Industrial Metals Stock Outlook - May 2014 - Zacks Analyst Interviews

Even though iron ore exports from India have lessened significantly in the last two years as the court imposed a ban on mining, an improvement in export shipments is expected this year. Brazil will also hike its exports. In case this excess supply is not matched by adequate demand, it will expose the market to the risk of a further decline in prices.

Per the World Steel Association, global steel production is expected to increase 3.1% in 2014, less than half of last year's rate and the slowest pace in at least 15 years. After it soared 6.1% in 2013 aided by support from government infrastructure investment, apparent steel use in China is expected to slow to 3% growth in 2014 as the Chinese government's efforts to rebalance the economy continues to restrain investment activities.

An impending slowdown in China's growth is bound to affect prices as China is currently the largest producer of steel and consequently the largest consumer of iron ore, accounting for around 60% of the global seaborne market. Thus the mismatch between the excess supply and demand for iron ore will keep iron ore prices subdued in the near term.

Mining - Non-Ferrous: Aluminium

Price Trends

In 2013, aluminium prices slid and in the fourth quarter, London Metal Exchange (LME) aluminum prices fell to a four-year low, given the oversupply of the metal in the market (evidenced by large aluminum inventories in LME warehouses). Realized aluminum prices declined 8% year over year in the first quarter of 2014. Supply outpacing demand led to the dismal performance, which was aggravated by rising inventories. Industry results suffered because of the decline in realized aluminum prices.

Aluminium Industry: Outlook

After aluminum prices bearing the brunt of chronic surplus, the global aluminium industry is going through a substantial change. Companies have decided to cut back on production. Rusal, the world's largest aluminum producer, reduced production by 9% in 2013 compared with 2012. Rusal has effectively attained almost a 3-year low cash cost within the aluminium segment.

Likewise, Alcoa Inc. AA has taken up a number of restructuring measures (including closure of smelters), and is aggressively pursuing cost-cutting actions. Alcoa, during the first quarter, announced three smelting capacity reductions. Once all announced curtailments and closures are executed, Alcoa will have reduced its operating smelting capacity by 1.2 million metric tons, or 28% since 2007.

On the demand side, aluminum consumption is expected to improve on a global basis spurred by the automotive and packaging industries -- the key consumer market. The automobile market is also becoming increasingly aluminum-intensive, given the metal's recyclability and light-weight properties. The global push to improve fuel efficiency in vehicles is expected to more than double the demand for aluminum in the auto industry by 2025. The airline industry is also expected to boost demand for the metal.

Following China, which accounts for over 40% of the global aluminum consumption, India appears promising as its current low level of aluminum consumption and high urban population growth make a favorable combination. With demand remaining strong and the industry pulling the reins on supply, the aluminum market is likely to witness deficits for a prolonged period which creates a supportive backdrop of high aluminum prices.

Mining - Non-Ferrous: Copper

Movement in Copper Price & Performance

For the most part of 2013, oversupply and lack of demand kept copper prices in check. LME spot copper prices averaged $3.19 per pound during first-quarter 2014. Lower prices hurt results of copper producers like Freeport-McMoRan Copper & Gold Inc. FCX, Southern Copper Corp. SCCO and Newmont Mining Corp. NEM. Demand from key end markets, like construction materials and electronics, remained weak due to the overall economic softness. Weakness in the Chinese economy led to decline in copper demand as it accounts for about 40% of the world's annual copper demand.

In the wake of the decline in metal prices, copper companies have reduced their budgeted future capital expenditures, exploration and other costs and are looking to rid themselves of some of their saleable assets. In 2013, Freeport diversified from its bread-and-butter copper mining business by venturing into the U.S. energy space with the acquisition of Plains Exploration & Production Company and McMoRan Exploration Co. The merger positions the combined entity as a leading natural resource conglomerate in the U.S.

Copper Industry: Outlook

The scenario in 2014 will be similar to 2013 with demand and supply imbalances. Notwithstanding the current volatility in prices, we have a long-term bullish stance on copper, supported by its widespread use, limited supplies from existing mines and the absence of significant new development projects. Prices will be influenced by demand from China and emerging markets, economic activity in the U.S. and other industrialized countries.

Overall Industry Ranking

Within the Zacks Industry classification, the Iron Mining and Non-Ferrous Mining industries are broadly grouped in the Basic Materials sector (one of the 16 Zacks sectors). We rank all of 258 industries in the 16 Zacks sectors based on the earnings outlook for the constituent companies in each industry. This ranking is available on the Zacks Industry Rank page.

The way to align the ranking and outlook from the complete list of Zacks Industry Rank for the 258+ industries is that the outlook for the top one-third of the list (Zacks Industry Rank of #86 and lower) is positive, while the outlook for the bottom one-third (Zacks Industry Rank #172 and higher) is negative.

The Iron Mining industry features in the top 1/3rd with its Zacks Industry Rank #63 indicating a positive outlook, while the Non-Ferrous Mining industry features in the middle tier at Zacks Industry Rank with a Zacks Rank of #91 indicating that the outlook is on the neutral side. One could say that the near-term outlook for the group as a whole depicts a Neutral outlook.

Please note that the Zacks Rank for stocks, which are at the core of our Industry Outlook, has an impressive track record, verified by outside auditors, to foretell stock prices, particularly over the short term (1 to 3 months). The rank, along with the Expected Surprise Prediction ESP (Read: Zacks Earnings ESP: A Better Way to Find Earnings Surprises) helps in predicting the probability of earnings surprises.

Sector Level Scorecard in Q1

As we have crossed the halfway mark in the Q1 earnings season, for the 77.3% of the companies in the Basic Material Sector that have reported, earnings increased 1.2% in the first quarter of 2014, a much weaker performance than the 29.3% rise in earnings witnessed in the fourth quarter of 2013. Taking into account all the companies in the Basic Material sector that are yet to announce their results, earnings is expected to dip 2.2%.

The expected earnings dip should not make investors shy away from the Basic Material sector as the feebleness in the first quarter is broad-based and not concentrated in any one sector. Of the 16 Zacks sectors, 5 are expected to experience a year-over-year earnings decline.

Q2 & Beyond: What Zacks Predicts

In the second quarter of 2014, earnings of the Basic Material sector is expected to recover and grow 11.6% and accelerate further to 14.6% in the third quarter. In the fourth quarter, earnings growth is expected to decelerate to 6.1%. Overall in fiscal 2014, earnings are expected to grow 10% and thereafter at 18.2% in 2015.

Overall Industry Outlook

Overall in the metals market, increased supply and insufficient demand exerted a downward pricing pressure on commodities and this trend is expected to continue over the short term. Additionally, cost inflation is expected to be a headwind for metal and mining companies over the next several years, driven by a number of factors: labor, energy, ore grades, currencies, supply constraints and taxes. Global economic uncertainties, softening commodity prices and higher input costs are increasing the pressure on company margins.

To combat this, mining and metals companies are reviewing their portfolios to identify underperforming assets and to shut down or divest these high-cost and non-core assets. Industry consolidation, automation technology, owner-operated mines and investment in energy assets are some of the steps that these companies are taking to mitigate the impact of rising costs.
 
Growth in the U.S. and an improving global macroeconomic scenario in tandem will boost demand in the industry. Revival of the Chinese economy will be instrumental in driving growth in the industry.
 
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