Alcoa Corporation (AA) Q1 2013 Earnings Report, Transcript and Summary

Good day ladies and gentlemen, and welcome to the first quarter 2013 Alcoa earnings conference call. [Operator instructions.] At this time, now, I’d like to turn the call over to Kelly Pasterick, director of investor relations. Please proceed.

Thank you, operator. Good afternoon and welcome to Alcoa's first quarter 2013 earnings conference call. I'm joined by Klaus Kleinfeld, Chairman and Chief Executive Officer; and William Oplinger, Executive Vice President and Chief Financial Officer. After comments by Klaus and William, we will take your questions. Before we begin, I would like to remind you that today's discussion will contain forward-looking statements relating to future events and expectations. You can find factors that could cause the company's actual results to differ materially from these projections listed in today's press release and presentation and in our most recent SEC filings. In addition, we have included some non-GAAP financial measures in our discussion. Reconciliations to the most directly comparable GAAP financial measures can be found in today's press release, in the appendix of today's presentation, and on our website at www.alcoa.com under the Invest section. Any reference in our discussion today to EBITDA means adjusted EBITDA, for which we have provided calculations and reconciliations in the appendix. And with that, I'd like to hand it over to Mr. Klaus Kleinfeld.

Thank you very much, Kelly. Good afternoon to everybody and before we go through all the details, let me give you a summary on how I see this quarter. I think it’s been a great start into the year. We are delivering a strong number of results here. All segments are profitable. Net income is the best net income since the third quarter of ’11. EBITDA, 16%, up sequentially, 11% year over year. Record profitability on the downstream, 20% EBIT margin, 20.9% EBIT margin to be precise. We have improved performance also on the upstream side, despite year on year lower metal prices. Strong liquidity, $1.6 billion cash on hand, and a solid global end market growth, and we are reaffirming our aluminum demand growth of 7% for 2013. So with that, let me hand over to Bill Oplinger, our new CFO. Bill, welcome.

Thanks, Klaus. As Klaus just highlighted, we had a very strong first quarter. I’ll start the financial review with a quick summary of the income statement. As you can see, revenue of $5.8 billion was down slightly on a sequential quarter basis, based on two fewer production days in Q1 versus Q4. Compared to last year, revenues were down 3% on lower LME prices, which were down 8%, and the impact of primary production curtailments in Europe. However, due to strong productivity, which you will see more details on later, COGS percentage actually improved sequentially by 110 basis points. And overhead costs were also down sequentially from the highs we saw in Q4 2012. Looking at other income, recall that we had a large gain of $320 million in the fourth quarter associated with the sale of [Tapoco] power assets. From a tax perspective, our tax rate for the quarter was 27.4%, which was favorably impacted by a $19 million discrete tax item which will be discussed on the following slide. So overall, results for the quarter are net income of $0.13 per share. Now let’s move to the special items for the quarter. Included in the net income of $149 million was a net benefit of $28 million, or $0.02 per share, associated with special items. Stripping that benefit out, we made $0.11 per share, which is $0.05 higher than last quarter. There were four noteworthy special items in the quarter: restructuring costs of $5 million related to the exit of the [litho] business in China, which was announced in the fourth quarter, and additional severance related costs of $2 million from a prior layoff program. In addition, we booked a $19 million positive impact in discrete tax credits primarily due to the American Taxpayer Relief Act. Lastly, there’s…

Thank you very much, Bill. So let’s continue and go to the end markets slide here. Thank you very much. So if you look at that slide, and compare it to what you saw the last time, in the last quarter. This has not changed very much. We continue to forecast basically worldwide growth in all of our end markets, and there are substantial, as you can see, sector as well as regional differences. So let’s go through this in the usual way. Aerospace, we see and project a 9-10% growth in 2013. Large commercial aircraft, the largest segment in this, we see this growth even higher than that, with 12%. In this segment, the backlog is now 9,400 aircraft. That’s more than eight years of production. And we are also seeing that gradually the deliveries are increasing in single aisles like the Boeing 737 or the A320. And on the twin aisles, we are actually seeing higher realized prices. And on top of it, the underlying fundamentals here, improved air travel demand on the passenger side. The expectations are up 5.4% for this year in cargo, up 2.7%. So this is all good, and people are projecting that airline profitability will also point up $10.6 billion. It’s a number that people expect for this year. Also interesting is that other than the large commercial aircraft segment, which is doing, as I just said, very well, we do see a rebound on the regional jets, plus 40%, as well as business jets, plus 16%. The only uncertainty in this larger aerospace segment is the defense sector. But overall, it’s a very attractive and very stably growing end market. Let’s move on to the next segment, U.S. automotive. U.S., let’s start with that. On the automotive side, new vehicle sales continue…

[Operator instructions.] The first question comes from the line of Brian Yu from Citigroup.

