Avoid Alcoa After The Latest Results

| About: Alcoa, Inc. (AA)

Summary

Alcoa shares have fallen steeply since its third-quarter results as the company missed estimates, and it is likely that end-market weakness will continue to take a toll.

Though Alcoa will be splitting its business into two from next month, this move might not work as both the upstream and downstream businesses will face headwinds.

Aluminum prices will continue to trend lower on account of an increase in smelting capacity in China, which will lead to higher aluminum oversupply.

Additionally, auto demand in the U.S. is tailing off as, despite subsidies, automakers have been unable to enhance their deliveries of late.

Alcoa (NYSE:AA) reported its third quarter 2016 results last week. The company reported revenue of $5.2 billion, which was down from $5.6 billion reported in the year-ago quarter, and also fell short of analyst expectations of $5.3 billion. The third-quarter net income came in at $166 million, i.e. $0.33 per share, which was way better than $44 million, or $0.06 per share, in the year ago quarter. However, the company missed the adjusted EPS estimate of $0.35 as it reported an adjusted EPS of only $0.32, after excluding special items. The adjusted net income was $161 million.

A look at the positives

Both the segments of Alcoa felt market pressures during the third quarter. The revenue from the aluminum business was $2.3 billion, which meant almost no growth over the preceding quarter. This segment was hurt due to the continued weakness in aluminum prices and the impact of curtailed and closed operations. However, the segment showed productivity savings of $190 million for the quarter and that of $569 million year to date, which is already past its 2016 annual target of $550 million.

On the other hand, the Arconic segment that sells products made of higher-end specialty aluminum and titanium alloys to the automotive, aerospace, and construction industries was on the receiving end of customer adjustments to delivery schedules due to delays with new jet aircraft engines. Also, the softness in the North America commercial transportation market and pricing pressures led to weakness in this segment. However, there was some relief provided to this high-margin segment due to some strong North America automotive volume.

Market prospects

The company has stated that it is expecting global automotive production to increase by 1% to 4% this year. The company also said that the aircraft deliveries are expected to be flat or increase by up to 3% at the maximum in 2016. This might not bring a smile to the face of Alcoa investors, but it is indicative of a possible revenue growth if not margins across all segments.

Also, we are going to see the company split into two entities from the start of the next month. This will mean that the focus on each business will be sharper after that. As is well known by now, the newly incorporated Alcoa Corporation will focus on the upstream business related to the traditional smelting processes. On the other hand, the Arconic business will be focusing on engineering products for aerospace and automotive businesses.

This move is expected to help as the management will be able to deal separately with its traditional aluminum business and the higher value metals and specialty alloys business. The latter, i.e. the newly formed Arconic, will be catering to the aerospace customers. Moreover, many of the materials that this segment is producing and shipping to aerospace customers right now are mostly titanium and specialty alloy products rather than aluminum products.

These materials are expected to enjoy faster growth and deliver higher margins for Arconic over time. So, in a way, Arconic won't be much affected by the ups and down of aluminum, the commodity. Moreover, with the emergence of new age companies in automobile as well as aerospace segments, Arconic is bound to see a surge in demand for its specialty products in the future. This is a significant takeaway for investors from the news of the split.

On the other hand, the upstream legacy business of aluminum mining and smelting will lose the stability provided by the downstream products business till now. It will be more correlated to aluminum and alumina price fluctuations. This is bad news for Alcoa since the price of aluminum is expected to remain weak going forward.

A look at the bear argument

However, in my opinion, both the upstream and downstream segments of Alcoa will continue to face weakness going forward. For instance, the upstream business will be hurt by lower aluminum prices in the future. This is because the oversupply in the aluminum industry will continue going forward, leading to lower prices.

This is because the supply of aluminum could increase in China in the second half of the year due to an increase in smelting capacities. For instance, aluminum smelting capacity in the Xinjiang province of China could increase by 4.3 million tons by 2020, which will have a negative impact on pricing since this currently accounts for 12% of the current output in China. Additionally, another 4.5 million tons of capacity will go online in Inner Mongolia and Shandong provinces.

The extent of the oversupply could be understood from the fact that supply addition in Xinjiang is enough to exceed aluminum smelting capacity in Europe and Russia. Hence, the increase in oversupply in aluminum will continue to weigh on pricing, which is bad news for Alcoa investors.

On the other hand, auto sales in the U.S. have been losing pace of late. For instance, in the month of August, auto sales in the country declined 4.2% on the back of weak demand. In fact, it is estimated that auto sales in the U.S. will now continue to lose momentum on the back of soft demand that has already peaked by now.

Meanwhile, in the month of September, auto sales dropped 0.6% at the top six auto makers. This was despite the fact that automakers offered huge incentives in a bid to lure customers. The following chart shows the increase in incentives offered by automakers this year:

Click to enlarge

Source: The Wall Street Journal

Conclusion

Thus, the guarantee of the success of both the downstream and upstream segments going forward, even after the split, is not a foregone conclusion. As such, I think that it will be a good idea to stay away from Alcoa as its weakness post the results will continue.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.