Alcoa (NYSE:AA) will kick off this quarter’s earnings season when it announces its Q4 results after the market closes on Tuesday, January 8. Alcoa’s results are closely eyed as it usually is the first Dow company to post earnings. We expect the company to record soft earnings, but most investors will watch for any cues on its outlook. Aluminum prices and demand remain sluggish due to global economic conditions. Also, aluminum inventory continues to remain high relative to demand, keeping a further lid on London Metal Exchange (LME) prices for aluminum.
In December, the rating agency Moody’s put Alcoa’s debt rating on review for a possible downgrade citing a challenging operating environment and a fall in aluminum prices this year. According to Moody’s, aluminum prices are not expected to show significant recovery 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. 
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Alcoa’s management has taken certain steps to meet challenges. It is making efforts to reduce its debt from present levels of $8.3 billion, shifting its focus to value added products used in the aerospace industry and cutting capacity in smelters to streamline operations.
Importance Of Aluminum Prices For Alcoa
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.
Aluminum Price Trend In Q4
The continuing European debt crisis, slowing Chinese growth, and the U.S. fiscal cliff situation have contributed to the decline in aluminum demand and prices over the last few quarters. The price trend chart on the London Metal Exchange (LME) shows aluminum prices falling steeply from nearly $2,100 at the beginning of Q4 to breach $1,900 before rallying back steadily to about $2,100 as of today. However, prices failed to breach the $2,200 mark throughout the quarter. As mentioned before, we think that high inventory levels are keeping a lid on prices. While LME prices are not the actual realized prices for Alcoa, they do indicate a broader trend in global aluminum prices.
What Does The Fiscal Cliff Deal Mean For Alcoa?
A fiscal cliff deal was reached and ratified at the beginning of 2013 and Alcoa stock prices received some boost. However, at this point it would too early to claim a positive long term gain. Manufacturers and the rest of the U.S. economy still face uncertainty on the debt ceiling, in addition to the delayed budget cuts. At best, it seems like the can has been kicked down the road.
What Is Alcoa’s Management Doing To Meet Challenges?
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. 
Alcoa reported an operating loss figure of $143 million in Q3 2012. We think that the company should pare down its debt (currently $8.3 billion) in line with its lower earnings rate. Alcoa claimed 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.
Alcoa says that it 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. 
The company’s recent strategy realignment and capacity cuts for smelters and alumina refining should continue to drive productivity improvement. Further, its Saudi Arabian project is on track and is expected to start full-fledged operations in early 2013. This will help the company’s efforts to geographically diversify its operations. Additionally, vertical integration should help the company maintain healthy margins even with depressed prices.
We believe that Alcoa’s long-term fundamentals are strong while it continues to face near term headwinds. 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 have a Trefis price estimate for Alcoa of $10 which will be revised after the fourth quarter earnings results.Notes: