Alcoa Q2 Earnings Review: Productivity Improvements And Value-Added Businesses Offset Impact Of Weak Aluminum Pricing

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Alcoa (NYSE:AA) released its second quarter earnings results and conducted a conference call with analysts on Wednesday, July 8. Productivity improvements and Alcoa’s ongoing transformation of its product portfolio towards value-added products, offset the impact of weak aluminum pricing and higher maintenance and labor related costs on the company’s results. The company’s adjusted net income, which excludes the impact of one-time charges, stood at $250 million in Q2 2015, as compared to $216 million in the corresponding period last year. [1] The company reported one-time charges, totaling $110 million after tax in Q2, primarily pertaining to the closure of smelter, power plant, and mine facilities. [2] Quarterly revenues stood at $5.90 billion in Q2 2015, around 1% higher as compared to the corresponding period a year ago. [1] In this article, we will take a closer look at Alcoa’s Q2 results.

Weak Pricing Offset by Productivity Improvements

Alcoa’s average realized price per ton of aluminum sold stood at $2,180 in Q2 2015, around 5% lower on a year-over-year basis. [1] This was partly due to lower London Metal Exchange (LME) aluminum prices. The company uses LME prices as a reference for the prices of its own primary metal sales. LME aluminum prices averaged roughly $1,750 per ton over the course of Q2 2015, as compared to $1,800 per ton in the corresponding period of 2014. [3]

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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. [3] 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. [4]

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. [5] 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. [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.

The weakness in aluminum prices weighed on the performance of the company’s upstream businesses, the Primary Aluminum and Alumina business segments. The after-tax operating income of the Primary Aluminum segment fell to $67 million in the second quarter this year, as compared to $97 million in the corresponding period of last year. [8] However, despite weakness in aluminum, and consequently alumina pricing, the after-tax operating income of the Alumina business segment rose to $215 million in Q2 2015, as compared to $38 million in Q2 2014. ((Alcoa’s Q2 2015 Earnings Release, Alcoa Website)) This was primarily because of cost savings from the closure of high-cost refining capacity over the course of the last year.

Company-wide productivity improvements boosted Alcoa’s year-over-year quarterly profits to the tune of $209 million post tax. [8] These productivity improvements offset the impact of higher costs to the tune of $187 million pertaining to higher maintenance and labor related costs. ((Alcoa’s Q2 2015 Earnings Call Transcript, Seeking Alpha))

Portfolio Transformation and Performance of Value-Added Segments

The Global Rolled Products (GRP) and the Engineered Products and Solutions (EPS) divisions constitute Alcoa’s value-added business segments, which produce value-added light metal products with a focus on the automotive and the aerospace markets. The fortunes of Alcoa’s upstream businesses are to a large extent dependent on aluminum prices. To lessen its dependence on the prices of the metal, Alcoa has shifted its focus towards value-added products, which is reflected in its revenue figures. The percentage contribution of the GRP and the EPS segments sales to Alcoa’s total revenues has steadily increased. This figure (considering only sales to third parties) has risen from 54.4% in 2012 to 57.7% in the first half of 2015. ((Alcoa’s Q2 2015 Earnings Release, Alcoa Website))

The results of the GRP segment in Q2 2015 were boosted by robust demand for aluminum sheet from the automotive sector. In addition, productivity improvements offset the impact of lower aluminum prices. Lastly, Alcoa’s company-wide efforts to boost productivity also helped boost the segment’s results. [8] As a result of these factors after-tax operating income for the GRP segment rose marginally to $76 million in Q2 2015, as compared to $70 million in Q2 2014. [8] After-tax operating income for the EPS segment rose to $210 million in Q2 2015, up from $202 million in Q2 2014. [8] Higher shipments driven by recent acquisitions and productivity improvements offset the impact of weak pricing on the results of this segment. Shipments of this segment are expected to rise rapidly in the coming years driven by recent acquisitions.

See our forecasts for Engineered Products Shipments

The Road Ahead

The company expects to continue its ongoing strategic shift towards value-added products in 2015. The investments made by the company in boosting its production capacity, and enhancing the breadth of its product offerings, should result in an increased share of value-added products in the company’s overall revenues in the years to come. In addition, the company expects to continue improving the productivity of its operations. Alcoa expects to realize benefits totaling $900 million from productivity improvements. ((Alcoa’s Q2 2015 Earnings Call Transcript, Seeking Alpha)) A combination of an increasing share of value-added products and productivity improvements, should continue to mitigate the impact of weak aluminum pricing over the rest of the year.

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Notes:
  1. Alcoa’s Q2 2015 Earnings Presentation, Alcoa Website [] [] []
  2. Alcoa’s Q2 2015 Earnings Call Transcript, Seeking Alpha []
  3. LME Aluminum Prices, LME [] []
  4. World Economic Outlook January Update, IMF []
  5. Aluminum Price Premiums: Disconnect Between LME and Reality Continues, Metal Miner []
  6. Global aluminum production; the sound of one hand clapping, Reuters []
  7. Aluminium price drops after China tax cuts, Financial Times []
  8. Alcoa’s Q2 2015 Earnings Release, Alcoa Website [] [] [] [] []