Aluminum Producers Prepare for Stagflation

By Peter Pham - October 26, 2012 | Tickers: AA, RIO | 0 Comments

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Alcoa (NYSE: AA), the leading U.S. aluminum producer, gave the markets a warning due mainly to the slowdown in the Chinese economy in conjunction with the Eurozone crisis, as weak demand has pulled global consumption down by 1%.

In its latest third quarter earnings release, Alcoa, who kicks off earnings season and generally sets the tone for the quarter, reported a net loss of $143 million, or $0.13 per share, showing a considerable decline from the net loss of $2 million in the previous quarter and a net profit of $172 million reported a year ago. However, the current loss was largely due to settlement of environmental and legal suits, including the $85 million paid to the state-owned Aluminum Bahrain BSC (ALBA) to settle the four year old legal battle over bribery accusations.

Excluding these items pushes earnings to a gain of $0.03, which was ahead of analysts’ expectations of a breakeven quarter. Revenues for the quarter fell sequentially by 2.1% and 9.1% year over year to $5.83 billion, which was still higher than the expected $5.54 billion. The growth forecast has been reduced from 7% to the current 6%.

Alcoa’s legal battles, particularly those concerned with environmental damage, are probably never going to be over. A recent survey has found hay grown in an area in East Iceland to have been contaminated, most likely, by Alcoa’s plant located nearby and is therefore not fit for consumption. Alcoa has a large presence in Iceland, as the biggest and most powerful firm operating in the country.  Alcoa’s sales globally are $10 billion greater than Iceland’s 2011 GDP.

Alcoa, like Rio Tinto (NYSE: RIO), has attributed the decline to the falling demand in China; but the recent stimulus package might change the outlook for the better in the coming quarters. 

In the past 12 months, aluminum prices have fallen by 10% and have touched a three year low, but have seen a recent rise from early September due to relatively stronger demand as leading producers, such as Alcoa, Rio Tinto and Norsk Hydro (PINK:NHYDY) cut their supplies.

I believe that aluminum prices have most likely bottomed and should hold in this range, based on supply and demand issues.  In essence, we will have sector rotation; but instead of economic sectors it’ll be countries rising and falling while overall demand stays roughly the same. However, with an average of around $2,200/MT in 2013, it is not expected to reach anything close to the pre-global financial crisis level of $3,300/MT but will bounce around the predicted price zone until inflationary effects take over. Over the past year, aluminum prices have averaged at $2,064/MT. In other words, while the situation is expected to improve, it is not going to be a significant progress.

Although Rio Tinto’s primary operations include aluminum, it is involved in exploration and production of other metals and minerals as well. In fact, 44% of its revenues come from iron ore, and its primary operations are in the developed markets Australia and North America. Alcoa and Norsk Hydro operate exclusively in the aluminum industry, which is the primary reason behind the relatively better performance of their stocks as compared to Rio Tinto's. The two companies basically sell aluminum for a variety of purposes from beverage cans to transportation vehicles. Both operate primarily in North America, Europe (particularly Norway), Australia and Brazil.

Rio Tinto, on the other hand, is increasing its focus on the emerging markets of China, which will form a significant part of its $16 billion future investment plan, along with Mongolia, where it has just taken control of the $5.2 billion Oyu Tolgoi copper-gold mine (one of the biggest in the world). Rio Tinto’s advantage is coming from its large investments in the emerging markets, something which Alcoa and Norsk Hydro have been largely unable to do, that will add value to the company in the long run.

Since the beginning of the current year, Alcoa has risen by 5.2%, while Rio Tinto and Norsk Hydro are up 5% and 3.25%, respectively. The three stocks have easily outperformed the SPDR S&P Metals and Mining ETF (AMEX:XME), which focuses on metals and mining companies and has been down 4.8%. 

However, the focus on one product has also given them maximum exposure to a commodity whose prices have been falling more or less continuously for the past three years. The much larger Rio Tinto’s vast portfolio of products and services has ensured that it continues to generate positive return on equity. Since the beginning of the second half of 2011, Alcoa has dipped by a massive 40.2%, followed by Norsk Hydro’s fall by 32% and Rio Tinto’s 24%, close to XME’s drop of 28.6% in the corresponding period.  

Rio’s more diversified portfolio make it a safer bet as we move into a stagflationary period of debt deflation and monetary expansion, which will should imply a range-bound global equity market and just enough demand for companies like Alcoa and Norsk to survive but not materially grow, unless the demand for Aluminum fundamentally changes.

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