Bill, I think you had mentioned in your prepared remarks that with the free cash flow targeting, we’d be looking to deploy more aggressive operational. If you could kind of list those out for us in order that they would be deployed. And then along those same lines, it looks like on the credit rating side, it’s still under review. How important is that, maintaining an investment grade rating, in conjunction with the free cash flow objective?

Brian, we have said all along that we are very committed to it, and Bill had that in his presentation. We are very committed to be free cash flow positive this year and we are operating against that. You see in this quarter, again, in spite of all the headwinds on the primary side, they are showing really really good performance. You can see we’re coming down on the cost curve. And then you see a very, very good and strong performance also on the [mid] and even more so on the downstream side. That’s a strategy we’re executing against. But we’re very committed to being cash flow positive this year. And we use basically every lever for that. You can go from days working capital and to be able to get another four days out, honestly, we ourselves were surprised that we were able to do that. That has been very, very good performance from everybody. It requires a lot of care for the detail, for the productivity that you saw in there. A lot of work going into that.

And specifically, Brian, when we talk about improving on the operational targets, last year we delivered over $1.2 billion in gross productivity. We’re looking at further deployment against the current productivity target. We’ll be aggressively managing capital, both sustaining and growth. And our upstream business clearly understands that at the current metal price cash is very important. So as Klaus said, it will be productivity, it will be overhead, it will be working capital, and it will be capex. As far as the ratings go, I think Klaus alluded to it. It is important for us to maintain investment grade. We, I think, had a very strong cash generation quarter in relation to where we’ve been historically. And we are working with the ratings agencies to ensure that they understand all the good things that we’re doing within the company to meet their metrics.

The next question comes from the line of Michael Gambardella, JPMorgan. Please proceed sir.

I just wanted to say I thought some of the charts were very good that you included on this go round of the aerospace chart on 25. Giving people a sense of where your exposures are I think is great slide, and some of the other slides were very good too. I appreciate the extra guidance on some of those segments. On the [debt] side, I think on one of the slides you said your target to maintain debt to capital for the year is 30-35%. I think you said you’re at 35% in the first quarter. So you’re basically saying you’re going down in terms of leverage from this point on, for the year. Is that correct?

Our target is 30-35%. We’re sitting currently at 34.7%. And net debt to cap is 30.5%.

Okay, and one last question. On the automotive exposure, are you planning more capacity to the auto sheet body, [unintelligible]?

Yes. That’s what the expansion that we have underway in Davenport is targeted at. Absolutely.

But above and beyond the Ford pickup?

We have not mentioned what customers we are catering to, and will not do that. But I did mention that the capacity that we are bringing online is pretty much already committed.

The next question comes from the line of Sal Tharani, Sachs. Please go ahead.

A couple of quick questions around free cash flow. Do you include the modern investment in your free cash flow calculation?

The modern investment is post the free cash flow calculation, so it actually goes into cash for investments. So the free cash flow calculation is simply cash from ops less sustaining capital. And since this is an investment, it’s not covered there.

And on that line, this new development happening in Messena, where you’re going to spend $50 million plus in capex, and plus the cleanup, is that included in your capex budget? Or is it on top of that?

It is included in our capex budget. And just to be clear, on the Messena record of decision, that has already been reserved. So that’s in there already.

And this $52 million takes you to the full spending you need? Or there will be several phases beyond this?

There will be several phases.

Do you know what the total will be over the next couple of years?

The $52 million is spent over the next few years, and as we get closer, we’ll announce the size of the project in the future.

Next question comes from the line of Timna Tanners, Bank of America Merrill Lynch. Please proceed, sir.

Not a sir. Just wanted to ask you a little bit about some of the overhead cost savings. So in your corporate expenses line and your SG&A line. That’s where, at least on our estimates, the outperformance was. So just wondered if you could give us a little bit of help on kind of the run rate for the first quarter and is that sustainable throughout the year, or if we might see the seasonal trend of higher costs as the year moves on.

