Alcoa (NYSE:AA) is a fully integrated producer of aluminum: it mines bauxite, refines it into alumina, makes primary aluminum and also produces midstream products like flat rolled sheets and downstream engineered products. The company’s results are closely eyed as it usually is the first Dow company to post earnings and because it gives investors a clue to the likely results of other industrial goods producers. Aluminum, being one of the most important industrial metals, is closely tracked and followed by analysts and investors alike. Although Russian company UC Rusal is the biggest producer of aluminum by volume, its foreign listing makes Alcoa more important from an investor’s point of view.
Despite enjoying such an exalted status, Alcoa’s fortunes tend to be volatile because of its dependence on aluminum prices, and aluminum prices don’t always reflect the fundamentals of demand and supply. According to trends observed on the London Metal Exchange (LME), aluminum prices have been reacting quite strongly to macroeconomic factors and sentiment. Alcoa’s management has admitted as much by demonstrating the evenly balanced demand-supply scenario in its annual earnings presentation.  According to the company, the pricing trend on the LME is showing little correlation with this balance. ((LME Aluminum Price Graph, LME))
In view of such uncertainty in prices, what Alcoa can and must do is focus more on value added products to improve and stabilize margins and earnings. This would also help boost its share price and valuation in the eyes of investors.
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- Alcoa’s Q2 2016 Earnings Preview: Weakness In Aluminum Pricing To Negatively Impact Results
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- Why Brexit Will Not Significantly Impact Aluminum Prices
Alcoa’s Value Added Products
Alcoa manufactures value added products in two business segments: Flat Rolled Products and Engineered Products and Solutions.
The Flat-Rolled Products segment produces and sells aluminum plate, sheet and foil. Products in this segment include rigid container sheet, which is sold directly to customers in the packaging and consumer market and is used in the production of aluminum beverage cans. This segment also includes sheet and plate used in the aerospace, automotive, commercial transportation, and building and construction markets.
The Engineered Products and Solutions division produces titanium, aluminum, and super alloy investment castings, forgings and fasteners, aluminum wheels, integrated aluminum structural systems, and architectural extrusions used in the aerospace, automotive, building and construction, commercial transportation, and power generation markets. These products are sold directly to customers and through distributors. This division also manufactures hard alloy extrusions products, which are sold to customers in the aerospace, automotive, commercial transportation, and industrial products markets. 
Why Focus On These?
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. These assertions are borne out by the After Tax Operating Income (ATOI) figures for each division.
In 2011, the Alumina and Primary Metals divisions had ATOI figures of $607 million and $481 million, respectively, while the Flat Rolled and Engineering Products divisions had ATOI figures of $266 million and $539 million, respectively. In 2012, however, ATOI for the Alumina division sunk dramatically to $90 million and that for the Primary Metals division to $309 million. The Flat Rolled and Engineered Products divisions showed remarkable resilience and ATOI for these climbed to $358 million and $612 million respectively. These numbers demonstrate not only the continuing importance of the upstream business segments but also their volatile nature. This volatility lends unpredictability to earnings, which can be mitigated through a greater focus on value added products in the downstream segments. These products also have high margins as obvious from the all-time high EBITDA margins of 19% observed for the Engineering Products division in 2012. 
Prospects For Value Added Products
In 2012, Alcoa witnessed robust global growth in the aerospace segment to the tune of 13-14%. Going forward, Alcoa predicts a constant 9-10% growth rate in this segment. The company touts a large backlog of order for planes with Boeing and Airbus which might take up to 8 years to clear. This ensures a steady requirement for the products sold by Alcoa’s downstream segments.
Recently, Alcoa signed a new agreement for strategic technology and commercial cooperation with Commercial Aircraft of China Ltd. (COMAC) which is a significant player in the fast growing Chinese aerospace market. Under the new agreement, AFS will provide COMAC with technical assistance in fastener and assembly tooling selection, joint design consideration and quality system management. The technical assistance will include engineering, design and training. In return, COMAC will purchase a significant chunk of its requirement for fasteners from AFS which will be used in the production of COMAC’s C919 aircraft. ((Alcoa Fastening Systems Enters Strategic Partnership with COMAC, Alcoa Press Release))
Also, the automotive segment in the U.S. is expected to grow by 4% next year while its growth in China is expected to be 12-19%. Another 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.
Demand from the packaging, building and construction sectors is expected to remain flat or increase marginally over the next year.
It is thus clear that Alcoa has a better future if it focuses on downstream businesses that produce specialized products. It would help reduce volatility in earnings, generate higher margins, and lower the company’s dependence on aluminum prices which it cannot control.
We have a Trefis price estimate for Alcoa of $8.Notes: