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Alcoa's Bloodbath: Weak Demand, Tight Margins

by: Hard Assets Investor October 09, 2008 | about stocks: AA    
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By Julian Murdoch

With everything that's been going on in the market lately, what's a little more bad news?

After the market closed on Tuesday, Alcoa (AA) started the third-quarter earnings reporting season with a bang. Unfortunately, it was not the fun party kind, but the giant gaping crater kind.

Analysts (Bloomberg survey) had estimated that Alcoa would post earnings around 51 cents per share. The reality turned out to be 37 cents per share. Needless to say, Alcoa's stock price took a beating, hitting a low of $13.40 on Wednesday before closing at a 52-week low of $14.71 - down nearly 12% on the day, and off an ungodly amount from its midsummer high of $45/share.

Chart: Alcoa performance

The problem, according to Alcoa, is a devil's brew of falling aluminum prices, falling demand and tight margins. Let's take those one by one. 

Aluminum Prices

Commodity investors are accustomed to roller coaster rides, but aluminum has been a true E-ticket ride. 

YTD LME Aluminum Alloy Cash Buyer

Chart: YTD LME Aluminum Alloy Cash Buyer

In the beginning of the year, it looked like aluminum could do no wrong. The first quarter saw record increases with LME aluminum rising over $700 per tonne. Prices fluctuated around the $3,000/tonne level until the great downward slide (let's not call it a crash) of this summer. Current prices aren't far off where they started the year, but that's not much comfort if you're Alcoa - or an Alcoa shareholder. 

Demand (Or The Lack Thereof)

Forty-eight percent of aluminum is used in construction and transportation - things that require day-to-day confidence from buyers in both the retail and industrial sector. Neither industry is looking good right now. Boeing (BA) is still in the middle of a strike, and the longer it goes on, the more likely production (and therefore aluminum consumption) will fall. Already, analysts are beginning to revise down their estimates for airplane delivery.

Things are even worse on the ground. Auto sales in North America are down, as are orders for trucks. Alcoa put the numbers down 14% and 13%, respectively, during the earnings call. Things are even worse in Europe, with Alcoa stating that the European auto market is down 20%.

Even the Japanese aren't immune. MarketWatch reported that a Japanese media source says Toyota (NYSE:TM) is expecting consolidated operating profit to be 40% less than expected for its fiscal year that ended in March. Also in the report was the concern that Toyota might miss its 2008 sales targets. Needless to say, its share price took a hit - down 11.6% on the Nikkei. It's worth pointing out that this isn't hard news, just aggressive speculation, but it makes sense.

If there is any good news on the demand front, it's that China is still experiencing growth, although it is expected to slow to 15% rather than a previously expected 22%. But at this point, the fact that we're talking about slowing growth as opposed to outright decline has to be seen as a positive in what is otherwise a dismal, dismal base metals environment.

Tight Margins

Falling prices and lower demand don't kill you on one condition - you can scale your costs so quickly and so linearly that margins remain intact. It's still not fun, but it's not, you know, lethal.

One of the largest cost components for aluminum smelting is energy. We've talked about this before: one-third of the cost of aluminum is energy, and right now, crude oil seems to drive the energy bus. High energy costs squeeze smelters' profit margins, and because demand has fallen, companies like Alcoa weren't able to pass those high costs on to their customers - instead they made less money. And although the price of oil has come down, those cost savings are not being realized quickly enough to make a difference to Alcoa's bottom line.

Chart: Crude Oil

Looking Ahead

Like good corporate spin doctors, Alcoa's leadership spent Tuesday's call trying to point out (or invent) positives. From Alcoa's 8K-bundled press release filed on October 8:

"We have taken action to conserve cash and maximize profitability through very adverse economic conditions," said [Klaus] Kleinfeld [Alcoa's president and CEO]. "Given the sharp decline in metal prices and increasingly soft demand in our key markets, we are stopping all noncritical capital projects, making targeted reductions to match market conditions, and are adjusting our manufacturing capacity to meet demand in rapidly changing upstream and downstream markets. We are halting production at our smelter in Rockdale, Texas, adjusting alumina capacity accordingly, and are continually reviewing under-performing assets throughout our portfolio. And, we are suspending our share buy-back program." 

In other words, they are in complete reaction mode.

But let's back up a bit. In January 2008, the company announced record profits, and CEO Alain Belda crowed from the rooftops about current and future plans. 

