Moody’s has placed Alcoa‘s (NYSE:AA) Baa3 senior unsecured rating on review for a potential downgrade late Tuesday. The review is applicable to all of the company’s total debt of $8.3 billion. The major reasons cited were the fall in aluminum prices this year and weak prospects of a sustainable and significant recovery in prices over the next several quarters. 
Aluminum prices on the London Metal Exchange, which are used as a benchmark by the company to determine its own prices, have averaged $2,051 this year. This is 15% lower than last year. Prices touched a 34-month low in August as global supply exceeded demand. 
Why Is Moody’s Placing Heavy Emphasis On Aluminum Prices?
Alcoa is organized into four business segments: Alumina, which mines bauxite and processes it into the precursor to aluminum; Primary Metals, which smelts aluminum; Flat-rolled Products, which makes sheets used in beverage cans as well as airplane wings and car parts; and Engineered Products and Solutions, which makes aerospace fasteners, turbine blades and truck wheels. While the Flat-rolled and Engineered Products and Solutions divisions produce value-added products and thus generate higher margins, a significant proportion of Alcoa’s earnings still come from the Alumina and Primary Metals divisions. This makes its earnings highly sensitive to aluminum prices.
Is Alcoa Cognizant Of Its Problems?
Alcoa’s management claims to be working to increase Alcoa’s profitability in divisions that produce engineered products and supply aerospace customers while cutting costs in its mining and smelting segments. In October, Alcoa cut its 2012 global aluminum demand forecast to 6% from 7%, but maintained its long-term outlook that aluminum demand will double in 2020 from 2010 levels. However, this says nothing about the performance expected over the next couple of years or so, which according to Moody’s, doesn’t inspire confidence. 
Alcoa reported an operating loss figure of $143 million in Q3 2012. Moody’s thinks that the company should pare down its debt in line with its lower earnings rate. Alcoa claimed recently on its Investor Day in November that it has cut $5 billion in costs since 2008 through productivity improvements such as increasing yields out of its refineries and streamlining operations by cutting capacity in smelters.
A company spokesperson said that the company has cut its near-term maturities to roughly $400 million over the next four years (excluding 2014 convertible bonds), and expects net debt to be down 30% from 2008 to between $6.8 billion and $7.1 billion by end of 2012. We think that Moody’s will prefer to wait to see the company stick to its commitments, rather than taking it on its word at the moment. 
There is little Alcoa can do about aluminum prices, which are probably being driven not by fundamentals but investor sentiment and macroeconomic factors such as the Euro zone crisis, worries over mounting U.S. debt and the hotly debated fiscal cliff situation, and the slowdown in China. Fundamentals alone cannot explain the volatility that has been observed in aluminum prices this year. What Alcoa can and must do is to focus more on engineered products to improve margins and earnings. In an environment of slow economic growth, it would be a stretch to expect aluminum prices to trend upwards because it is primarily an industrial metal.
We recently revised the Trefis price estimate for Alcoa to $10 after the third quarter earnings results.Notes: