Alcoa Q2 Earnings Preview: Productivity Improvements To Offset Impact Of Weak Aluminum Pricing

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Alcoa (NYSE:AA) will release its Q2 2015 results and conduct a conference call with analysts on Wednesday, July 8. We expect the company’s efforts to boost the productivity of its operations, including the closure of high cost smelting capacity, to offset the impact of weak aluminum prices on its quarterly results. In addition, a spate of acquisitions over the past year should boost the volumes of the company’s Engineered Products and Solutions (EPS) business segment. Alcoa further advanced the transformation of its product portfolio towards value-added segments with more announcements in Q2. In this article, we will take a look at what to expect from Alcoa’s Q2 results.

See our complete analysis for Alcoa

Aluminum Pricing

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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. Economic weakness in Europe and slowing Chinese growth have contributed to the weakness in aluminum demand, and consequently prices, over the last few quarters. [1] China, the world’s largest consumer of aluminum, is expected to witness a slowdown in GDP growth to 6.8% and 6.3% in 2015 and 2016, respectively, from 7.4% in 2014. [2]

On the supply side, production capacity has not been reduced corresponding to the weakness in demand over the last few quarters. Persistently high aluminum inventory levels relative to demand have kept 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. [3] Despite inventories being at a record highs, 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 provisions of subsidies or renegotiated power contracts to smelters, which serve as a disincentive to cut production. China accounts for around half 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. [4] This oversupply situation is expected to keep aluminum prices depressed.

As a result of the fall in LME prices, regional aluminum prices in China are trading below the costs of production of a majority of Chinese domestic smelters. [5] However, Chinese aluminum producers were boosted by a recent decision of the Chinese government to provide tax breaks and subsidized power to domestic aluminum smelters. [6] In addition, the Chinese government also reduced export taxes on Chinese exports of the metal earlier in the year. [7] A combination of these factors is likely to lead to an increase in Chinese production and exports, which could further worsen the gap between supply and demand, resulting in weak global aluminum prices. This is reflected in the trajectory of London Metal Exchange (LME) aluminum prices so far this year.

LME aluminum prices averaged roughly $1,800 per ton over the course of the second quarter in 2014. These prices averaged close to $1,750 per ton in Q2 2015. [8]  Lower aluminum prices are likely to weigh on the company’s results, particularly those of the Primary Aluminum and Alumina business segments.

Recent Developments

Alcoa announced the permanent closure of its Poços de Caldas primary aluminum smelter in Brazil, with effect from June 30. [9] Alcoa has been reducing high cost smelting capacity, as it seeks to better align its business to the lower aluminum pricing environment. Alcoa’s smelting capacity stood at 3.5 million tons per year (MTPY) at the end of 2014, as compared to 4.04 MTPY at the end of 2013. [10] With the closure of the Poços de Caldas smelter, the company’s smelting capacity will be reduced further to 3.4 MTPY. [9] The reduction in smelting capacity is reflected in the company’s aluminum shipment forecasts.

See our forecasts for Alcoa’s primary aluminum shipments

The closure of high cost smelting capacity and other productivity improvements boosted the company’s pre-tax profits to the tune of $238 million in Q1. ((Alcoa’s Q1 2015 Earnings Call Transcript, Seeking Alpha)) The company is targeting savings of $900 million for the whole year. ((Alcoa’s Q1 2015 Earnings Call Transcript, Seeking Alpha)) The company’s productivity improvement initiatives are expected to offset the impact of weak aluminum pricing on the company’s Q2 results on a year-over-year basis.

Alcoa continued the transformation of its product portfolio in Q2 as well. The company invested $22 million to set up Hot Isostatic Pressing (HIP) technology capabilities at its aerospace facility in Whitehall, Michigan. The move will boost the company’s capacity to produce titanium, nickel and 3D-printed jet engine parts. [11]

As a result of smelting capacity closures and acquisitions and investments, which have boosted Alcoa’s capacity for value-added products, Alcoa has been increasing the share of value-added businesses in its revenues. Alcoa’s Global Rolled Products (GRP) and Engineered Products and Solutions (EPS) divisions, which produce value-added light metal products with a focus on the automotive and the aerospace markets, together accounted for 57.4% of the company’s overall revenues in Q1 2015, as compared to 54.4% in 2012. [12] In calculating these figures, we have only considered third-party sales. The company’s increasing emphasis on value-added products was reflected in the EPS segment’s shipment figures, which rose 17% year-over-year in Q1. [12]

What We Would Like To Know From The Conference 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 and margin improvement. It would shed some light on the road ahead for Alcoa.

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Notes:
  1. LME Aluminum Prices, LME []
  2. World Economic Outlook January Update, IMF []
  3. Aluminum Price Premiums: Disconnect Between LME and Reality Continues, Metal Miner []
  4. Global aluminum production; the sound of one hand clapping, Reuters []
  5. Chinese aluminium smelters shut more capacity as prices dive, Reuters []
  6. China measures set to boost aluminium supply, Financial Times []
  7. Aluminium price drops after China tax cuts, Financial Times []
  8. LME Aluminum Prices, LME []
  9. Alcoa to Close Poços Smelter in Brazil, Alcoa News Release [] []
  10. Alcoa’s 2014 10-K, SEC []
  11. Alcoa Invests in Aerospace Technology in Michigan to Capture Demand for Bestselling Jet Engine Parts, Alcoa News Release []
  12. Alcoa’s Q1 2015 Earnings Release, Alcoa Website [] []