China’s aluminum giant is a lightweight stock

Investors could be forgiven for thinking Aluminum Corp of China’s return to profitability, fatter margins and surging share price makes the lightweight metal producer a stock to own but that may not be the case.

The company, better known as Chalco, may be a giant of China’s aluminum industry but it’s a pygmy where it counts: profits, revenue growth and return on capital. The first quarter results delivered a miserly profit of CNY63 million struck off a 22% year-on-year fall in revenue, the lowest top line performance since the global financial crisis. While at first brush these numbers may appear uninspiring, the depressing reality is they represent a significant improvement on the CNY10.8 billion loss delivered in the prior quarter.

Although investors don’t seem bothered with whimsical concerns like earnings growth given Chalco’s Hong Kong and Shanghai shares have, respectively, powered 50% and 53% higher this year. This represents a victory of momentum investing over the underwhelming fundamentals of China’s aluminum industry, one in which the price for the lightweight metal actually posted a 4% decrease in the quarter. The fact the company is looking to raise equity capital through the issue of additional Shanghai-listed A shares is tacit admission by management that the current share price may be as good as it gets for a while, a sentiment with which Barron’s Asia agrees given the massive premium to book value at which the stock trades.

Overcapacity lies at the heart of the Chinese industry’s problems and Chalco needs to do its bit to deal with a glut of the metal. “Less is more” appears to be the management mantra in the global metals and mining industry but Chalco apparently didn’t get the memo. The theory is that a simplified and focused portfolio of assets is the right path to take in the pursuit of higher returns at a time of beaten down commodity prices. While the market debates the pros and cons of BHP Billiton’s $15 billion spinoff of its non-core assets into South32, investors have got too far ahead of themselves on the turnaround prospects for China’s largest aluminum producer given the super slow motion pace at which it is restructuring and shedding its wanted assets.

The combination of excess supply and weak aluminum prices has left Chalco’s finances stained with red ink. It defies credulity that a company that has recorded negative free cash flow – or cash available for distribution to investors – for the past six years could enjoy such a hefty rise in its share price, especially given analysts forecast the trend to continue into 2015. While heavyweights of the global aluminum industry like Alcoa, Rusal and Norsk Hydro have decided to shrink their way to glory through capacity cuts and strict capital expenditure discipline, Chalco continues to keep spending.

The brutal economics of where Chalco sits on the cost curve should spur the company’s management to take a more forceful approach to restructuring. Bernstein Research estimates that its assets inhabit the highest quartile of costs for aluminum smelting and bauxite mining, while its alumina refining assets fare only slightly better. With Shanghai Futures Exchange aluminum down about 8% over the past six months, it is difficult to see Chalco achieving profitability, or more importantly positive free cash flow, for the foreseeable future without more radical cost cutting and asset sales.

The cost of power is another pressing issue for the maker of a commodity known as ‘solid energy’. Lowering electricity costs are essential to bolstering the bottom line and the company has invested significantly in its own power generation capacity, but it remains at the mercy of the National Development and Reform Commission to drop power tariffs or for coal prices to fall further to reduce the cost of its own supply.