Alcoa (NYSE:AA) recently released its Q2 2013 earnings results. The company reported revenues of $5.85 billion which 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, includes the 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. 
After the results, we have updated our model to reflect Alcoa’s performance in the first half of the year. The continued slide in aluminum prices from last year has affected the company’s performance, especially in the upstream segment. It is trying to mitigate the negative impact of lower prices by focusing on its value added businesses which generates higher margins. The automotive and aerospace sectors present the biggest growth opportunities to Alcoa in the foreseeable future.
Below we explain which factors will drive Alcoa’s valuation in the future and give our thoughts on the likely performance of the company’s individual business segments.
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.
Aluminum Prices: Present And Future
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 $1,720/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. 
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 for the rest of the year. Beyond that we expect a modest recovery in prices because Alcoa and other major producers like Rusal are cutting excess smelting capacity by shutting down plants or idling them. Also, we think that some Chinese smelters will eventually have to close because production at current price levels will become unsustainable beyond a point even with state subsidies. According to Alcoa’s own estimates, about 40% of all Chinese smelters are making losses. (Alcoa Looks At Idling More Aluminum Smelting Capacity Amid Industry Headwinds, Trefis)
Persistently high inventory levels have kept a lid on aluminum prices for some time now, but Alcoa has 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. 
Our View Of Various Business Segments
In the second quarter, Alcoa’s alumina division gained handsomely due to higher Alumina Price Index (API) prices, favorable exchange rates and productivity related improvements. After-tax operating income (ATOI) increased sequentially from $58 million to $64 million. 
API is a relatively new mechanism to price alumina, as opposed to the old system of pricing it as a percentage of LME aluminum prices. Thus, the pricing for alumina is now a function of its own demand and supply dynamic to a large extent. This was demonstrated through the relatively flat alumina prices this quarter, even as aluminum prices nosedived. In view of this, we expect a modest growth in alumina prices going ahead. Lower expected costs for caustic soda, a key raw material, and productivity gains will improve margins.
2) Primary Metals:
This division is affected the most by aluminum prices on the LME. In the second quarter, falling LME prices impacted ATOI negatively by $81 million and was the major reason why ATOI fell from $39 million in Q2 2012 to a negative $32 million this quarter. For reasons mentioned above with respect to the price scenario, we expect the primary metals segment to show weak results for the rest for the year but show improvement in later years once prices pick up.
3) Global Rolled Products (GRP) & Engineered Products And Solutions (EPS):
These two divisions make value added products and have been largely responsible for cushioning the impact of weak aluminum prices. 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, largely offset by productivity gains and higher volumes. But 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. In fact, the EPS division recorded its best ever EBITDA margin this quarter. Thus, these two divisions were relatively insulated from the impact of low aluminum prices.
Going forward, we see robust demand from the automotive and aerospace sectors for Alcoa’s value added products. Boeing and Airbus have signed large deals with Alcoa. These firms currently have a large backlog of orders to fulfill- around 9,900 planes-which Alcoa estimates equals 8 years of production. Therefore, we expect continued strong results in the GRP and EPS segments. The continuous innovation and premium positioning of its products allow Alcoa to generate high margins in the EPS segment. We expect continued modest increase in prices as well as margins over time.
The interested reader may want to refer to slide 25 of Alcoa’s Q2 2013 earnings presentation for greater detail on how the company makes productivity gains.
We have a Trefis price estimate for Alcoa of $7, which will shortly be revised in view of the latest earnings results.Notes: