domestic manufacturing sector is entering contraction territory, and soft GDP growth is dragging down domestic demand.

On one hand, if the current environment drives the Chinese government to draw a line on basic materials' production rates, we should expect a pickup in aluminum prices. But, what will happen to companies like Chalco, China's biggest alumina and aluminum producer?

Chalco found itself in a bind, when domestically-focused players started popping up across the country like mushrooms after the rain. Although, it is way ahead of the pack in terms of distribution capabilities and scale, the over-crowded Chinese market doesn't leave enough elbow room for the company to thrive.

It's worth mentioning, though, that, the company is keeping an eye on other market opportunities, as well. Chalco is partnering with Rio Tinto, an Anglo-Australian miner, to get the ball rolling on the Simandou project – an iron ore mining project in the south-east of Guinea. But, the estimated cost of this project has skyrocketed, and several bumps along the way keep throwing a wrench in the works.

Furthermore, without strong capital spending and large building projects from the world's biggest industrial and manufacturing base, what will Alcoa do?

Alcoa has immense competitive advantages that enable it to stand at the forefront of the industry. But, when this industry is so tight that there's not really much room left to breathe, then, shouldn't you be worried?

The Foolish bottom line

Alcoa's cost-efficiency initiatives, as well as profit potentials steaming form its downstream business may paint a brighter picture for the long-term future. But, from where I stand, at least for the medium term, there are a few clouds on the horizon.

Last month, Moody's cut the company's main credit rating to junk citing weak prices and a tough market for its upstream business. On top of that, according to the final figures released by the Bureau of Economic Analysis, the U.S. economy grew in the first quarter at a dismal annual rate of 1.8%, well below previous estimates of 2.4%.

Obviously, with China walking on shaky ground and the U.S. economy moving at a snail's pace, Alcoa is caught between a rock and a hard place.

Fani Kelesidou has no position in any stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. Is this post wrong? Click here. Think you can do better? Join us and write your own!

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