So far in this crazy year for the markets, there’s been a number of surprising rallies. One of these is in aluminum. The commodities sector overall has been unkind to just about every resource company, but aluminum producers have bore a disproportionate share of the burden.
The industry benchmark Dow Jones U.S. Aluminum Index lost 38% in the markets in 2015. To put that into perspective, Brent Crude Oil — which is constantly in the news cycle — dropped 34% last year.
The aluminum index hasn’t exactly gotten off on the right foot in 2016, with January’s broad correction penalizing most financial sectors. Yet, since hitting bottom in the latter half of January, the aluminum index has jumped more than 40%.
One of the strongest contributors to the rally was the weakening U.S. Dollar Index. Since Jan. 22, the greenback has dropped more than 5% in relative strength against a basket of international currencies.
A weaker dollar is a much-needed tailwind for American-centered aluminum companies. Part of the pain of 2015 was aggressive Chinese competition — why pay more in real terms when currency markets were all but screaming in favor for Asian aluminum? Better yet, because of the uncertainties of the American economy, enacting monetary stimulus by the U.S. Federal Reserve isn’t entirely out of the question.
It would appear that aluminum investors have lots to be cheerful about. However, this is where the enthusiasm needs to get a reality check. First, currency dynamics are rarely factors in which you want to place much hope. Any number of events can suddenly change the dollar’s trajectory. We’re also in a presidential election cycle, which could potentially impact the markets depending upon who gets into the White House.
But for the aluminum sector specifically, the challenge remains overcapacity. Yes, individual aluminum companies have cut production to salvage profitability, and that has shown signs of success. Unfortunately, demand for Chinese aluminum has been very high relative to U.S. production, and there is still a considerable supply glut in the Asian powerhouse. Efforts have been made to address this supply imbalance, but the circumstance is not likely to change any time soon.
While the excitement for the recent aluminum rally is understandable, it’s a good time to step back and reassess the situation. Here are three aluminum companies that face a considerable challenge ahead.
Aluminum Stocks to Sell: Alcoa Inc (AA)
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In addition, Alcoa has led the charge in taking ownership of the aluminum malaise. Production cuts, a strategy shift and plant closures have led to better-than-expected savings last year.
But will it be enough for the markets when AA stock’s first quarter of fiscal year 2016 results are scheduled to be released next Monday? Analysts are expecting AA earnings to hit two cents a share, the lowest consensus estimate for Q1 since FY2012, when the forecast called for a loss of four cents. AA missed earnings consensus badly in Q2 and Q3 in FY2015, although it pulled itself together in the final quarter. Given some of the positive developments in aluminum earlier this year, it’s possible that AA could produce a positive surprise.
On the other hand, Wall Street is overall bearish on the markets. Earnings estimates broadly have been hit with negative revisions to an extent not seen in several years. While energy companies like Chevron Corporation (CVX) are key laggards, the problem is that there’s not much growth in other sectors. And what’s one of the biggest questions regarding AA stock’s future? You guessed it — earnings growth.
This isn’t to say that AA craters from here. There are, however, more than enough circumstances to warrant an extra degree of caution.
Aluminum Stocks to Sell: Rio Tinto plc (ADR) (RIO)
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Year-to-date, RIO stock is down roughly 5%, about even with AA stock’s performance over the same period. However, since AA hit bottom in mid-January, shares have jumped over 41%. For RIO, the equivalent rally against the year’s low has only netted a 26% gain. More worrying is the fact that over the past five years, RIO evaporated 62% of value in the markets, whereas Alcoa dropped 46%. Ideally, you’d like to see the hardest hit stock provide the most returns in a recovery rally.
That might not happen for RIO in the foreseeable future. While virtually all aluminum producers are starving for earnings growth, RIO has a very tough case on its hands. Not only did net income show a loss of $866 million last year, top-line sales tanked by 27%. Annual gross margin is also getting worse, not better. Whatever cuts they are making, RIO needs to do more of it.
Until they do, it’s difficult to imagine investors getting too excited about RIO stock.
Aluminum Stocks to Sell: Reliance Steel & Aluminum Co (RS)
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That also means that RS is significantly sheltered from the spot-price volatility of aluminum. In many ways, lower prices is a benefit, as it would cut down on Reliance Steel’s inventory costs.
The numbers are hard to argue against. On a YTD basis, RS stock is up 19% — well above many other companies in the aluminum sector. Against its January low, RS has tacked on 34%, with shares showing no sign of slowing down until just recently. As to be expected because of its service-oriented business model, RS has been a relatively solid long-term investment. In the past five years, Reliance shares have gained 18% despite massive volatility in the broad aluminum industry.
That said, it’s probably too late to jump on the RS bandwagon. Even though the company’s business structure can better absorb aluminum price shifts, it’s not completely immune, either. A clear example of this is in the earnings growth for RS, which historically is pretty flat. In addition, last year’s revenue of $9.35 billion was an 11% reduction against 2014’s results.
Among aluminum stocks, RS definitely inspires the most confidence. However, it’s where it goes from here that matters. Based on industry challenges lying ahead, it’s wiser to be conservative.
As of this writing, Josh Enomoto did not hold a position in any of the aforementioned securities.
