Value-added Businesses To Boost Alcoa’s Q3 Results

-3.28%
Downside
33.74
Market
32.64
Trefis
AA: Alcoa logo
AA
Alcoa

Alcoa (NYSE:AA) will report its third quarter results and conduct a conference call with analysts on October 8. We expect the company’s increasing emphasis on its high-margin value-added products to positively affect its results. In addition, the recent resurgence in aluminum prices will also positively impact the fortunes of the company’s upstream primary aluminum and alumina businesses .

The company has steadily shifted its product portfolio towards value-added products, in order to reduce its dependence on aluminum prices, which experienced an extended period of weakness over the past several quarters. The company’s value-added products enjoy pricing premiums and higher margins as compared to its upstream businesses. The benefit of such a strategy is likely to be reflected in its results.

See our complete analysis for Alcoa

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

Aluminum Pricing

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 weakness in aluminum demand, and consequently prices over the last few quarters. [1]

On the supply side, production capacity was not reduced corresponding to the subdued demand conditions over the last few quarters. Persistently high aluminum inventory levels relative to demand have kept London Metal Exchange (LME) aluminum prices depressed. This inventory was 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 failed to rationalize supply through the shutdown of smelting capacity. Though global aluminum majors like Alcoa and Rusal did make significant smelting capacity cuts, the same was not true of Chinese companies. This was 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 accounted for around 45% of the world’s aluminum production in 2013, and the expansion in production by Chinese producers more than made up for capacity cuts by global majors. [2] ((Alcoa, Rusal’s Aluminum Production Cuts Not Enough With China Smelting, Metal Miner)) This oversupply situation kept aluminum prices depressed over the last few quarters. This also prompted Alcoa to shift its product portfolio towards value-added products, in order to reduce its reliance on aluminum prices.

However, aluminum prices have rebounded recently. Global smelting capacity cuts in response to low prices have finally taken effect. LME warehouse stocks of aluminum were down around 10% in July, since the start of the year. [3] In view of the global smelting capacity cuts, as per a poll conducted by Reuters in July, the market for aluminum is expected to move from an oversupply of 235,500 tons in 2014 to a deficit of 4,444 tons in 2015. [4] However, global smelting capacity restarts in response to higher aluminum prices are expected to lower or eliminate the extent of the deficit next year. In any case, the tightening of the physical supply of aluminum has led to a recent rally in aluminum prices.

LME aluminum prices averaged roughly $1,800 per ton over the course of the third quarter in 2013. These prices have averaged close to $2,000 per ton in the third quarter this year. [1] Higher aluminum prices are likely to translate into better results for the company’s Primary Aluminum and Alumina business segments.

Alcoa’s Strategic Shift Towards Value-added Products

The Global Rolled Products (GRP) and the Engineered Products and Solutions (EPS) divisions constitute Alcoa’s value-added business segments. 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 superalloy 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 and power generation industries. The fortunes of the upstream segment are to a large extent dependent on aluminum prices. To decouple itself from its dependence on aluminum prices, the company has shifted its focus towards value-added products.

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 58% at the end of 2011, 2012, 2013 and Q2 2014, respectively. [5] In calculating these figures, we have only considered third-party sales. The company’s value-added products accounted for 72% of its total segment after-tax operating income in the first half of 2014. (( Alcoa’s Q2 2014 10-Q, SEC))

Recent Developments

Alcoa has bet big on the aerospace segment in its continued portfolio transformation towards value added products. In Q3 2014 alone, several major developments in the aerospace segment have taken place. These include the signing of a 10-year agreement worth $1.1 billion to supply jet engine components to jet engine manufacturer Pratt & Whitney, a division of United Technologies Corporation. [6] Alcoa also announced the signing of a long-term contract worth $1 billion to supply aluminum sheet and plate products to Boeing. [7] In addition to these developments in the aerospace sector, the company also announced that it will launch its lightest heavy-duty truck wheel in Europe in 2015. [8] The company also announced its intention to permanently close its Portovesme primary aluminum smelter in Italy, in order to reduce its high-cost smelting capacity. [9]

All these developments will translate into a growing share of value-added businesses in Alcoa’s revenue and profit figures in the coming years.

Expectations from the Earnings Call

In view of the company’s ongoing portfolio transformation, we would like to know from the company management, what the flurry of activity in the company’s value-added business segments would translate into in terms of revenue. Going forward, the impact of these value-added products on margins would also be of interest to us. It would help us understand how far the company is able to insulate itself from swings in aluminum prices.

View Interactive Institutional Research (Powered by Trefis):

Global Large CapU.S. Mid & Small CapEuropean Large & Mid Cap
More Trefis Research

 

 

Notes:
  1. LME Aluminum Prices, LME [] []
  2. U.S. Geological Survey Mineral Commodity Summary-Aluminum, 2014 []
  3. Aluminium prices hit 17-month highs, Financial Times []
  4. Aluminium smelter restarts seen undermining global deficit outlook, Reuters []
  5. Alcoa’s 2013 10-K, SEC []
  6. Alcoa Announces Jet Engine First in $1.1 Billion Supply Agreement with Pratt & Whitney, Alcoa News Release []
  7. Alcoa Signs Multiyear Supply Contract with Boeing Valued at More Than $1 Billion, Alcoa News Release []
  8. Alcoa to Roll out Lightest Heavy-Duty Truck Wheel in Europe, Offering Increased Fuel Efficiency, Payload, Alcoa News Release []
  9. Alcoa to Close Portovesme Smelter in Italy, Alcoa News Release []