Alcoa: Aluminum Prices Are still Key, but Watching Some Positives

Alcoa (NYSE:AA) reported Q3 earnings that beat estimates and the stock price rallied on the news. The positive results were driven by success in the downstream business (that makes aluminum parts for cars, planes, etc.) and productivity enhancements. However, Alcoa's results should be viewed in the context of aluminum prices, which were stable for Q3 and did not provide a headwind like in previous quarters. Going forward, aluminum prices will continue to drive the stock price. Aluminum prices are trading near multi-year lows and face headwinds, but have held a key level, so far. In this article, I will analyze the dynamics of aluminum prices and the impact on Alcoa. Although I am still cautious about aluminum, there are a few positives to watch.Basic Thesis On AlcoaThe following is my basic thesis about Alcoa from my previous article:My recent articles on Alcoa can be found here:LME Aluminum PricesThe price for aluminum on the London Metal Exchange (LME) is $1,875 m/t (3 month buyer). Aluminum prices have been weak for a couple of years:(Source: LME.com)However, in Q3, the price of aluminum was fairly stable.(Source: LME.com)As a result, aluminum prices did not act as a significant headwind for Alcoa like in previous quarters. Just because Alcoa generated good results in Q3, does not mean that aluminum prices are no longer a key driver of the company or the stock.Alcoa's management estimates that a $100 m/t swing in aluminum prices has a $240 million impact on annual net income (source: Alcoa's Q3 2013 earnings presentation)Alcoa can counter the negative effect of lower aluminum prices with productivity improvements and other actions. However, the headwind still exists.PremiumsThe price that Alcoa gets for the aluminum that it produces is based on the LME price, plus regional premiums (plus any value-added impact).Regional premiums have started to show some weakness:(Source: Alcoa Q3 2013 earnings presentation)Proposed changes to LME rules may be dragging down regional premiums: LME changes hurt aluminum premiums - Alcoa executives.Supply / DemandAlcoa updated its supply/demand outlook for aluminum and projects a 400,000 m/t deficit in 2013, a slightly larger deficit than projected at the end of the last quarter.(Source: Alcoa Q3 2013 earnings presentation)Despite the projections for a deficit, aluminum prices have been weak.Rusal, another large aluminum producer, seems more concerned about the supply/demand balance. Rusal's management recently stated:For more about production cuts, please see my previous article.Other MetalsThe trend in aluminum is similar to the trends in copper, gold and silver. It will be interesting to see if the broad weakness across the metals continues or if divergences emerge.In the meantime, weakness in gold/silver could continue to be a negative catalyst for aluminum.Aluminum (3 month buyer):(Source: LME.com)Copper - iPath Dow Jones UBS Copper Total Return Sub-Index ETN (NYSEARCA:JJC)JJC data by YChartsGold - SPDR Gold Trust ETF (NYSEARCA:GLD):GLD data by YChartsSilver - iShares Silver Trust ETF (NYSEARCA:SLV):SLV data by YChartsFinancials & ValuationThe key aspects of Alcoa's valuation:EstimatesAnalyst estimates increased slightly following the Q3 results.Stock PriceAlcoa's stock has been making lower-highs going back to 2011.I have been watching the $8 level as a key "bounce or breakdown" point. Although the stock dipped below $8 over the summer, it has bounced back.On an encouraging note, Alcoa's stock price has made higher-lows since July and has acted well following Q3 earnings.(Source: FreeStockCharts.com)Short InterestShort interest in Alcoa's stock has been increasing over the last few months.(Source: Nasdaq.com)Analyst SentimentPrior to the Q3 results, there were a couple of notable downgrades:Following Q3 earnings, analysts still seemed cautious:Key PositivesI have been (and remain) cautious on Alcoa, but it is important to recognize a few positives. The stock price may bottom before good news emerges.ConclusionsAlcoa generated good results in Q3. However, aluminum prices were neutral, compared to a headwind in previous quarters. This leads me to believe that the price of aluminum is still the key driver for the stock, despite the company's positive operational performance.Aluminum still faces more headwinds. Alcoa's supply/demand forecast seems to be at the optimistic end of the industry. The supply glut may continue to put pressure on aluminum prices.Despite the negativity, Alcoa's stock price has held up well. Maybe the negativity is priced-in.The key levels remain an $8 stock price and aluminum above $1,800 m/t.Disclaimer: The opinions expressed above should not be construed as investment advice. This article is not tailored to specific investment objectives. Reliance on this information for the purpose of buying the securities to which this information relates may expose a person to significant risk. The information contained in this article is not intended to make any offer, inducement, invitation or commitment to purchase, subscribe to, provide or sell any securities, service or product or to provide any recommendations on which one should rely for financial, securities, investment or other advice or to take any decision. 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