Alcoa’s Road Ahead

-3.41%
Downside
33.79
Market
32.64
Trefis
AA: Alcoa logo
AA
Alcoa

Alcoa (NYSE:AA) is the world leader in the production and management of primary aluminum, fabricated aluminum and alumina. It is present across the value chain in all major aspects of the industry: technology, mining, refining, smelting, fabricating and recycling. Alcoa is also a global leader in lightweight metals engineering and manufacturing. Alcoa’s operations consist of four operating segments: Alumina, Primary Metals, Global Rolled Products (GRP) and Engineered Products and Solutions (EPS).

Alumina and aluminum, primary and fabricated, represent about 80% of Alcoa’s revenues. Thus, the price of aluminum is a major influence on the fortunes of the company. Benchmark London Metal Exchange (LME) aluminum prices plummeted post the financial crisis. After staging a recovery, prices have fallen consistently over the last three years. LME aluminum prices are hovering around $1,800 per tonne, far below their 2011 peak values of close to $2,800 per tonne. The decline in aluminum prices has led to a corresponding downturn in Alcoa’s fortunes. Alcoa’s stock price is currently trading at around $13.45, far below $18 achieved in the early part of 2011. [1]

Alcoa has taken concerted steps to combat lower aluminum prices. The company has gradually shifted focus towards its midstream and downstream products that command a greater premium over aluminum prices and have higher margins. In this article we explore the company’s portfolio transformation in greater depth.

Relevant Articles
  1. What To Expect From Alcoa’s Q3 Results?
  2. What To Expect From Alcoa’s Q2 Results?
  3. What To Anticipate From Alcoa’s Q1 Results?
  4. What’s Next For Alcoa After Tough Q4 Results?
  5. Buy, Sell, or Hold Alcoa Stock As Aluminum Prices Remain Soft?
  6. Falling Aluminum Prices Will Weigh On Alcoa’s Q3 Results

You can check out our complete analysis for Alcoa here:

Aluminum And Alumina Prices

Aluminum has diverse applications in industry. It is an important input in the packaging, aerospace, automotive, construction, commercial transportation, power generation, capital goods and consumer durables industries. Thus, demand for aluminum is broadly correlated with industrial growth. The European debt crisis and slowing Chinese growth have contributed to the decline in aluminum demand and consequently prices over the last few quarters.

On the supply side, production capacity has not been reduced corresponding to the fall in demand.  Persistently high aluminum inventory levels relative to demand are keeping LME aluminum prices depressed. 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, market forces have failed to rationalize supply through the shutdown of smelting capacity. Though global aluminum majors like Alcoa and Rusal have announced smelting capacity cuts, 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 serve as a disincentive to cut production. China accounts for around 43% of the world’s aluminum production and the expansion in production by Chinese producers  has more than made up for capacity cuts by global majors. Thus, this oversupply situation is set to continue and is likely to keep prices depressed . [2]

The average realized price per tonne of aluminum for Alcoa has fallen consistently over the last three years. The average realized prices for aluminum have fallen from $2,636 per tonne in 2011 to $2,243 in 2013.

Alumina has historically been priced as a percentage of the more liquid and transparent aluminum price quoted on the LME. Contract terms have historically fluctuated in the range of 12-14% of the LME aluminum prices. This ratio is typically arrived at through negotiations between alumina refiners and aluminum smelters, who are the customers. Spot prices have been much more volatile as the alumina spot market is a very thin market. For 2012, Alcoa’s average realized price for alumina was approximately 14.1% of the average realized price for aluminum.

Over the years, the aluminum industry has moved away from a vertically integrated model where producers had their own bauxite mines and alumina refineries. Many independent aluminum smelters have come up and they buy alumina in the spot market. In such a case, a fair price discovery can be better achieved through market mechanisms. [3]

Therefore, Alcoa has implemented a move to price alumina based on an index of spot alumina prices rather than as a percentage of LME-based aluminum price. This change is expected to affect approximately 20% of annual contracts coming up for renewal each year. It will more fairly reflect the fundamentals of the alumina business in its own right, including the cost of raw materials and transportation.

Over time, we expect the pricing to be driven by the demand-supply dynamics for alumina, rather than being linked to aluminum prices. For 2014, Alcoa expects around 65% of alumina third-party shipments to be linked to the alumina price index or spot prices. The average realized prices per tonne of alumina fell from $370 in 2011 to $327 in 2012. Realized prices were steady at $328 in 2013 due to a greater proportion of customer contracts based on alumina index prices, offset by a decrease in contractual LME-based prices. However, even with a shift to index based price contracts, realized prices will remain low due to an oversupply situation.

Reduction In Smelting Capacity

In order to maintain its competitiveness in an environment of falling aluminum prices, Alcoa announced in May 2013 that it will review 460,000 tonnes of smelting capacity over a 15 month period. In 2013, the company management initiated a permanent shutdown of 146,000 tonnes of smelting capacity and announced a temporary curtailment of an additional 131,000 tonnes of smelting capacity. The review of the remaining 183,000 tonnes of smelting capacity is expected to be completed in the first half of 2014. ((Alcoa’s 2013 10-K, SEC))

As a result of these steps, Alcoa’s base smelting capacity reduced from 4.227 million tonnes at the end of 2012 to 3.953 million tonnes at the end of Q1 2014. Further, the company had 675,000 tonnes of idle capacity out of its base smelting capacity of 3.953 million tonnes. In addition to the review of smelting capacity, the company has also initiated measures to enhance productivity. The company expects these measures in tandem to maintain the competitiveness of its upstream operations. The company achieved productivity gains totaling $250 million across segments in Q1 2014. [4]

Portfolio Transformation

Low aluminum prices have put pressure on margins in the company’s Alumina and Primary Metals business segments. In order to compete effectively in such an environment, the company has made concerted efforts to rebalance its portfolio towards its value added products. The value added products have pricing premiums over the upstream businesses and command higher margins. Thus, the GRP and the EPS divisions have played an increasingly important role over the last three years.

The GRP segment is mainly involved in the production and sale of aluminum plate, sheet and specialty foil. This segment’s products are sold to customers in packaging and consumer goods, aerospace, automotive, brazing, building and construction industries. The EPS segment’s products include titanium, aluminum and super alloy investment castings, fasteners, aluminum wheels, integrated aluminum structural systems, architectural extrusions, forgings and hard alloy extrusions. These products are sold to customers  in the aerospace, automotive, building and construction, commercial transportation, power generation industries.

Alcoa’s portfolio shift towards its value added products is reflected in its revenue figures. The percentage contribution of the GRP and the EPS segments sales to the total revenues has steadily increased. This figure stood at 52.1%, 54.4%, 55.7% and 57.2% at the end of 2011, 2012, 2013 and Q1 2014 respectively. In calculating these figures, we have only considered third party sales.

The company is betting big on its automotive and aerospace customers to drive sales of its value added products. In the automotive segment, the company expects a growth of 2 -5% for 2014. U.S. auto sales reported strong figures in Q1 2014. Moreover, there is a fair bit of pent up demand in the U.S. This is indicated by the average fleet age, which currently stands at 11.4 years against a historical figure of 9.4 years. The company has also upped its production forecast for the heavy trucks and trailer market to 5-9% growth for 2014, up from its previous estimate of 1-5% growth. This is primarily based on the increase in orders received in Q1 2014 versus the fourth quarter. The company has raised the forecast for its European automotive markets to 0-4% up from its previous forecast of -1 to 3% for 2014, based on stronger year to date vehicle registrations data. The company also maintains a 6-10% growth target for its Chinese automotive markets.

In the aerospace segment, Alcoa has raised its production forecast from 8 to 9% for 2014. The company expects strong performance from its large commercial aircraft and regional aircraft segments. The combined backlog of 10,675 aircraft units for Boeing and Airbus represents eight years worth of production. Further, the company expects strong aviation demand from Asia and the Gulf region. [5]

In order to cater to the growing importance of the automotive segment, the company undertook a $300 million expansion of its automotive facilities at its Davenport, Iowa fabrication plant. The company also expanded its wheel manufacturing plant in Hungary to meet the growing European demand for its aluminum truck wheels. [6]

In the aerospace segment, the company recently signed a long-term agreement worth $290 million to supply aluminum sheet to Spirit AeroSystems over 5 years. Spirit is one of the largest designers and manufacturers of aerostructures for commercial, military, business and regional jets in the world. [7]

The Road Ahead

We expect the company to continue to focus on its value added products in the near and medium-term. We expect the supply glut to persist for aluminum, keeping prices subdued. In such an environment, the fortunes of the company’s upstream business will be more dependent on productivity gains rather than topline growth. Revenue growth for the company will be driven by the company’s GRP and EPS divisions, especially by the automotive and aerospace sales. Thus, Alcoa’s portfolio transformation towards value-added products is set to continue.

 

Notes:
  1. LME Aluminum Prices, LME []
  2. Alcoa, Rusal’s Aluminum Production Cuts Not Enough With China Smelting, Metal Miner []
  3. Push For Alumina Price Reforms, Financial Times []
  4. Alcoa’s Q1 2014 10-Q, SEC []
  5. Alcoa’s Q1 2014 Earning Conference Call Transcript, Seeking Alpha []
  6. Alcoa Completes $300 Million Automotive Expansion In Iowa To Meet Growing Demand For Aluminum Intensive Vehicles, Alcoa News Release []
  7. Alcoa Signs Long-Term Supply Agreement With Spirit AeroSystems For Aluminum Sheet, Alcoa News Release []