Aluminum Reality Check

Considering Alcoa (NYSE: AA) and the Aluminum Corp. of China (NYSE: ACH) both swung to profits in their prior quarter, one could argue that the industry was finally turning the corner. I'd probably even agree. However, I think the market may not realize just how long it will take to get all the way around the corner. Here's an aluminum reality check.

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The Good
Aluminum industry icon Alcoa set the tone for its brokers in early October by posting its first profit in five quarters. Alcoa topped expectations of a per-share operating loss of 9 cents; the company cleared 4 cents per share - even after "one time" write-downs. Score one for the sector. Had it just been Alcoa, the swing to profitability might have been dismissed. The Aluminum Corp. of China - sometimes just called Chalco - pulled the same stunt by also generating a profit in the prior quarter. Granted, it was 88% below earnings from the same quarter a year earlier, but it beats the losses taken in the meantime. Even though Kaiser Aluminum (Nasdaq: KALU) fell short of the expected per-share income of 29 cents last quarter, its operating income of 27 cents per share is impressive given the 31% decline in YOY revenue.

The only real disappointment was Century Aluminum (Nasdaq: CENX). The company would have taken a $15.1 million loss had it not been for an after-tax gain of $55.6 million on the termination of a contract. Century earned $35.8 million in the same quarter a year earlier; revenues fell by 59% on a YOY basis.

Still, three out of four is a majority, and in this case the majority seems to be healing a little.

The one common element specifically mentioned by the three earnings winners from the aluminum industry this past quarter? Drastic cost cuts are finally kicking in (and not costing more than they're helping). Quarterly sales were down by at least 30% in all four cases, however, meaning these companies have been shrinking their way to success. Still, it's better than the alternative.

The Bad
Before anyone reads too much into the return to profitability for most of the industry, let me rein in not your enthusiasm, but your timeframe.

I do think better days are ahead, but greater quantities at higher prices are necessary to continue to fuel that growth. We've only seen tepid improvements on both fronts, and the outlook isn't compelling.

For starters, some estimates suggest there's an excess inventory of 6.3 million tons of aluminum out there just waiting to be sold. That's 62 days worth of demand, which is nearly twice the historical on-hand supply. Other estimates suggest there's a more conservative overhang of only 4.6 million tons. Either way, there's plenty of it out there already, which will contain aluminum prices - and crimp margins - as long as consumption and production don't change dramatically.

As for demand, the message is relatively mixed, though with a pessimistic bent.

Alcoa is looking for an 11% increase in global demand for aluminum in the last half of this year, which is in stark contrast to its competitors' forecasts. Norwegian-based aluminum producer DJ Norsk Hydro (OTC:NHYDY) doesn't see any significant demand growth (except for China) through the end of this year, and next year's needs aren't necessarily all that strong either. The Aluminum Corp. of China only foresees a 4% increase in demand for all of 2010.

It doesn't exactly bode well, though the hardest-hitting piece of negative evidence may come from China's total consumption trend. The country is on pace to consume 1.8 million tons of aluminum in 2009, but it's also on pace to more than meet that need by producing 13.2 million tons of it. Chalco's President Luo Jianchuan says the whole industry is still dealing with 20% to 30% more capacity than it needs.

The Reality
Yes, things are better for aluminum companies, but better is a relative term. Overall demand still remains soft, while massive stashes of aluminum are apt to keep prices low for awhile.

Eventually both problems will be solved, but it could be well into 2010 or later before we really start to see fireworks. And, it could be a long and frustrating road for investors in the meantime, given that other industries seem to be recovering much better. (For more, see A Beginner's Guide To Precious Metals.)

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