CENX - Century Aluminum: More Headwinds To Profitability But Neutral On Shares

2023-10-19 15:00:25 ET

Summary

• This analysis does not assume that Century Aluminum Company stock will recover anytime soon, but rather that it will continue to perform according to a neutral stance.
• The stock is influenced by factors that negatively impact aluminum prices, including high borrowing costs and slow recovery in China.
• The company's profitability is expected to deteriorate in the short term, but most triggers are likely already factored into the stock's market value.
• Potential buyers have the chance to capitalize on a big opportunity if the economy goes into recession, while market participants appear to have settled on a soft landing scenario.

This Analysis Recommends a Hold Rating on Century Aluminum Company’s Stock

Century Aluminum Company ( CENX ) is a Chicago, Illinois-based manufacturer of aluminum products in the United States and Iceland.

This analysis assumes that this stock will continue to be impacted by factors that will not support the price of aluminum products for some time yet. These headwinds are largely due to high borrowing costs and elevated core inflation, which together create conditions that hinder growth in Western economies. Added to this is the slow recovery of China, whose economy is now grappling with serious crises in the real estate sector, after struggling with the impact of restrictions due to the COVID-19 virus.

It must be said that these headwinds should not lead to a significant decline in the share price of CENX, as the market has already largely priced them. After all, how long are the same topics in the daily narrative now? Central banks' tight monetary policy to curb core inflation; higher interest rates until the labor market loses some of its resilience; geopolitical tensions between countries and the consequences of armed conflicts on the prices of raw materials and fossil fuels. Barring a recession, which doesn't necessarily have to be the case to send the stock market into a real crisis and drag down CENX stock, the US aluminum producer's shares are expected to follow a trend that currently warrants a neutral view. However, this analysis leaves a small door open to the possibility of an economic recession given that the inverted US Treasury yield curve has been signaling it for months now. In that case, this analysis will not see a recession as a problem, as very interesting opportunities could arise for potential buyers looking for attractive entry points to gain exposure to the aluminum market through CENX. This analysis assumes that the scenario where CENX shares perform in line with the neutral stance is, however, highly likely. Instead, the scenario where CENX shares are hit by an economic recession has a very low probability of occurring based on what it seems from the daily narrative in my view.

Favorable Winds Will Blow Again on the Aluminum Market

I believe the stock has the potential to experience a strong recovery in the market, just as it did in the first half of 2021 when the easing of restrictions on the economy to limit the spread of the COVID-19 virus led to a rapid growth in demand for various raw materials, including aluminum. This had a positive effect on CENX's profitability, as the price of aluminum products rose amazingly, and shareholders benefited from the momentum in the form of a subsequent strong increase in the share price.

There will be a new cycle of rising commodity prices in my opinion, including aluminum, which could drive CENX share prices to higher levels, and this will likely occur as a result of the Fed's decision to ease its monetary policy, which currently consists of keeping interest rates “higher for longer”.

The Fed's policy rate cut, expected to begin sometime in 2024 according to this chart from Yahoo Finance , will also help restore positive sentiment in the industry. This sentiment is currently missing, which has a negative impact on aluminum demand and is the reason for the low price per ton.

From today's perspective, it is very difficult to predict when the price of aluminum will rise again, as the macroeconomic and geopolitical environment is currently extremely volatile. But it will happen anyway, because aluminum markets, like commodity markets in general, are characterized by fluctuations, although with a tendency to increase over the years.

The Situation of The Business at CENX

Currently, the stock price reflects modest profitability as the company's policy is more focused on controlling costs than increasing production. In addition to the low prices of aluminum products in the market, the company will not be able to ship more aluminum products until the economy needs more of these industrial goods than it can currently absorb.

Therefore, a low market price of aluminum, which is also expected by both Jesse Gary , president and CEO of CENX, and analysts at Trading Economics , due to weak demand, will continue to affect the company's results in the short term. Sales of refined aluminum products are not expected to perform better against the current background and its likely development in the short term.

At least for the entire second half of 2023, corporate profitability - a key catalyst for rising stock prices - appears to have no reason to improve compared to the first half of the year. Profitability hovered around levels of $24-$30 million for EBITDA and 4.4-5.1% for EBITDA margin in the first half of 2023.

