Alcoa (AA) will kick off this quarter’s earnings season when it announces its Q1 results after the market closes on Monday, April 8. Alcoa’s results are closely eyed as it usually is the first Dow company to post earnings. We expect the company to record soft earnings, but most investors will watch for any cues on its outlook. Aluminum prices and demand remain sluggish. Also, aluminum inventory continues to remain high relative to demand, keeping a lid on London Metal Exchange (LME) prices for aluminum.
Aluminum prices on the London Metal Exchange, which are used as a benchmark by the company to determine its own prices, have been dropping sharply since the latter part of February. Prices have dropped from $2100/tonne to below $1850/tonne and are still trending lower. 
While macroeconomic data from the U.S. has been quite positive recently, we don’t think that the pricing data and negative trend being witnessed for aluminum is puzzling in this context. This can be attributed to the time lag factor between economic indicators and prices of commodities. High inventories and suppression of market forces are more likely factors influencing the aluminum market.
Importance Of Aluminum Prices For Alcoa
Alcoa is organized into four business segments: Alumina, which mines bauxite and processes it into the precursor to aluminum; Primary Metals, which smelts aluminum; Flat-rolled Products, which makes sheets used in beverage cans as well as airplane wings and car parts; and Engineered Products and Solutions, which makes aerospace fasteners, turbine blades and truck wheels. While the Flat-rolled and Engineered Products and Solutions divisions produce value-added products and thus generate higher margins, a significant proportion of Alcoa’s earnings still come from the Alumina and Primary Metals divisions. This makes its earnings highly sensitive to aluminum prices.
The Aluminum Price Trend In Q1
In its 2012 annual earnings conference call, Alcoa’s management said that the prices of aluminum on the London Metal Exchange are being heavily influenced by macroeconomic factors and sentiment rather than supply-demand fundamentals. 
Indeed, the continuing European debt crisis and slowing Chinese growth contributed to the decline in aluminum demand and prices over the last few quarters. The correlation claimed above, however, seems to be breaking down in the first quarter of this year at first look if one compares the recent aluminum price trend with the latest macroeconomic data.
While European economies haven’t shown improvement, they haven’t deteriorated further either. Also, the macroeconomic data for U.S. seems to be positive for the most part. Passenger automobile sales are surging, indicating renewed consumer confidence. The housing market is on an uptick. This translates into higher sales of pickup trucks which are used extensively by construction companies. A lot of them are updating their old fleets. 
To understand this disparity, one must keep in mind that these indicators show a time lag. Aluminum would have been bought by automotive firms long back in order to produce and sell these vehicles now. Any pricing change would have been witnessed at the time of buying.
One factor that might explain falling prices is the persistently high aluminum inventory relative to demand, which may be keeping a lid on London Metal Exchange prices for aluminum. While LME prices are not the actual realized prices for Alcoa, they do indicate a broader trend in global aluminum prices. Also, despite inventories being at a record high, market forces have failed to rationalize supply through shutdown of smelting capacity. This is primarily due to state intervention in the form of provision of subsidies or renegotiated power contracts to smelters. This is more prevalent in China but also elsewhere. 
What We Would Like To Know In The Earnings Call
In its 2012 annual earnings call, Alcoa’s management had made 2013 growth projections of 9-10% for the aerospace segment, 4% for the U.S. automotive segment and 12-19% in the Chinese automotive segment. Also, the company had predicted a 7% growth rate for aluminum demand in 2013.
We would like to see if results in Q1 are in tandem with expectations so far. We are skeptical that the performance of the Chinese automotive market and the overall demand growth in the first quarter are in line with projections. 
We would also be keen to listen to the management’s comments on the aluminum pricing trend in the first quarter. It had sounded optimistic in the earnings call but market prices tell a different story.
We have a Trefis price estimate for Alcoa of $8.
- LME Aluminum Price Graph, LME
- Q4 2012 Earnings Presentation, Alcoa Website
- Rallying Auto Sales Signal Improving U.S. Economy, Fox Business
- Barclays forecasts LME Aluminum at $2,200/t by 2013 end, Commodity Online
- Q4 2012 Earnings Conference Call Transcript, Seeking Alpha
Disclosure: No positions