Alcoa‘s (NYSE:AA) senior unsecured rating on about $8.6 billion worth of debt was downgraded to Ba1 from Baa3 by Moody’s last week. The rating agency’s move was prompted by a prolonged slump in aluminum prices and the unlikely prospects of a near term recovery, which would challenge Alcoa’s profitability. The Ba1 rating basically classifies Alcoa’s debt as junk and will make it more expensive for the company to raise any more funds through bonds. Not only that, the company may now be facing removal from the Dow Jones Industrial Average (DJIA) index. 
While Alcoa has been taking steps to rationalize production capacity to stem the price decline resulting from an oversupplied market, it doesn’t seem to be enough to convince Moody’s. Other major rating agencies such as S&P and Fitch may soon follow suit.
- Aerospace The Byword For Alcoa With The Latest In A String Of Deals In The Segment
- Alcoa Q4 2015 Earnings Review: Weakness in Aluminum Prices Weighs On Results
- By What Percentage Will Alcoa’s Automotive Revenues Grow Over The Next Five Years?
- How Will The Revenue Composition Of Alcoa Change Over The Next Five Years?
- Alcoa’s Q4 2015 Earnings Preview: Productivity Improvements To Partially Offset Impact Of Weakness In Aluminum Prices
- Which Are The Major Growth Areas For Alcoa Over The Next Three Years?
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 Trends
Aluminum prices on the London Metal Exchange, which are used as a benchmark by the company to determine its own prices, have been dropping sharply since the end of February. Prices have dropped from $2,100/tonne to below $1,800/tonne by the end of May. 
The initial slump was driven by disappointing economic data emerging out of China. Also, other factors like large LME warehouse inventories and money flowing out of commodities to equity markets have kept a lid on prices despite a fledgling U.S. recovery. While LME prices are not the actual realized prices for Alcoa, they do indicate a broader trend in global aluminum prices. Despite inventories being at a record high, for a long time market forces failed to rationalize supply through the shutdown of smelting capacity. This was primarily due to state intervention in the form of provision of subsidies or renegotiated power contracts to smelters, especially in China.
However, at the end of Q1, Alcoa had claimed that smelting capacity in China is now being rationalized and global inventories are now stable. This may well be the case for prices have stayed within a specific band for the last couple of months. The company itself is looking at cutting down around another 11% of its smelting capacity over the next 15 months or so, after having idled 13% of its capacity last year alone. Most of the cuts would be carried out at older, less efficient plants. ((Alcoa to Review 460,000 Metric Tons of Smelting Capacity for Possible Curtailment, Alcoa Press Release))
Moody’s has acknowledged Alcoa’s success in reducing costs and improving productivity and has kept the outlook stable. But citing the slower growth in China and recessionary conditions in Europe, it said that the aluminum industry will continue to face headwinds and Alcoa will find it difficult to bring down its debt levels. 
Alcoa will find it costing more to raise funds in the market through new debt issues due to higher yields it would have to offer to compensate for the lower credit rating. Also, refinancing its existing debt will now be costlier.
Given that Alcoa is only the second company in the DJIA in the last thirty years to have its investment rating cut to junk, questions are bound to be raised over its continued presence in the index. Alcoa’s current market value of about $9 billion is less than one-third the value of Travelers Cos., the second smallest company in the Dow. Passive institutional investors and exchange-traded funds (ETFs) design their portfolios according to the composition of major popular indices such as the DJIA. Any change in index composition prompts re-balancing and re-constitution of portfolios through buying and selling of stocks in the index. The DJIA does not use a rules-based, objective process to determine index composition. The stocks are chosen by the editors of the Wall Street Journal and a removal of stocks is quite infrequent. Also, the credit rating of a company isn’t mentioned in the DJIA guidelines used by the editors for stock selection. Some market participants, however, are questioning Alcoa’s continued presence in the DJIA.
Aluminum consumption in the U.S., as a percentage of the overall Gross Domestic Product (GDP), has declined over the last five decades. While it represented 0.2% of the U.S. GDP in 1959 when Alcoa joined the DJIA, today it constitutes just 0.02%. This trend is mirrored in Alcoa’s steadily declining share of the Dow, from 2% 10 years ago to 0.4% today. This data raises questions over the aluminum industry and Alcoa’s continued membership in the DJIA. In addition, Alcoa’s share price continues to suffer due to an aluminum supply glut even when industrial activity in the U.S. is picking up. This sends a signal quite opposite to what the DJIA is supposed to reflect as a proxy for the country’s industrial performance. Some investors would prefer to have Alcoa replaced by a financial or technology company, as these sectors are underrepresented in the index now. 
We think that if the aluminum market conditions don’t improve, the next review of the DJIA could very well see Alcoa’s ouster from the index. This will reduce the stock’s liquidity and limit the upside potential to its price, resulting in disappointing investor returns.
We have a Trefis price estimate for Alcoa of $7.Notes: