Alcoa (NYSE:AA) released its second quarter earnings and conducted a conference call with analysts on Tuesday, July 8. The company reported strong year-over-year quarterly profits, driven by its value-added businesses. Net income for the quarter stood at $138 million, as compared to a net loss of $119 million in the corresponding period a year ago. Excluding special items, net income stood at $216 million this quarter as compared to $76 million in the corresponding period last year. Special items in Q2 2014 include restructuring charges related to closure of the Point Henry Smelter in Australia, as well as the company’s Australian rolling mills. Other costs included in special items are costs associated with the Firth Rixson acquisition agreement and the company’s recently completed U.S. labor contract negotiations. 
The company’s quarterly revenues remained flat year-over-year at $5.8 billion, with increases in revenues in the Engineered Products and Solutions (EPS) and Primary Metals segments offsetting declines in the Alumina segment.
Alcoa is focused on its portfolio transformation towards value-added products. At the same time, the company has emphasized cost reductions in order to make its upstream businesses more competitive.
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Performance of Individual Segments in Q2
Alcoa measures the operating performance of individual segments using the after-tax operating income (ATOI) metric.
ATOI for the EPS segment stood at $204 million, up 8% sequentially. Higher volumes and favorable productivity gains were responsible for this improvement. The segment reported an adjusted EBITDA margin of 23.1%, compared to 22.2% for Q1. ((Alcoa Reports Strong Second Quarter 2014 Profits Driven By Continued Portfolio Transformation, Alcoa News Release))
ATOI for the Global Rolled Products (GRP) segment stood at $79 million, up 34% sequentially. Higher seasonal demand for can sheet and strengthening orders for brazing sheet, industrial and commercial transportation products due to recovering economies in Europe and the U.S., drove the performance of this segment. Second quarter results were favorably impacted by the absence of a charge related to the planned permanent shutdown of the company’s rolling operations in Australia, which was present in Q1. These favorable impacts were partially offset by costs associated with the company’s recently completed U.S. labor contract negotiations. ((Alcoa Reports Strong Second Quarter 2014 Profits Driven By Continued Portfolio Transformation, Alcoa News Release))
ATOI for the Alumina segment stood at $38 million, down 59% sequentially. The decline in ATOI was primarily due to the benefit from the sale of Alcoa’s Suriname gold mine interest in Q1, unfavorable foreign exchange rates, lower Alumina Price Index (API) pricing, and additional costs due to outages and maintenance. Adjusted EBITDA stood at $39 per ton, down $10 per ton from Q1.((Alcoa’s Q2 2014 Earnings Presentation, Alcoa Website))
ATOI for the Primary Metals segment stood at $97 million, up $112 million sequentially from an after-tax operating loss of $15 million in Q1. The third-party realized price for the segment stood at $2,291 per ton in Q2, up 4% sequentially. The improvement in results was due to higher London Metal Exchange (LME) pricing and regional premiums, increased power sales, and the absence of special charges recorded in the first quarter, offset by unfavorable foreign exchange rates. Adjusted EBITDA stood at $337 per ton, $187 per ton higher than in Q1. ((Alcoa’s Q2 2014 Earnings Presentation, Alcoa Website))
The company gave its outlook on growth in key end markets in its conference call. 
In the aerospace segment, the company maintained its outlook of 8-9% global sales growth in 2014. The large commercial jet segment is expected to grow at 12.1%, driven by a strong commercial jet order book, which represents nine years of production. The strong order book is also reflected on the jet engines side with 23,000 engines on firm order. Demand for regional jets is expected to grow at 13.2%.
The company maintained its growth outlook at 2-5% for the North American automotive segment in 2014. The average age of passenger cars in North America stands at 11.4 years, against a historic average of 9.4 years, which implies pent-up demand. The company maintained its outlook for 0-4% and 6-10% growth in the European and Chinese automotive segments.
In the North American heavy-duty trucks segment, Alcoa has raised its growth forecast quite substantially from 5-9% to 10-14%. This is because of the robust order flow that Alcoa is witnessing in this segment, with orders up 20% on an year-over-year basis. The company maintained its expectations for shrinkage of 1-5% for the European heavy-duty truck segment.
The company maintained its expectations of shrinkage of 1-2%, growth of 2-3% and 8-12% for the North American, European and Chinese packaging segments.
In the building and construction segment, the North American segment is expected to see growth of 3-4%, based upon the 11% increase in non-residential contracts awarded in May. The company maintained its outlook on a shrinkage of 2-3% and a growth of 7-9% in the European and Chinese markets respectively.
Lastly, in the industrial gas turbines segment, the company expects a shrinkage of 8-12% at a global level. Orders were flat compared to 2012 levels. The gas turbine market is being negatively impacted by the increase in market share of coal in Europe and North America due to low coal prices, and subsidized renewable energy in Europe.
Aluminum has diverse applications in industry. 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 have kept LME aluminum prices depressed. This inventory has been built up partially as a result of aluminum being tied up in financing deals, which were made possible due to low interest rates. ((Aluminum Price Premiums: Disconnect Between LME and Reality Continues, Metal Miner)) 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 the 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 has kept prices depressed. 
However, aluminum prices have risen to their nine-month highs over the last month or so. Expectations that a mineral export ban from Indonesia, and global smelting capacity cuts could mitigate the oversupply situation have led to a recent rally in aluminum prices. However, this rally will only persist if the Indonesian mineral export ban and smelting capacity cuts fundamentally alter the structural oversupply situation. 
The fortunes of the company’s upstream businesses- the Alumina and Primary Metals segments- are to a large extent dependent on aluminum prices. In view of the uncertainty regarding aluminum prices, the company has shifted its focus towards value-added products, which command greater pricing premiums and command higher margins as compared to the upstream businesses.
Alcoa’s shift towards 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’s value-added products accounted for 76% of its total segment after-tax operating income in Q1 2014. ((Alcoa Boosting Aerospace Capabilities in Virginia to Meet Demand for Next-Gen Aircraft Engine Parts, Alcoa News Release))
In order to make its upstream businesses more competitive, the company has taken steps to to lower costs through idling high-cost smelting capcacity. As a result of these steps, Alcoa’s base smelting capacity reduced from 4.227 million tons at the end of 2012 to 3.953 million tons at the end of Q1 2014. Further, the company had 675,000 tons of idle capacity out of its base smelting capacity of 3.953 million tons. ((Alcoa’s Q1 2014 10-Q, SEC)) In the second quarter, Alcoa completed the curtailment of 147,000 tons of smelting capacity in Brazil at São Luís (Alumar) and Poços de Caldas. In August, Alcoa will permanently close the 190,000 ton Point Henry aluminum smelter in Australia. Further, in the second quarter, the start up of the company’s Saudi Arabia smelter, the lowest cost aluminum production facility in the world, was completed. This smelter is a part of Alcoa’s joint venture with Ma’aden. These actions complement the company’s portfolio transformation and have made the upstream businesses more competitive.
Thus, the company has performed solidly in Q2, driven by its portfolio transformation and cost savings for its upstream businesses.Notes:
- Alcoa Reports Strong Second Quarter 2014 Profits Driven By Continued Portfolio Transformation, Alcoa News Release [↩]
- Alcoa’s Q2 2014 Earnings Conference call Transcript, Seeking Alpha [↩]
- LME Aluminum Prices, LME [↩]
- Alcoa, Rusal’s Aluminum Production Cuts Not Enough With China Smelting, Metal Miner [↩]
- Aluminum price hits nine-month high as bearish wagers are off, Financial Times [↩]
- Alcoa’s 2013 10-K, SEC [↩]