Alcoa Corporation (AA) Q2 2013 Earnings Report, Transcript and Summary

Good day, ladies and gentlemen, and welcome to the Second Quarter Alcoa Earnings Conference call. My name is Philip and I will be your operator for today. At this time, all participants are in a listen-only mode. Later we will conduct a question-and-answer session. (Operator Instructions) As a reminder, this conference is being recorded for replay purposes. I would now like to turn the conference over to your host for today, Ms. Kelly Pasterick, Director of Investor Relations. Please proceed.

Thank you, Philip. Good afternoon, and welcome to Alcoa's second quarter 2013 earnings conference call. I am joined by Klaus Kleinfeld, Chairman and Chief Executive officer and William Oplinger, Executive Vice President and Chief Financial Officer. After comments by Klaus and Bill, we will take your questions. Before I begin, I would like to remind you that today's discussion will contain forward-looking statements related 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 would like to hand it over to Mr. Klaus Kleinfeld.

Well, thank you, Kelly, and good afternoon to everybody. Thank you for tuning in. Let's start off with the key highlights for this quarter. We continue to deliver a strong underlying performance offset by special items on the performance side. We do see strong revenues despite lower metal prices. Metal price has declined 8% in the last quarter. Record profitability in the downstream, the after-tax operating income was up 23% year-on-year. Alcoa's value add business of first half of the year now makes up for 57% of our revenues and accounts for 80% of the segment after-tax operating income. Productivity strong with $539 million goes really through all business segments. I'll talk about that a little more later. Days working capital hits another record and we have been able to get another six days down, pretty spectacular. That alone equals $400 million on a year-over-year basis. Cash from operations comes out at $514 million, positive free cash flow with $228 million, strong liquidity when you look at the balance sheet with $1.2 billion cash and that in addition to having paid down $566 million of debt in the quarter. So, that shows you a very strong performance on the special items. The special items are primarily really related to restructuring and resolving legal legacy matter here, so those things and Bill will show you in detail are really targeted to improve our future competitiveness. And, why don't I immediately hand over Bill to you, so that you can guide us all through this?

Thanks, Klaus. As Klaus just highlighted, we had strong underlying performance in the second quarter. I will start the financial review with a quick summary of the income statement. As you can see, we held revenues steady on a sequential quarter basis at $5.8 billion, despite $161 per metric ton drop, or 7% in realized aluminum prices and LME cash prices were down 8%. Revenue levels were maintained by strong sales in the aerospace, packaging, building and construction and automotive markets. Compared to last year, revenues were slightly lower by 2% on a 4% drop in realized aluminum prices. Cost of goods sold percentage increased slightly by 120 basis points due to the lower LME impacts in revenue, largely offset by better productivity across the businesses. The change in other income and expense is largely due to unfavorable mark-to-market impacts on energy contracts. By now you know that we took significant restructuring and other charges in the quarter totaling $244 million on a pre-tax basis. I'll give further details on these charges on the following slide. Our effective tax rate for the quarter was negative 16.5%, which at first glance may be somewhat confusing to you. In this case, the restructuring charges, some of which had no or very low tax benefits resulted in a pre-tax loss and yet we still had tax expense in the quarter hence the negative rate. If you exclude discrete items, our operational rate for the quarter is 37%. We'd expect our operational rate to be approximately 35% for the full year. However, we will continue to experience swings in this rate given the volatility of our profit drivers within each taxing jurisdiction. So overall results for the quarter are net loss of $0.11 per share, but excluding special items, we have net income of…

Yes, thank you, Bill, and why don’t we go straight to the end markets. So, let’s start with aerospace. So we confirm our expectations that we are going to see a 9% to 10% global growth for this year in the aerospace market. Over 900 orders and commitments were signed at the Paris Air Show. I will talk more about it a little later. Value of that being $135 billion. The backlog for Airbus and Boeing now makes up 9,900 planes and that equals eight years of production. We have also seen that the airline fundamentals are improved, passenger demand is up, the revenue passenger kilometer is up 5.3%, cargo up, freight ton kilometers or miles whatever you want to choose 1.5% and industry profitability, the expectation also was up, the expectation now lies at $12.7 billion, compared to $7.6 billion in the last year. New aircraft orders also translated into new orders for jet engine, and Pratt & Whitney added over 1,000 new engines to their backlog, and GE recorded over $26 billion and engine deals are very, very good and I'll talk about that a little later. What's also important is, segments that really were not doing much up until recently like the regional jet segment is rebounding. We expect a 40% increase for this year. And the business jet, we expect 12% increase, so the only uncertainty that we have in the aerospace market these days really is the defense side, but everything else is really pointing in the right direction, meaning up. So, let us go to the next segment, automotive. In, automotive, let us start with the U.S. We are upwardly revising our production forecast to plus 2% to 5% from 0% to 4% that we had before. Why did we do that? Because, we…

(Operator Instructions).

