The largest U.S. aluminum producer, Alcoa Inc. (NYSE:AA), reported earlier this week better than expected 3Q13 results as both automotive and aerospace end markets showed improvement and realized pricing was stronger than expected.
The strong commercial airline growth and an estimated 8 years of backlogs at Boeing and Airbus are driving the healthy growth of 9.5% in the aerospace end-market, which remains the highest growing end-market for Alcoa, despite the budget cuts resulting in a decline in the defense business. The aerospace industry demand is expected to grow by 9.5% and auto demand by 4% in 2013.
Although the company reported better-than-expected results, the operating environment remains challenging for Alcoa. Aluminum prices remain under pressure, aluminum futures on LME averaged $1845 a metric ton in the third quarter, down 13% year-over-year. For 9 straight years supply has exceeded demand.
A steep increase in Alcoa's own estimate of aluminum surplus indicates that the company underestimated the inventory surplus. The stronger-than-expected Chinese refinery production and weak demand has prompted the company to raise its aluminum surplus estimate to 636,000 tons from 130,000 tons previously forecast. Citi estimates an even bigger 2013 surplus to be 775,000 tons. This means that unless demand increases sharply, which seems unlikely, or supply growth slows down, aluminum prices will likely remain under pressure.
Despite of the impressive results, especially the cost reductions that the company has been able to achieve, and a strong growth in aerospace end-market demand, the company will continue to struggle to achieve positive free cash flow. The aluminum prices remain under pressure and the headwinds in upstream segments will be challenging for the company to overcome in near future.
After adjusting for one-time items, Alcoa reported adjusted 3Q13 EPS of $0.11, beating consensus sell-side estimates of $0.05 per share. Better-than-expected upstream pricing and costs largely drove the beat. The company reported consolidated after-tax operating income (ATOI) of $338 million, an increase of 11% from the previous quarter. Adjusted EBITDA of $675 million also improved Q/Q by $59 million.
Going forward the company expects after-tax operating income in both Global Rolled Products and Engineered Products to be down sequentially by 25% and 10% respectively. Upstream is expected to be unchanged, before adjusting for LME, FX and premiums.
The company maintained its growth rate in the annual aluminum demand at 7% for 2013. Other than the global heavy truck and trailer market, which the company now expects to grow by 7%, Alcoa kept other end-markets growth outlook unchanged. While the Europe automotive outlook remains challenged, the growth forecast for Chinese automotive and heavy truck and trailer has improved.
Alcoa's valuations aren't looking very attractive either. The company is trading at a trailing P/E ratio of 70.0 and forward P/E ratio of 19.37. It has a price-to-book ratio of 0.7 compared to the industry average of 0.8. Alcoa has a price-to-sales ratio of 0.4, slightly above the industry average of 0.3. The aluminum producer has a price-to-cash flow ratio of 5.3, lower than the industry average of 9.1. Alcoa has a dividend yield of 1.5%.
Conclusion and Investment Thesis
Although Alcoa reported stronger-than-expected results primarily due to lower-than-expected costs in the alumina segment and higher-than-expected prices in the primary metals segment, looking forward the challenges remain for AA. Given the potential for supply response and plentiful exchange inventories there is little fundamentally based upside to spot aluminum prices. In fact even before considering the impact of lower aluminum prices on Alcoa's earnings going forward the company is faced with some other challenges. Alcoa's steady downstream earnings are also showing signs of softness. High aerospace OEM inventories and seasonality are expected to drive a 15% decline in overall downstream results in the next quarter.
Moreover, under the current aluminum price, headwinds in the upstream segments will be challenging for Alcoa. Of course the company should report better results and it will also be positive for AA's stock price when the realized aluminum prices move higher; however, as of now it seems unlikely. The current aluminum inventories are more than 80% above the historical average (Barclays estimates) and as the premiums also start to fall, in the near-future the operating environment remains challenging for this New York-based aluminum producer.
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