Alcoa: Looking Past The Results

| About: Alcoa, Inc. (AA)

Summary

Alcoa shares have tanked after the company reported its third-quarter results last week as it missed estimates, but this could be a buying opportunity.

Though Alcoa’s revenue dropped, its earnings increased tremendously on the back of massive productivity savings, a trend that should continue going forward.

Alcoa is making progress in the bauxite segment as its third-party bauxite contracts have increased to $468 million so far this year on the back of demand in China.

China’s bauxite requirement will stay strong as the country isn’t self-sufficient yet, as it is importing approximately 30% to 40% of its bauxite requirements and 10% of its alumina needs.

The third-quarter earnings of Alcoa (NYSE:AA) that were reported earlier this week took a toll on the stock as it fell more than 14% due to a miss on both earnings and revenue. Its earnings for the quarter came in at $0.32 per share, while revenue was $5.21 billion. Both of these fundamentals fell short of the consensus estimate by 6% and 2%, respectively. Even more surprisingly, its revenue declined 6% on a year-over-year basis and 2% on a sequential basis.

However, the point to note here is that despite this decline in the revenue, its earnings per share grew 357% from last year. This improvement in the bottom line can be attributed to its efforts generating exceptional productivity gains across its business segments. In fact, Alcoa achieved productivity gains of $377 million across all segments last quarter.

Therefore, it won't be a wise idea to dump the stock just because its revenue is under pressure, mainly due to weakness in the aluminum prices. However, investors can look at other positives such as productivity gains, cost reductions, new contracts, end-market improvements, and a rebound in aluminum prices that should enable Alcoa to report better results going forward. Let's take a look at these points.

Productivity gains more than offset the weakness in aluminum prices

To stay profitable in a low pricing environment is a tough task. However, Alcoa is pulling the right strings on the back of its productivity initiatives. In fact, the company has generated around $1.11 billion in productivity gains this year through process optimization moves, reducing the lead times, improving quality, and reducing overheads. This is given in the following chart.

Click to enlargeSource: Alcoa

More specifically, Alcoa recognized $187 million in productivity gains for its Arconic segments and roughly $190 million for the Alcoa business last quarter. On a year-to-date basis, its Arconic segments have realized $547 million and Alcoa segments have enjoyed $569 million of productivity savings.

The most important thing is that the company remains on track to deliver $650 million in efficiency gains for Arconic and plans to achieve more for Alcoa because it has already exceeded its target of $550 million for the year, which will enhance the bottom line.

New contracts will be tailwinds

Alcoa will also benefit from third-party bauxite sales. During the third quarter, Alcoa signed a new contract valued at $53 million for the next couple of years. This was on the top of the $60 million contract it had signed in the second quarter of 2016. On account of these new contracts, its third-party bauxite contracts have risen to $468 million so far this year. Under these new contracts, Alcoa is expected to supply bauxite to its customers in China, the United States, Europe, and Brazil.

As a result of these new contracts, the company anticipates its bauxite sales to triple in 2016 from that of 2015 levels. Moreover, bauxite business remains very promising for the future due to robust demand from China. According to Investor Intel, China's bauxite need is not over yet as the country isn't self-sufficient yet. At present, China is importing approximately 30% to 40% of its bauxite requirements and 10% of its alumina needs.

The other report from Bloomberg states that bauxite demand in China is growing rapidly and is forecasted to rise significantly in the next 15 years. As such, companies such as Rio Tinto (NYSE:RIO) are planning to invest nearly $1.9 billion in raising output due to China's quest for raw materials for its aluminum smelter and alumina refineries.

Click to enlarge

Source: Bloomberg

Given such a robust demand for bauxite in China, Alcoa is doing the right thing by signing new contracts in the region that should enhance its bauxite sales.

Continued improvement in the cost structure should improve Alcoa's earnings

Apart from gaining new contracts, Alcoa is proactively managing its costs and capacity that will strengthen its earnings performance in the future. For instance, Alcoa has lowered its alumina cost curve target to the 17 th percentile, representing a 4-point improvement over its target and a 13-point improvement since 2010. Likewise, its alumina cost curve has been reduced to the 38 th percentile on the global aluminum cost curve, illustrating a 13-point improvement since 2010.

On account of these cost containment efforts, Alcoa's smelting cash production costs are down by $349 per metric ton as compared to 2015 levels. In fact, these efficiency measures have produced nearly $65 million of productivity improvements so far this year.

The company has been able to achieve this reduction in costs due to higher productivity and utilization. For instance, its refinery ran at 90% of the name plate capacity last quarter. As a result of the reduction in costs and higher productivity due to such measures, Alcoa's alumina EBITDA per metric ton was 40% higher in the third quarter of 2016 as compared to the prior-year quarter.

In addition, Alcoa has lowered its SG&A expenses by more than 4% on a sequential basis. Also, it has reduced its research and development expenses and restructuring charges by 3% and 22%, respectively, on a sequential basis. As a result of these reductions, its total costs and expenses during the third quarter came in at $4.8 billion, representing a decrease of 3% from the second quarter of 2016.

Conclusion

Although Alcoa's share price has been beaten after the recent earnings release, its long-term prospects remain healthy. At the same time, the company is benefiting from its productivity gain initiatives that should boost Alcoa's earnings in the future. Also, its efforts to reduce its cost curve and other expenses cannot be overlooked. So, despite the headwinds in aluminum pricing, Alcoa remains a good bet going forward.

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.