The comparison that you’re drawing is against the fourth quarter, and typically we see a higher spend in the fourth quarter. And so we did not see that recur in the first quarter, and it came from a series of initiatives. I don’t anticipate that we will see significantly higher SG&A during the course of the year.

I would actually go even a little further, Bill. The most likely scenario is that we will continue to bring SG&A down. Wouldn’t you agree with that?

Klaus is alluding to the fact that we have a series of internal initiatives to lower overhead expenses.

So in addition to the productivity gains, focus on the SG&A and corporate expenses is something we can expect this year?

Yes.

The next question comes from the line of David Gagliano, Barclays. Please proceed.

My first question is along the same lines as Sal’s question earlier. Does the free cash flow target for the year, or being free cash flow positive target for the year, include or exclude the EUR200 million payment in Italy and the $450-500 million pension funding requirement?

It is after those. So yeah, it includes the effect of those. That’s the case.

And then my follow up, just on the primary metal segment, it looks to us like the third-party realized price worked out to about a $0.17 per pound premium when you do it on a per-pound basis over the LME average. If you lag the LME average by about two weeks. My question is if we assume regional premiums don’t change, is that magnitude of a premium over the LME a reasonable assumption moving forward?

I think that you see where the regional premiums are, and the rest, I think you will be able to figure out yourself.

I guess the question, in the past there have been some timing issues. I just want to make sure there’s no timing issues with regards to this quarter.

The timing issue is the same as you’ve always seen, and as Bill referred to, it’s a 15-day lag on the LME.

The next question comes from the line of Tony Rizzuto, Cowen Securities. Please proceed.

My question is how should we think about EBITDA margins in the EPS division with segment in the remainder of this year. And if you could give us a vision for 2014, obviously you’re not going to cover [unintelligible]. Just want to get a better feel for that as we go forward.

As you are well aware, we have targets out for every one of the businesses, and also targets for our EPS business. And the target for the EPS business is broken down in a growth target, which we basically put out at the end of 2010, for ’11, ’12, and ’13. So this is the last year. And we said we were going to achieve $1.6 billion additional revenues, and we broke that down into various buckets. And the second thing we said was the profitability target. And we said we want to make sure that the performance is above historic norms. And as you can see, in this one slide that I provided, when you see the 10-year performance year in EPS, you see that we have stably gone up and we continue to attempt that. And I think you also saw that with this quarter now, a 20.9% EBITDA margin, is a nice place to be at. And that’s our commitment.

I don’t have the slide deck in front of me, but is it possible that we could see those margins maybe getting up? Is it possible they could get up to the mid-20 range? Is that something that you’re thinking about?

Well, we have a commitment, as I said, and when you have a chance, take a look at the slides, and you can access those. The commitment is very clear. We’re going to have a performance on EPS that’s above historic norms. And you can clearly see where the historic norms are.

Yeah, and the extent of the guidance we’ve given, Tony, is around the second quarter. EPS had a record first quarter, 20.9%, and they’re projected to be 5% better in the second quarter.

[Operator instructions.] The next question comes from the line of Aldo Mazzaferro, Macquarie. Please proceed.

On the Messena project, now that you’ve moved ahead and decided to go forward with it, is there any timing that you see in terms of the EPA finalizing their plan for cleanup, and of the wide variety of what they’re saying could be the range? I’m just wondering if you have any clarity.

The good news is what’s called the Record of Decision has been put out by the EPA last week. So this is final. And after 25 years, I think, I don’t know exactly when this whole debate started. And a very good cooperation with the communities, with the EPA, a lot of testing, a lot of science that goes into it, we have been able to come to a conclusion, and the EPA has basically come out with this final decision, which is called the Record of Decision. And it’s in line with what they had proposed before as a remedial action plan. And if you want to attach a dollar number to it, the dollar number is $243 million. And Bill said it before, the good news also is that because we had been working very intensely together with everybody there, this is also the number that we have accrued, so there is no impact coming from that. It was a lot of work for a lot of people, and very, very good cooperation and fortunately openness towards the science.

The next question comes from the line of Paratesh Mirza, Morgan Stanley. Please proceed.

I had a question about your capex, of a billion dollars of sustaining capex and $550 million in growth capex. How much of that is for upstream versus downstream?

Unfortunately I don’t have that right in front of me. But you can clearly follow up with Kelly and she’ll give you a better estimate of it. You can imagine that a large portion of that is in the upstream, with some of the sustaining capital requirements that we have. It’s specifically around residue storage areas and things like that. So we will follow up.