"We have invested in new plants, expanded production at others, modernized operations, renegotiated long-term power agreements, and built new energy facilities to extend our energy access at competitive rates, while also continuing to invest in growth markets such as Brazil, China and Russia. These actions, combined with portfolio and cash flow management, our share repurchase program, conservative leverage, and our commitment to sustainability delivered results now, and will continue to generate quality profitable growth for decades."

Back then, aluminum prices were just about where they are right now - within a few hundred dollars per tonne.

From exuberant optimism to "very adverse economic conditions," all with the same price of aluminum. Admittedly, inventory levels and future economic growth outlooks have changed, but (like the market) the commentary seems a bit histrionic on both sides. It was never as good as it seems, and it's likely not as bad as it seems today.

Alcoa did get in a voice of moderation later in its remarks:

"While we face volatile and uncertain markets today, longer-term trends will drive a rebound in global aluminum demand, and the forward market reflects underlying optimism on medium-term aluminum pricing," said Kleinfeld. "During difficult times, we will examine opportunities across the industry to improve our competitiveness, use every lever to improve profitability, and position the company to deliver stronger value when demand improves."

Always end on a positive, right? Well, despite what feels like well-earned cynicism on my part, it might not be just spin.

China, the country responsible for producing about a quarter of the world's aluminum, closed smelters and reduced production this summer because of inadequate energy and high input costs. Aluminum Corp of China Ltd. (Chalco) [NYSE:ACH], has been hit just as hard by high costs as Alcoa, warning on Tuesday that its third-quarter results are going to be down more than 50%. If demand in China is going to continue to grow, the aluminum will have to come from somewhere, and with declines in shipping and energy, Alcoa might be able to position itself well competitively when the market recovers.

Pulling that off would require some seriously on-top-of-it management. Given that Alcoa misses its own earnings guidance 50% of the time, it's hard to be too optimistic.

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This article has 5 comments:

  •  
    Oct 09 05:18 PM
    Clear, informative article -- thanks! One question, Julian: even if Alcoa's management in the past has been poor, do you think Klaus Kleinfeld deserves the benefit of the doubt? I haven't followed it closely, but I'm under the impression he did a great job at Siemens before a bribery scandal among his underlings forced him to leave.
    Reply
  •  
    Oct 10 02:39 AM
    In case you dont realize... our whole aluminium industry is still too small to support the need of our automotive industry to build lighter cars . We still need to build twice as many smelters or more to meet the requirments of the automotive industry in order to boost the fuel efficiency. The world still produce thirty tons of steel for every ton of aluminium. We had been busy stripping all our homes of old aluminium framed windows to boost scrap supplies, yet it is n ot enough . We will demand far more aluminium than you would imagine in the forseeable future.. We will save a lot of energy recycling aluminium than recycling steel.
    Reply
  •  
    Oct 10 02:43 AM
    That is why we are bullding ridiculously tiny cars of steel while we can buiild more comfortable cars made of aluminium for same fuel efficiency.. tiny cars is not practical and we found that out already long ago... That was the reason we returned to bigger cars and gas guzzling this last time around... Tiny cars will never survive here in America . Put aluminium in tiny cars to make them bigger and more comfortable..
    Reply
  •  
    Oct 10 02:48 AM
    Everyone bought up steel stocks where they should ini aluminium stocks... Steel is three times as heavy as aluminium... One pound of aluminium is as strong as two pound o f steel. One pound of alumiium is 50% bigger than two pound of steel.. imagine that?!!!! Aluminium is stronger by lighter density and bigger mass than steel. Everyone will love aluminium again!
    Reply
  •  
    Oct 13 12:21 AM
    You could make humongous cars out of plastic. LOL I wonder why suspend the stock buybacks, honestly it's never been cheaper and what a way to instill confidence, why not just scale back the buyback? How safe is this dividend? That seems like the 800lb gorilla in the room. According to the balance sheet they are sitting on a lot of finished goods, not good in todays environment. We like to see cash when times are tough, during the call I believe they stated 1:3 debt to cash, I wonder if they are counting goods as cash. Feedstock costs seem to be cheapening that's a plus. Maybe that's the plan, gorge on material while it's cheaper to make it and horde it until things get better. Seems Klaus has inherited a sh*t sandwich. Long AA on valuation. Though, I think a dividend cut will have the faithful running for the exits.
    Reply
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