For the latter part of 2023, the company even expects a worse EBITDA figure of $10 million - $14 million, which, if the company confirms the trend of the last twelve months in terms of sales volumes - let's say no more than 175,000 tons of aluminum products delivered quarterly – and with an expected "realized LME aluminum price" of around $2,020 per ton, then leads to an estimate that the EBITDA margin should be between 2.8% and 4%. The “realized LME aluminum price” estimate of $2,020/ton is approximately 4% below the average between the current market price for aluminum products per ton and the analysts' 12-month price target . This is because the price CENX received from selling its aluminum products was, on average, 4% below the market price over the past 10 quarters.

The estimate of CENX' future profitability is calculated as the ratio of expected adjusted EBITDA per ton of aluminum shipped [ = ($14 million X 4 quarters) / (175,000 tons of aluminum products shipped X 4 quarters)] to expected realized LME aluminum price per ton ($2,020 per ton) which differs a little from the adjusted EBITDA margin conventionally calculated as a percentage of net sales. From a statistical perspective, the difference consists of a standard deviation of 110.13 basis points from an average of 222 basis points.

Therefore, this analysis assumes that CENX's future operating profitability calculated using the traditional method will be approximately 3.5%, which represents a deterioration compared to the first two quarters of 2023, as shown in the table below.

Should this be the next opportunity for Century Aluminum Company to generate revenue, given the unfavorable direction the global macroeconomic scenario is heading for aluminum fundamentals, it is reasonable to assume that the share price may continue to experience headwinds that could greatly affect its chances of recovery in the near term.

This is because the estimates are significantly below adjusted EBITDA levels of $70 million for Q3-2021 and $106 million for Q1-2022 and below adjusted EBITDA margin levels of over 12% for Q3-2021 or compared to the peak of 14% during Q4- 2021. These are CENX's profitability levels when the recovery from the COVID-19 pandemic crisis required CENX to market over 190,000 tons of aluminum products on a quarterly basis.

Supporting the explosive release of pent-up demand for aluminum products, CENX shipments reached 215,000 tons in the second quarter of 2022. These levels were sky-high compared to the first part of 2023. The comparison provides a clear picture of how the company had to slow down its operations to adapt to the new, weaker fundamentals of the aluminum products market. In the first half of 2023, they were significantly lower, reaching 173,649 tons in the second quarter of 2023 and 181,165 tons in the first quarter of 2023.

In terms of sales prices, the “realized LME aluminum price” averaged $2,700/ton between late 2021 and early 2022. Or even the peak of $3,061 per tonne reached in the second quarter of 2022 before the rise in energy prices created serious new headwinds to corporate profitability for Century Aluminum Company and other operators in the industry. These past price levels are huge compared to where aluminum prices are currently headed, based on estimates from Trading Economics analysts.

The Outlook for the Aluminum Product

Analysts see a significantly lower price for production from CENX and of course other industrial operators, mainly due to two things: a “higher for longer” hawkish stance from the US Federal Reserve on interest rates needed to continue to counter elevated core inflation, and a slowing Chinese economy. These factors are proving to be so detrimental to the demand for aluminum products that they are affecting the sentiment of an entire industry .

The weakening of demand conditions, as evidenced by the ongoing deterioration in consumer confidence , will also affect future aluminum supply volumes.

This is because the rate hike reduces near-term growth prospects for many key sectors that require aluminum products. For example, the construction sector, one of the largest users of aluminum products, currently faces a very bleak outlook due to lower demand for loans to purchase a house and lower demand for refinancing an existing loan to purchase a more expensive place of living. The increase in the cost of money, along with core inflation remaining well above the 2% target, is weighing on the purchasing power of US households.

Moreover, consumption now also lacks support from China, which normally absorbs a large share of the global supply of aluminum products, largely due to the crisis currently affecting the main pillar of the Chinese economy, the real estate sector.

The economy of the Asian country and the world's largest aluminum consumer by volume is paying for the financial woes of China Evergrande Group ( EGRNQ ) and Country Garden Holdings Company Limited ( CTRYF ) ( CTRYY ) in a way these major real estate companies cannot meet their offshore obligations, leading to uncertainty about the creditworthiness of an entire sector.

