I have been a long-term bull on aluminium and there is a secretly quiet boom that has been occurring for over a decade. Now before discussing this boom, it needs be stressed that this is a boom in usage and not in the aluminium price as we, as investors, are typically accustomed to focusing on. A price boom in aluminium will come with time but there are ways in which investors can profit from now while still being exposed to the future potential of the aluminium industry.
The unique combination of regulatory requirements and increased adoption across the automotive, technology and aerospace industries is seeing an unprecedented usage of aluminium. In the US, car manufacturers must have a 34.1 miles per gallon (MPG) average range across their entire sales fleet by 2016 increasing to 54.5 MPG by 2025. Dispute court appeals this has now been upheld and is now the law. Similar requirements are present in Europe along with emission mandates of how much carbon dioxide can be emitted by engines per mile. The ramifications of these requirements will be threefold:
- Greater use of hybrid technology
- Smaller engines and turbocharged
- Lighter vehicles via an increased usage of aluminium and composite materials
Aluminium has for decades been used in aerospace and in exotic vehicles from Lamborghini, Porsche and Ferrari. Mainstream manufacturers are now rapidly adopting aluminium with a host of new cars from Land Rover, Jeep, Mazda, Lexus, Mercedes and even the highest selling vehicle in the world, the Ford F-series pick up truck, all using substantially greater amounts of aluminium. Tesla’s electric vehicles are made of aluminium and to increase range on hybrid and electric vehicles they need to be light.
The chart below shows that aluminium’s inclusion in motor vehicles has increase every year for the past 40 years and will accelerate for the next decade.
By 2025 global light vehicle aluminium content will be 16 million tonnes making the light vehicle market the most important driver for the aluminium industry. This consumption represents a 33% increase over 2015 aluminium consumption of 48.3 million tonnes.
This accelerating demand is not being reflected in aluminium prices yet and to be honest we don’t want it to. Prices rising too quickly now will reduce the adoption of aluminium in the automotive industry as it will prove too costly for mass market production. A lower price will convince mainstream manufacturers to continue to upgrade production facilities to use aluminium – an exercise that costs hundreds of millions of dollars.
LME stockpiles have been falling rapidly with the increase usage but Chinese dumping of aluminium in Asian markets have kept prices contained along with a stronger US dollar. But the increase in aluminium demand has appeared in other commodities, namely in the production of aluminium – alumina and bauxite.
Alumina prices have increased over the past year and are remaining relatively steady in Australian dollar terms as the chart below shows. Australia’s largest producer of alumina and bauxite – Alumina (AWC)via its 40% ownership of AWAC joint venture with Alcoa – is benefiting from a fall in the Australian dollar, improving alumina prices and falling energy costs as the industry is very energy intensive.
Alumina is almost debt free having sold some underperforming assets and with its cashflow no rapidly improving has begun to pay out dividends once more. In fact on FY2018 forecasts the yield on AWC is now comfortably above 8%. When taking into account the huge demand driving the downstream aluminium industry we can be comfortable that alumina prices will remain at current levels of around A$350/tonne or higher and therefore forecasts on future cashflows can be confidently forecastes. Moreover, Alumina continues to reduce its costs and improve EBITDA margins which now stand at $105/tonne as of the last quarter.
Our valuation metric suggests that at current alumina prices and currency levels AWC is valued at around $2.20. However, if the Australian dollar begins to fall south of 75c and alumina prices begin to head higher to just 2011 levels, AWC’s valuation is closer to $3.00 such is the leverage the company has to improving industry conditions, with the potential for a significant uplift in dividends along the way. In fact over the next 3 years UBS this week ranked AWC as the number one stock with best earnings profile across the ASX 200.
Therefore, the recent weakness in the AWC share price is one to take significant advantage of. The share price sell off has largely been the result of the fallout of iron prices (has nothing to with AWC) and wrongly, the fall in aluminium prices. While aluminium prices have fallen in the past 6 months AWC’s margins have actually improved some 25%, completely out of sync with market perceptions of how the business is performing.
Strong support exists on AWC in the $1.60/1.55 zone and we see this area holding the recent retreat and technical indicators are now starting to turn positive suggesting we are in the early stages of witnessing a turnaround in fortunes. Once AWC begin to surpass $1.65/1.70 this should trigger a buying rush similar to what was seen throughout 2014 and if so a return back to $2.00 at the very least could be underway.
As the CEO of Alcoa, Klaus Kleinfeld, stated last year – “This is the best industry conditions in 125 years”. It seems the world just hasn’t realized it yet.
