Alcoa (NYSE:AA) released its fourth quarter earnings on Tuesday. The company’s reported revenues of $5.9 billion were higher 1% sequentially on better aluminum pricing but down 2% compared to last year. Despite 5% higher aluminum prices sequentially at around $125 per tonne, weaker demand from packaging, industrial, and commercial transportation markets impacted on results. While weak demand from the packaging segment can be attributed to seasonality, we think that the demand trends in the industrial segment and the commercial transportation segment are reflective of the general state of the economy. 
Net income for the fourth quarter stood at $242 million compared to a net loss of $143 million in the previous quarter and $191 million in the fourth quarter of 2011. Full year net income was $191 million compared to $611 million in 2011. 
Alcoa managed to reduce costs and the working capital cycle and increase productivity. It also monetized non-core or non-optimal assets to boost its liquidity position. We think that the larger goal was to maintain its investment grade rating which has been placed under review by Moody’s. The company management also stressed its overriding focus on cash generation in order to keep debt at sustainable levels and be able to meet pension costs.
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The company management pointed out what has already been known for some time: that the prices of aluminum on the London Metal Exchange (LME) are being heavily influenced by macroeconomic factors and sentiment rather than supply-demand fundamentals. What was noteworthy was that while data for primary aluminum showed a slight supply deficit, the supply-demand dynamic for alumina was shown to be in balance. The slight supply deficit for primary aluminum can’t be causing the high volatility being witnessed in aluminum prices on the LME. 
The realized price of aluminum for Alcoa fell by 12% year-over-year which impacted revenues by around $1 billion. The company charges a premium on LME benchmark prices and witnessed these premiums coming under pressure.
Productivity Related Improvements Offset Cost Escalations
Alcoa managed to increase the productivity of its operations and reduce costs. The company estimated that the benefits due to these amounted to $1.3 billion for the whole year. While overall operating costs increased this year, mainly on account of higher prices for natural gas, fuel oil and transportation costs, they were more than compensated for due to productivity related improvements. While additional cost escalation for the year amounted to $670 million, the value captured through productivity improvement amounted to $786 million. The additional value boosted the company’s bottom line. Considering that Alcoa’s net income for the full year stood at $191 million, it is a pretty significant contributor to profitability. Since it is only to be expected that in a weak economic scenario neither demand nor volumes sold would increase much, productivity would always be an important factor in determining profitability.
Automotive And Aerospace Segments
Alcoa witnessed robust global growth in the aerospace segment to the tune of 13-14%. The bulk of this growth came due to demand for commercial planes rather than civilian aircraft. Going forward, while Alcoa predicts a constant 9-10% growth rate in this segment, we think that some caution is warranted beyond a couple of years.
The company touts a large backlog of order for planes with Boeing and Airbus which might take up to 8 years to clear. However, we think that it is quite possible that the global macroeconomic scenario could throw a wrench in the works. If the macroeconomic sentiment weakens due to the Euro zone being unable to find a way out of its present mess or the U.S. failing to resolve its budget problems, economic growth may not pick up elsewhere. An example would be countries in Asia dependent on Europe as a major export destination. In the event of a prolonged slump, the airlines in Asia may opt to delay or cancel orders for their planes which in turn would slow down assembly lines temporarily at Boeing and Airbus. The U.S. fiscal deficit problems could also reduce defense spending on equipment drastically.
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.
The same caveats hold true for the automotive segment as well which is expected to grow by 4% next year in the most optimistic scenario. In the U.S., Alcoa is already expecting a drastic decrease in production in the commercial vehicles segment next year. The scenario in China is somewhat optimistic due to the infrastructure related spending being carried out by the government now. Alcoa is expecting a 12-19% growth rate in the automotive segment in China next year.
A potential area of growth could be the industrial gas turbine segment. Power plants in the U.S. are switching to natural gas from coal owing to the cheap prices of natural gas thanks to the shale gas revolution. Further encouragement is being provided by environmental regulations which mandate cuts in carbon emissions.
The demand from the packaging, building and construction sectors is expected to remain flat or increase marginally over the next year.
Long Term Demand Growth On Track
Assuming that macroeconomic downside scenarios mentioned above don’t materialize, the demand growth for aluminum may actually exceeding Alcoa’s expectations. In 2010, Alcoa forecast a doubling of demand by 2020 at a Compounded Annual Growth Rate (CAGR) of 6.5%. Over the last two years, demand has grown at a CAGR of 7% and the expected growth next year has been pegged at 7%. 
Alcoa intends to grow its Global Rolled Products and Engineering Products and Services businesses since these produce value-added products and thus generate higher margins. It would be crucial for the company to reduce its debt to a sustainable level and bring it in line with its earnings in order to maintain its investment grade rating.
We have a Trefis price estimate for Alcoa of $10 which will be revised after the fourth quarter earnings results.Notes: