Weak Prices Dent Alcoa’s Results But Value-Add Products Brighten Outlook
Alcoa (NYSE:AA) released its second quarter earnings on Monday, July 8. The company’s reported revenues of $5.85 billion were slightly lower than Q2 2012 revenues of $5.83 billion, mostly due to a 4% drop in realized aluminum prices over the period. Including the impact of special items, it reported a net loss of $119 million. The after-tax special items, worth $195 million, include costs associated with restructuring and the resolution of a legacy legal matter. Excluding special items, the net income stood at $76 million, a sequential decline of 37% from $121 million. The decline was largely due to lower LME prices. [1]
The global rolled products as well as the engineered products and solutions segments reported higher year-over-year after tax operating income (ATOI) figures due to higher productivity and volumes. The alumina segment showed a 10% sequential rise in ATOI primarily due to positive trends in the Alumina Price Index (API) prices, favorable foreign exchange rate movements and savings related to productivity. As expected, sequential ATOI in the primary metals segment declined primarily due to lower aluminum prices and higher costs and entered negative territory. This also shows that the traditional correlation between alumina and aluminum prices is no longer valid. Earlier, alumina used to be priced as a percentage of market aluminum prices.
The company’s management maintained its demand and growth projections made at the end of 2012.
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Aluminum Prices And Inventory Levels
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 $2,100/tonne at the beginning of the year to below $1,800/tonne and are still trending lower. Towards the end of June, LME prices touched a four-year low of $1,758/tonne. Alcoa’s average realized price in the second quarter stood at $2,237/tonne, a 4% year-over-year decline. The prices are higher than LME prices because Alcoa charges a premium over the benchmark. [2] 
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 we expect weakness in prices to persist in the foreseeable future.
Persistently high inventory levels have kept a lid on aluminum prices for some time now, but Alcoa said that inventories have been coming down due to production curtailments and continued solid demand. Inventory in China declined by 99,000 tonnes over the quarter and off-exchange finance stocks in the U.S. declined by 159,000 tonnes. [3]
Performance Of Individual Business Segments
In the engineered products and solutions (EPS) division, ATOI rose sequentially from $173 million to $193 million due to innovations, productivity gains and higher sales volumes. The division reported a record adjusted EBITDA margin of 22.2%. Alcoa is upbeat about the aerospace market and maintained its 9-10% growth projection for 2013. The company touts a large backlog of 9,900 orders for planes with Boeing and Airbus which might take up to 8 years to clear. It signed orders worth $135 billion with these companies at the recently concluded Paris Air Show.
In the global rolled products (GRP) division, ATOI declined marginally on a sequential basis to $79 million from $81 million due to low metal prices. Most of the adverse impact was mitigated by strong demand from the aerospace, automotive, and packaging businesses.
In the upstream part of the business, Alcoa’s alumina division gained handsomely due to higher Alumina Price Index (API) prices, favorable exchange rates and productivity related improvements. ATOI increased sequentially from $58 million to $64 million. The ATOI for the primary metals segment, however, stood at a negative $32 million compared to a positive $39 million in the previous quarter. The sequential decline was caused by lower LME prices and higher costs, including the maintenance costs related to power plant outages in Australia and the U.S. ((Alcoa Q2 2013 Earnings Presentation, Alcoa Website))
Outlook
Alcoa has maintained its 2013 global aluminum demand growth figure at 7%.
In the U.S. automotive segment, the company has revised its auto production forecast upwards to 2-5% from the earlier projection of 0-4%. This has been done in view of continued strong passenger car sales due to which automakers are reducing planned shutdown of plants in summer. In Europe, however, Alcoa has maintained its forecast of a 2.5% decline. The growth forecast for China has been maintained at 7-10%.
In the heavy truck and trailer segment, Alcoa has revised its forecast upwards based on the segment’s performance in the first six months. It still expects negative growth, but the figure has been revised to 9-13% from 15-19% previously. The growth rate in the industrial gas turbine segment has been maintained at 3-5%. Power plants in the U.S. are switching to natural gas from coal owing to cheap prices of natural gas thanks to the shale gas revolution. Even though rising gas prices have allowed coal to make a partial comeback, demand remains robust.
Overall, Alcoa has been shifting its business mix focus to value-added products over the last few years. The company’s value-added business in the first half of the year constituted almost 60% of its revenues and accounted for 80% of the segment after-tax operating income. If this trend continues in future, it will boost margins and reduce earnings volatility due to aluminum price fluctuations.
We have a Trefis price estimate for Alcoa of $7, which will shortly be revised in view of the latest earnings results.
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Notes:- Alcoa Reports Strong Operational Performance Offset by Special Items, Alcoa News Release [↩]
- LME Aluminum Price Graph, LME [↩]
- Alcoa Q2 2013 Earnings Conference Call, Seeking Alpha [↩]