First question, please.

Your first question comes from the line of Tony Rizzuto from Cowen and Company.

Thanks a lot for all the detail you have provided. I have got two questions. One is, how should we think about the sustainability of the premium over the LME metal prices? See that it widened out to $0.175 per pound and I know there has been some attempts by the LME to try to change offloading requirements. Are you concerned by that at all that it could narrow somewhat going forward?

Yes, well, look, I mean, the rules have only come out recently. They are for discussion, and on top of it, the LME has said, they won't apply that before 2014. I am not exactly sure what the rule wants to achieve because when you look at these so-called inventories that are stuck in the LME, we are really only referring to the cancelled warrants, and the cancelled warrants make up around 2 million, we would expect the total inventories visible and invisible to be around 10 million, so we are talking about 20%. The rest of the metal is really freely moving. Then when you look at the rules, it's basically really applying to two warehouses, Detroit, Metro Detroit and Pacorini in Vlissingen. So, those are the things that come to mind here and I also believe that probably the majority of the metal that's getting cancelled is probably waiting and these SKUs is going to lower cost of warrant storage. I feel that financing of the inventory remains attractive. You mentioned the contango has widened, the interest rates are still low. They might go up a little, but at the same time we’ve talked about that before. They would only go up if the economy recovers. That's basically what all of the central bankers have clearly said and I believe that that's what they will do then physical demand will kick in, so I am really not too concerned. What strikes me is that, the metal availability which I’ve read in some of the coverage, people are complaining about the metal availability. I don't think that that has ever been an issue in the aluminum market. Frankly if there is somebody who hasn't got metal available, I mean, you can send me an email or give me a call and we will solve that. I think there are producers that are willing most of the producers are willing to sign contracts and we've also seen that some of the consumers use the lower cost financing to build some consignments stocks themselves and have acted as warehouses. I think that that's probably what I would see there. I mean, if I think of the rule by itself or the LME by itself, the economy in general is recovering slowly with different speeds in Europe, as well as in the U.S. and there is some uncertainty around how the quantitative easing will wind down. I think, the interest is that LME really avoids the risk of a disruptive or sudden impacts and rather gradually over time adjusts and so this is our thoughts on this. We will obviously actively participate in the discussion and will provide our view to the LME, so not particularly concerned, but important to study, important that it is not too disruptive, not too sudden and rather gradually over time.

Thanks, Klaus. And, just a follow-up if I may. You have got some very exciting developments going on in the aero fastener side and I was wondering if you guys could provide some color on the growth rate of the aero fasteners in the quarter. However, you may (inaudible) quarter-on-quarter basis or year-on-year basis. That would be helpful.

Well, we have not provided the fasteners and the breakdown on that. I mean, that would be a pretty endless thing, but you've seen we have a growth target for our engineered products and solutions business out there and this is the $1.6 billion of additional organic growth from 2010 on to this year and we said that we are going to do that while we will be achieving profitability above the historic highs and you can see that we are acting against that again in this quarter when you look at our engineered products and systems business and we will continue that.

Thank you very much.

Your next question comes from the line of Curt Woodworth of Nomura.

(Inaudible) some of your supply/demand estimates for China.

Can you speak up a little bit, Curt? Please? Curt? Did we lose you?

Curt has dropped off from the line.

Okay. Well, we can bring him back at a later point in time, so let's move on to the next one.

All right. Your next question comes from the line of Brian Yu from Citi. Please proceed.

Thanks. Good afternoon, Klaus. On page 14 of the presentation slides where you go through the positive free cash flow target, your year-to-date spending is obviously well below the target. I think you mentioned that the Saudi JV, but that's going to be back half loaded. Is there any components of the managed growth capital and sustaining capital that would be back-half-loaded too?

