Alcoa (NYSE:AA) deserves a lot of credit for managing a difficult aluminum market and continuing to make productivity improvements. Unfortunately, the market doesn't reward feel-good stories. Accordingly, while Alcoa shares continue to look cheap and the long-term aluminum market fundamentals look better, it seems probable that these shares won't really work until aluminum prices get going again.

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A Pretty Strong First Quarter, Relatively Speaking
Alcoa's first quarter wasn't great in absolute terms, but the company did do a fair bit better than expected and Wall Street is all about relative performance.

Revenue rose about 1% as production and shipments were higher across the board despite tough pricing. Profitability was more problematic, though. Gross margin slid more than five points, while operating income fell around 57% and EBITDA fell roughly 25%.

Weakness in the Profitable Alumina Segment
One of the big headwinds for Alcoa was the relatively poor performance of the alumina business. Alumina production is actually more difficult than aluminum smelting, and Alcoa actually enjoys a substantially larger share of the global alumina market (about 20%) than the aluminum market (near 10%). What's more, it is generally a much more profitable segment.

This quarter, though, after-tax margins in alumina plunged. After-tax operating income dropped approximately 75% despite a 3% year-on-year production increase. Backing out additional information, it looks like Alcoa was squeezed by simultaneous price declines and cost increases.

There also seems to be an overcapacity in the alumina industry right now. While alumina production is dominated by large companies like Alcoa, Rio Tinto (NYSE:RIO), Chalco (NYSE:ACH) and Norsk Hydro (OTCBB:NHYDY), that isn't proof against supply imbalances. Alcoa looks set to address this with further capacity cuts, but cutting capacity in what has historically been a very profitable business is definitely a mixed blessing.

SEE: Aluminum Reality Check

End-User Markets Looking Better ... Sort of
End-user aluminum markets seem relatively healthy in many respects. Demand in commercial aerospace is growing by double-digits, demand in automobile manufacturing is good and Alcoa's management is seeing a less-bad market for global trucks and trailers.

All of that is nice, but aluminum prices are still weak - recently around 93 cents a pound on the London Metal Exchange. That's below the estimated cost of production in China (around $1/lb.), but I'm reminded of Keynes' famous quote that markets can stay irrational longer than you can remain solvent.

Underlining a problem for Alcoa is an issue it shares with BHP Billiton (NYSE:BHP), Vale (NYSE:VALE) and Freeport McMoRan (NYSE:FCX) - the large impact of incremental Chinese demand. Right now, the Chinese economy is soft and that's pressuring a lot of metals. The $64,000 question, though, is whether this is just a momentary soft patch or whether the "China effect" is on its downward slope for the commodity sector.

The Bottom Line
I struggle to accept the idea that Chinese commodity demand has peaked for the decade. Be that as it may, Alcoa is still struggling within a weak market - though management ought to be commended for its progress on productivity initiatives.

Perhaps not surprisingly, consensus EBTIDA estimates have dropped significantly - by about 10% over the past three months. Given Alcoa's outperformance this quarter, though, maybe conservative analysts have over-corrected and there's still legitimacy in the old estimates of about $3.3 billion in 2012 EBITDA. If that's the case, and Alcoa still deserves a seven times multiple, these shares are still worth about $14 on that basis.

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At the time of writing, Stephen Simpson did not own shares in any of the companies mentioned in this article.

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