Alcoa (NYSE:AA) will kick off this quarter’s earnings season when it announces its Q2 results after the market closes on Monday, July 8. Alcoa is usually the first Dow company to post earnings. We expect the company to record soft earnings, but most investors will watch out for any cues on its outlook. Aluminum prices are constantly going downhill and demand remains sluggish. Also, aluminum inventory continues to remain high relative to demand, keeping a lid on London Metal Exchange (LME) prices for aluminum. Alcoa announced smelting capacity cuts in May but it was not enough to prevent Moody’s from downgrading its debt rating to junk.
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 latter part of February. Prices have dropped from $2100/tonne at the beginning of the year to below $1800/tonne and are still trending lower. ((LME Aluminum Price Graph, LME))
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 comes from the Alumina and Primary Metals divisions. This makes its earnings highly sensitive to aluminum prices.
The Aluminum Price Trend In Q2
The European debt crisis and slowing Chinese growth have contributed to the decline in aluminum demand and prices over the last few quarters. These factors remain unchanged so weakness in prices is expected to persist in the foreseeable future.
One factor that might explain falling prices is the persistently high aluminum inventory relative to demand, which may be keeping a lid on London Metal Exchange (LME) prices for aluminum. While LME prices are not the actual realized prices for Alcoa, they do indicate a broader trend in global aluminum prices. Also, despite inventories being at a record high, market forces have failed to rationalize supply through shutdown of smelting capacity. Companies like Alcoa and Rusal have announced smelting capacity cuts but the same cannot be said of Chinese companies. This is primarily due to state intervention in the form of provision of subsidies or renegotiated power contracts to smelters which serves as a disincentive to cut production. Nevertheless, we think that beyond a point even Chinese smelting capacity will have to be rationalized.
Smelting Capacity Cuts And Debt Rating Downgrade
In May, Alcoa announced that it would cut about 11% of its smelting capacity, or 460,000 tonnes, over the next 15 months. It is taking this step in response to a 33% drop in aluminum prices since 2011. The facilities where this exercise will be carried out have not been decided upon yet, but it will focus on its most expensive plants and those subject to the risk of rising energy or regulatory costs. The company operates smelters in the U.S., Canada, Brazil, Australia and Europe. 
As of now, Alcoa already has an idle smelting capacity of 568,000 tonnes, or 13% of the total. Cutting down further on capacity will cause its market share to decline if others don’t follow suit.
Despite the capacity cuts announced by Alcoa, Moody’s lowered the company’s senior unsecured rating on about $8.6 billion worth of debt to Ba1 from Baa3. It cited a prolonged slump in aluminum prices and the unlikely prospects of a near term recovery as reasons for the downgrade. Alcoa will find now find it costlier 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. The downgrade may also put a question mark over Alcoa’s continued presence in the Dow Jones Index. It is only the second company in the last 30 years to have its debt rating cut to junk and its market value of about $9 billion is less than one-third the value of Travelers Cos., the second smallest company in the Dow. Also, 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. ((Alcoa Junk Downgrade Is Rare Trauma for Dow Stocks: Commodities, Bloomberg))
What We Would Like To Know In The Earnings Call
In its 2012 annual earnings call, Alcoa’s management had made 2013 growth projections of 9-10% for the aerospace segment, 4% for the U.S. automotive segment and 12-19% in the Chinese automotive segment. Also, the company had predicted a 7% growth rate for aluminum demand in 2013.
We would like to see if results in the first half of the year are in tandem with expectations so far. While the U.S. economy seems to be picking up, we are skeptical that the performance of the Chinese automotive market and the overall demand growth are in line with projections. 
We would also be keen to listen to the management’s comments about Alcoa’s future price expectations. Market prices in the first six months of the year haven’t lived up to Alcoa’s expectations.
We have a Trefis price estimate for Alcoa of $7.Notes:
- Alcoa to Review 460,000 Metric Tons of Smelting Capacity for Possible Curtailment, Alcoa Press Release [↩]
- Q4 2012 Earnings Conference Call Transcript, Seeking Alpha [↩]