Brian, we are essentially not putting out a revised full year estimate for capital expenditures and we will come in under the target and that's what we are trying to signal by way of showing you the half year numbers, but no, we haven't given guidance on what second half will look like.

Okay, and then if I follow-up along those kind of same lines, you have got some growth targets that you are well on track. It doesn't seem like much of that is tied to capital spending. What is being deferred? Is that something that you would spend the following year?

Yes, I would say that the growth targets are not at risk. Frankly, we look at every investment here on a standalone basis. We believe the way we have to manage our business is owning quite a number of different businesses. Some businesses are under enormous stress from external factors. So you see that we are shutting down facilities, curtailing them and restructuring them. At the same time, in the same quarter, we are utilizing great opportunities that we see on some ends. I mentioned two big areas are aerospace and automotive. We are putting capital in there. We are growing in this. We are capturing the opportunities. We will continue to do that. That's how we think about it. The capital allocation will have to stand on its own. There is no capital investment that has not been grinded very, very substantially through our corporate process. The capital threshold that we have out there, it's just the minimum requirement which we rarely get to, to be honest. Usually it's much, much higher the returns that we are approving. Okay, we have got to make sure that when Curt comes back online. Okay, next question, please.

Your next question comes from the line of Paretosh Misra from Morgan Stanley. Please proceed.

A question on your aerospace end markets. As you look ahead to the future opportunities within the aerospace market, which segment would capture that? In other words, historically you were capturing two-thirds of that in the engineered products and one-third in the flat-rolled. Is that expected to continue or with the changes that might change?

Well, no. This is good news. The good news is that we will be able to grow our aerospace business in every one of the segments that caters to aerospace and the segments that you have to think of is on the GRP side, it's basically plate and rolled material, right. So that falls into - it’s a big category in the Global Rolled Products side. On the EPS side, if you go through the EPS you look at forged parts, where it falls into, you look at our engine parts, our investment casting parts, the small and the big ones. We have smaller parts, air foils, as well as big investment casts. Then you look at the fasteners. So, those are really the segment that it falls into. Then there's a small element of it that even goes into the upstream side which is the high purity aluminum, right, which goes into our GPP side. But that's a very small part, right. But there are some applications, particularly out of space applications that require high purity aluminum. By the way also small alumina part which is rocket fuel. But those are small things, just for completion's sake.

Right, and if I could ask a follow-up? This is about your Tennessee investment. Could you remind me how much capacity it would add and what part of existing infrastructure you can use for this? Basically, I am trying to figure out what would be the barriers to entry into this market?

Yes, well, the barriers to entry is when you go to automotive and the main is heat treating, heat treatment capacity, that's usually the big bottleneck here. So, that's why we are adding this heat treatment here and some other things in Tennessee. What we do have there is already a very good hot mill which we can now leverage in a very, very good cast house, which we can leverage. Tennessee used to be extremely strongly focused on packaging and future it will also allow us to do packaging as well as auto, right? So, this is one of the big advantages of the Tennessee decision. Okay. Next caller on line?

Your next question comes from the line of Curt Woodworth from Nomura.

Okay. Good. Curt is back. Okay. Good.

Sorry about that. Klaus, I just wanted to get a little bit more color on your thoughts on China. I see you are showing an increased deficit, but when you look at the LME price relative to the average cash cost of produce I think most all these smelters in China are loss-making. So, I guess the question is, why don't you think more production is being cut given where the price is? And if China continues to produce at what's arguably loss making levels, do you think the global market, you can ever see more meaningful reduction and kind of the inventory overhang that the western world guys are facing? Thanks.

Yes. Well, there's so much we could talk about China. First thing is, we do see that our projection of an 11% demand growth for aluminum in China is really confirmed, right? So, demand continues to be strong, so that's the first thing. Second thing is, there are curtailments underway and we do see that and you saw it also reflected and Bill had an overview slide that showed also China, when you get a chance they take a look at that and you do see in there that there are curtailments particularly of the high cost smelters on the East Coast, and at the same time there is a slowdown of adding capacity in the West, right? So, in total the capacity that we see in China, is pretty stable. An important thing that I can't emphasize enough I have the feeling is that, in spite of what China does, I mean China for us in the aluminum industry is living on a different universe, so that universe let's call it earth aluminum and China aluminum and they rarely communicate, right? Because, they are high cost and they are not going to export and that's extremely important. I believe that we will continue to see the Chinese aluminum industry to restructure. We currently believe 41% of all of the smelters are under water and also keep in mind that the opportunity cost in this industry for China, Inc., are very high because they have to put energy and they have to put water in, they have to put air pollution in, and all of these are things that they really don't have that much of - and the employment impact as we discussed, I don’t know what, I mean, half year or nine months ago of this industry is very, very low. On top of it they import bauxite and alumina, so I am pretty confident that we will continue to see restructuring going on and probably in an accelerated fashion under the new leadership.