To support the price of aluminum, China, which is not only a consumer but also a major producer, is trying to prevent factory production capacity from exceeding certain domestic limits by operating assets more discreetly and avoiding inefficient infrastructure. At the same time, Indonesia has also joined China's efforts to curb global aluminum supplies by banning bauxite exports. Bauxite is the main mineral from which aluminum is made.

However, if China and Indonesia, which have the ability to influence global aluminum supply, indeed do so shortly, this could be confirmation that global economies see the demand for aluminum products remaining weak for the foreseeable future.

The Financial Condition of CENX

As long as these global conditions remain complex and their macroeconomic challenges impact markets for aluminum products, Century Aluminum Company will probably focus on careful resource allocation and maximum cost control in the face of declining aluminum prices and the threat of a resurgence of expensive energy procurement as a result of the conflict in Ukraine and the Hamas attack on Israel.

The company says it has total liquidity of $231.1 million as of June 30, 2023, which is significantly higher than the $50.6 million available in cash on hand and short-term securities.

Debt exposure was high and amounted to approximately $575.2 million as of June 30, 2023. Although this was largely due to the availability of lines of credit for use with banking institutions in the United States and Iceland, and not solely the $246.6 million senior loan, there is currently a financial liability that cannot be covered by operating income.

Primarily due to weak aluminum demand and prices, the twelve-month operating income was a loss of $55.2 million, compared to the twelve-month interest expense of $33.7 million as of the second quarter of 2023 . The negative dynamics result in money being burned rather than created until aluminum market conditions improve.

This situation could raise concerns among investors about the company's ability to remain solvent until conditions in the market for aluminum products become more favorable, which will occur at some point in the future, as these markets are cyclical. However, besides total liquidity available, the potential to release $127 million worth of resources invested in working capital as of Q2-2023 will help ensure CENX has the necessary coverage to meet its financial obligations, including meeting CapEx needs.

The inventory, which represents 73% of total current assets as of Q2 2023, has significant potential to avert major financial problems as it can free up a significant amount of cash that CENX will use to finance the continuation of its operations and enable its investors to continue to benefit from the volatility of aluminum prices.

Additionally, CENX will likely maintain capital expenditures at the recently observed level of approximately $70 million or lower until the price of aluminum products enters its new up-cycle.

The Stock Valuation

Retail investors should be aware of the following: Century Aluminum Company share prices are expected to remain under pressure due to an expected further decline in profit margins, but not to the extent that there will be a significant pullback as most triggers are already priced in.

This analysis also estimates a target price that can be used to gain exposure to the aluminum products market through CENX, should the economy enter a severe recession. An amazing entry point will put the retail investor in a stronger position for the next price increase in the industrial commodity, which will simply happen sometime in the future. A trigger could come from the Fed as soon as its policy markers change their view on interest rate policy, and this could likely happen sometime in 2024.

However, for now, it is appropriate to stick with a Hold rating.

Shares were trading at $6.82 per unit giving it a market cap of $628.22 million as of this writing. Additional bearish sentiment, based on short interest at 18.11%, appears to be translating into short-lived headwinds. This could temporarily push the stock further below the current 50-day moving average of $7.29 and widen its range from the 200-day moving average of $8.88.

Shares are also 27% below the middle point of $9.345 in the 52-week range of $5.72 to $12.97.

With interest rates expected to peak at 5.6% from the current range of 5.25%-5.5% before the end of the year, and the risk of energy costs rising again amid geopolitical tensions and conflicts, shares of CENX have more than one reason to fill the gap to the downside between the 14-day RSI, currently at 48.12, and the oversold level at 30.

However, since the U.S. stock market has likely largely priced in the ongoing headwinds, an economic recession would now have to occur to create the headwinds that would cause CENX stock to plummet in my view.

Will a Recession Occur?

Retail investors may want to closely monitor the spread between the one-year U.S. Treasury bond yield and the 10-year U.S. Treasury bond yield, as this indicator, which currently consists of an inverted yield curve, continues to point to a recession.

Under normal circumstances, the curve is not inverted in the sense that the yield on 10-year U.S. Treasury bonds is higher than the yield on one-year U.S. Treasury bonds. Because longer-term loans carry a greater risk of financial insolvency than shorter-term loans, the former should also normally provide a higher reward than the latter.

