Alcoa Earnings Preview: Low Aluminum Prices Will Weigh On Results
Alcoa (NYSE:AA) will report its second quarter earnings results on Tuesday, October 8. This is the first time in years when the company won’t be seen kicking off the earning season because it was removed from the Dow Jones Industrial Average (DJIA) index last month. We expect the company to record soft earnings, but most investors will watch out for any cues on its outlook. Aluminum prices have been going downhill recently and demand remains sluggish. The flat-rolled and engineered products divisions may partially offset the negative impact of low aluminum prices on the primary metals business. ((BofA, Alcoa and HP are ousted from Dow Jones index, Los Angeles Times))
Aluminum prices on the London Metal Exchange, which stayed between $1,700-1,800 per tonne in July, showed a sudden spike to nearly $1,900 per tonne in August and again dropped sharply to July levels before the end of the month. Prices in September stayed between $1,700-1,800 per tonne. On average, prices in Q3 2013 were lower than in Q2 2012. Alcoa uses LME aluminum prices as benchmark for its own prices. [1]
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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 revenues still comes from the Alumina and Primary Metals divisions. This makes its earnings highly sensitive to aluminum prices. [2]
The Aluminum Price Trend In Q3
The European debt crisis and slowing Chinese growth have contributed to the decline in aluminum demand and its prices over the last few quarters. The long term expectations for these factors remain largely 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. In fact, one Chinese company even announced plans to add 550,000 tonnes of smelting capacity by the end of this year to take advantage of cheap power. [3]
Concentrating On Value Added Products
In face of falling aluminum prices, Alcoa is concentrating on expanding its flat-rolled and engineered products businesses which generate higher margins. The company is targeting the automotive and aerospace sectors in particular.
In the third quarter, Alcoa conducted a ground breaking ceremony for its planned $275 million expansion of the Tennessee operations. The expansion is being carried out to meet the rapidly growing demand for aluminum in the auto production segment and is supposed to be completed by mid-2015. ((Alcoa Breaks Ground on $275 Million Auto Expansion in Tennessee, Alcoa News Release))
In its Q2 2013 earnings presentation, Alcoa projected that the aluminum body sheet content per vehicle in North America will rise from 14 pounds in 2012 to nearly 55 pounds in 2015 and 136 pounds in 2025. This represents a mind-boggling ten-fold increase in aluminum content per vehicle over the next 13 years. According to the company, the increase in aluminum intensity per vehicle will occur due to the new U.S. Corporate Average Fuel Economy (CAFE) standards which demand better fuel economy in vehicles from manufacturers. This can be achieved by replacing steel with aluminum to make vehicles lighter. ((Alcoa Q2 2013 Earnings Presentation, SEC))
In order to meet the industry’s projected needs, Alcoa needs to expand its production capacity. It has already been doing so by investing nearly $300 million for the expansion of its Davenport Works plant in Iowa. This project is currently underway and scheduled to be completed by the end of 2013. However, it would be sufficient to meet the projected increase in demand only till 2015. The expansion of the plant in Tennessee is aimed at taking care of the incremental demand beyond 2015. Most importantly, the long-term supply contracts with customers are already in place for incremental growth in production volume.
What We Would Like To Know In The Earnings Call
In its Q2 2013 earnings conference call, Alcoa’s management had maintained 2013 growth projections of 9-10% for the aerospace segment, 2-5% 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. ((Alcoa Q2 2013 Earnings Conference Call, Seeking Alpha))
We would like to see if results at the end of Q3 are in tandem with expectations. 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.
Also, we would like to have more view of the additional revenue stream that Alcoa expects to generate from its Tennessee plant expansion.
We have a Trefis price estimate for Alcoa of $7.
Understand How a Company’s Products Impact its Stock at Trefis
Notes:- LME Aluminum Price Graph, LME [↩]
- Alcoa 2012 10-K, SEC [↩]
- Alcoa, Rusal’s Aluminum Production Cuts Not Enough With China Smelting, Metal Miner [↩]