The next question comes from the line of Charles Bradford, Bradford Research. Please proceed.

Could you talk a bit about the assorted projects and what kind of startup costs you’re incurring, and how they’re going to run for the next few quarters?

Well, as I said, I mean, the good news is we are ahead of our own plan. We had the first hot metal on the 12th of December last year. So this has only been 25 months after the pouring of the first concrete. So now we’re ramping up, and also on the ramp up things look really good. So we will be complete as I think it was on one of the slides there. We will be able to basically produce for this year roughly 250,000 tons of metal. Construction is almost 90% complete there on the smelter side. And for next year, we will be at full operating capacity. I don’t know whether we have given out any breakdown. I don’t think so.

I think we alluded to it in January, to a $20 million outflow in the first quarter, and we did better than that. And so we were approximately $12 million outflow in the first quarter. And we’re projecting to maintain that in the second quarter. So that’s a combination of startup costs and actual operations. And we believe, at this point, that’s ahead of where we would have thought to have been at this point in the project.

We have a follow up question from the line of Sal Tharani, Sachs. Please proceed.

On slide 26 you talk about aluminum lithium. It’s very interesting that you are talking about almost a 30% CAGR [unintelligible] This is the revenue I think you expect Alcoa to generate. I was wondering if you have the capacity to increase, and do you have, I don’t know whether it’s license or qualifications, needed to move on to new product with these airlines, or also the [air frame] producers. Or are you still working on those?

To start with the second part, and I think I actually mentioned that, most of these revenues are already committed contracts. So yes, we have that. It’s basically designed in. On the capacity side, we are, as we speak, building out our capacity, because at this point in time the capacity for aluminum lithium production that we have is basically in Pittsburgh at our tech center, and then [unintelligible] in our U.K. facilities. And we are building an outlet, basically, in LaFayette. And that’s also built into the capital costs for this year. That’s going to be specialized on aluminum lithium. So that’s where we stand.

And just quickly on the auto side, I know you’re not telling us which customer it is for the Davenport facility, but [unintelligible] everybody it’s an idea we’re looking at. And if there is another platform which goes fully aluminum, let’s say, down the road, 2017, 2018, I’m just wondering if Davenport would be enough, or you can further expand, or do you think another facility will be needed if you become part of the provider for that platform.

That’s a very, very good question, and I can tell you, Davenport is not enough. Davenport is not enough. Basically, Davenport is basically sold out, even though we haven’t even built that part, the automotive side of things. So that is something to talk about at a later point in time. But that’s better news, more good news than bad news, I would say.

And needless to say, we have optionality. [crosstalk] We haven’t announced at this point, but we do have optionality going forward.

And in fact, the optionality allows us also to do some things that we probably could not have done before.

The last question comes from the line of Harry Mateer, Barclays. Please proceed.

So I’m just going to follow up with one question on the credit rating if I can, Bill. Given that you’ve been executing against the backdrop of your free cash flow targets and your operating performance, is there anything left to do here to try and save that rating? You know, is issuing equity something that’s on the table to save that? And then related to that, can you just walk us through potential debt reduction levers in the next six months? I guess specifically, you do have a maturity coming up in July. How do you plan to take care of that? Are you going to refinance it? Or pay it down with cash?

The plan is to pay it down with cash. So just to be clear on that, Harry. Before we’re even considering issuing equity, we have a series of options, a series of levers, that we will be pulling at various stages. And it’s continued capital reduction, better productivity, better working capital, and if need be, asset sales. So those are all the things that we have in our arsenal to ensure that we stay where we need to be from a cash flow perspective. So we are committed to ensuring that we keep that investment grade rating.

Okay, I guess that’s all the time we have today. So let me conclude. All in all, I think you all agree we had a strong quarter. What makes me very positive here, our strategy is working. I mean, step by step, little by little, we are making progress. You see that the value-add businesses are ever-greater contributors to our bottom line, and that they have great growth opportunities. Also, thanks to the innovation capabilities, technical capabilities, that we have. And I think that you also see that the upstream side is gaining competitive business and overcoming some headwinds. As many of the questions referred today, I think you can also tell we have a very, very strong commitment throughout the company. Otherwise, we would not be able to achieve such numbers on working capital, to commit to generate cash in every aspect. So with that said, thank you very much for joining us.