Thus, the indicator that short-term yields are outperforming longer-term yields indicates that the short-term outlook is considered much riskier by investors than before, and this could likely herald the start of a sharp deterioration in the economic cycle.

This indicator has proven to be very good at predicting an economic recession. As the GuruFocus chart shows, seven of the seven negative cycles of the last nearly sixty years were predicted by an inverted yield curve.

Currently, the one-year yield is 5.471% versus a 10-year yield of 4.845%.

A recession spells such bearish sentiment for U.S. stocks, which in light of a 24-month beta of 2.12 times, should create strong headwinds, potentially sending CENX stock plummeting from current levels.

I believe there is no great chance of this economic recession scenario happening, as the persistent narrative suggests that the Fed can raise interest rates just enough to slow the economy and cool inflation, but not so much as to stop the cycle and force a recession.

But this narrative has been dominant for months, meaning that if a recession were to actually occur, it would catch almost all market participants by surprise and the consequences could be severe for the stock market as well.

Recession: Very Low Chance, but Would Reduce the Disconnect Between the Market and the Value of CENX’s Profitability

Let's now estimate the price target that would be appropriate for CENX stock, as this would be in line with the likely near-term profitability that this analysis previously estimated for this company. This is a target price that the stock could achieve if the economy enters a recession.

First, let's assume adjusted EBITDA of $56 million for the trailing twelve months through Q2 2024. This represents an annualized measure on the high end of the company's guidance of $10 million to $14 million for the third quarter of 2024.

Then, Century Aluminum Company has the following Enterprise Value (EV) equation: The EV of $1.18 billion is equal to the market cap of $628.22 million plus total debt of $575.20 million plus other items of $31.90 million minus cash of $50.60 million.

Since Century Aluminum Company has an estimated adjusted EBITDA of $56 million in forward terms, its EV/forward adjusted EBITDA ratio is currently 21.70x.

But as a benchmark for the assessment of the US-listed stocks of the aluminum producers, Aswath Damodaran, professor of corporate finance and equity valuation at New York University's Stern School of Business, suggests an EV/EBITDA ratio would need to be 5.30x to qualify the aluminum stock as fairly priced by the market.

Therefore, assuming all other components remain more or less at current levels, the market capitalization of CENX stock must decrease by 52.76% to $296.8 million, implying a share price of $3.22 given that there are 92.38 million outstanding shares in circulation.

However, it is a very low price that the stock would only reach in exceptional cases such as a severe economic recession which frankly cannot even be ruled out at the moment, but whose probability of occurring is very marginal, according to the prevailing narrative.

The share price has never fallen by this magnitude. However, due to the positive correlation between the stock and the price of aluminum, there may be a chance for CENX stock to move closer to the $3.22 price target in the event of a recession.

After the rapid recession due to the outbreak of the covid-19 pandemic crisis, the CENX share price traded around that level.

The gray area in the chart above is almost always above zero and therefore implies strong positive correlations between CENX and the aluminum price. The positive correlation means that when the price of aluminum falls, CENX shares will also behave accordingly.

The reader could get confused by the fact that the share price has gained 7.42% in the last 12 months, while the aluminum price has lost 5.92%. This performance is the result of the difference between prices twelve months ago and current prices but cannot explain anything that happened in between. The correlation between the securities remains positive, but with the peculiarity that the aluminum price has a different slope towards the x-axis than the CENX stock price towards the x-axis. This trend is due to the aluminum price falling much faster amid bearish sentiment than its ability to recover when sentiment rose again.

In the chart above, aluminum futures (ALIZ2023) are the benchmark for aluminum prices.

Conclusion

Century Aluminum Company's profitability continues to be threatened by various adverse macroeconomic and geopolitical factors that will affect demand and market prices for aluminum products and cause production costs to remain high.

Currently, the shares appear overvalued compared to the expected profitability of their business. Most of the headwinds have already been priced into the market value of this stock, so the stock price is not expected to drastically change its performance patterns in the near future.

A drop in share price that will align EV/EBITDA to the 5.30x target could follow if the economy enters a recession, which the inverted US Treasury yield curve continues to indicate as the next cycle for the US economy. Such a cycle deterioration, which will objectively create opportunities as shares approach oversold levels, has little chance of happening according to the dominant narrative in my opinion.

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