Okay. Thanks.

Your next question comes from the line of Timna Tanners from Bank of America. Please proceed.

Yes. Hi. Good evening.

Hi, Timna. How are you?

Hello. Since last quarter, just a simple question, I just want to get your updated thoughts on the Moody's decision to downgrade the investment-grade rating and with the S&P putting on warning I know you probably prepared to answer this. Just want to get your updated thoughts, please?

Well, look, first is, we were disappointed by Moody's decision. Second, we remained committed to maintaining investment-grade ratings. We are executing on all strategy. I mean, our goal for 2013, again, is that we will be positive free cash flow, you saw how we are tracking against it and I assume that people will see that that's pretty good under the conditions we are under. The Moody's decision, if you had a chance to read the Moody's report, actually it really says it in a very fair way. It's more a reflection on their view of macroeconomic conditions with volatility of metal prices than a reflection of the financial and operating strength of Alcoa which they do admit, right? They also do see that we have a strong balance sheet and liquidity. There are really limited near-term bond maturities. We control what we can control and you see that, and we cannot control the metal price volatility.

Absolutely. I guess, that was the second question that leads into that, right? Given the strong performance in your downstream business, which I think you have done a great job highlighting, would it not make sense to try to address the volatility upstream and maybe consider some hedging or other mechanism to kind of offset that up and down movement in the…?

Timna, that's a good point, and I think probably over the 125 years that Alcoa is around, at least that from the time that hedging was possible, this has been the debate, typically when Bill and I sit down with investors and have that discussion, investors don't like it because typically they want the aluminum exposure. We do a little bit of hedging once in a while, particularly when it comes around a growth project or a particular structure that we have when we have it tied to an energy contract or those types of things, but other than that our impression is people rather want to be exposed to it. Frankly when you look at some folks that have hedged pretty substantially, it's rather limited with rather limited success, I would say.

Okay, fair enough. Thank you.

And Timna, if you don't mind, if I can just address your first question also. A couple of other points to keep in mind and Klaus did say it, but it's important to note that from a maturity perspective, we have the convertible that we expect to convert next year and we don't have maturities until 2017. Secondly, since the downgrade, we have been in the commercial paper market, and we have done a sizeable amount of commercial paper. Now you will see on our balance sheet we didn’t end the quarter with commercial paper because we simply had the cash generation to be able to cover it. So I think that's also a good sign that the commercial paper market certainly hasn't been closed to us after the downgrade.

Okay, Timna. Next question please.

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

Could you talk a bit about Ma'aden and what the current status is of the smelter. It has been operating now at least partially for six months. Where do you stand on some of the other start-ups?

Yes, well, on Ma'aden, I have given you a pretty detailed description last time. Obviously, what we see now, we have progressed. We are now seeing, and overall project is 80% complete, all is on-track. The smelter, as you know, started to operate on December 12 last year, continues to operate. We are bringing it fully online until the end of the year. We actually do have a solution also on the power side. Some of you that are more familiar know that there is some issue on brining the power station online. This will not affect us because there is even a backup solution and they have been making also substantial progress on that. The second thing, the rolling mill, we will, as expected, roll off the first coil in end of the year, in December this year. So that also goes very well. The project completion on the rolling mill is currently at 82%. Then, on the refinery, we are also doing well, 57% complete, and the mine, we have just started, this is the last piece and is at 20%. So, all pretty good on-track as expected, and yes, so we are rolling.

The only think I would add to that, Chuck, is that from a budget perspective, overall, we are on-track.

Totally on-track.

Totally on-track from a budget perspective, and I think it will be one of the first megaprojects in our industry to be delivered on budget.

Don't jinx it. I mean, that's why I am going to knock on wood here, you know. So, okay.

Yes, let's not jinx it.

Exactly Chuck, thank you for the question.

This sounds good.

Yes, it does sound good. It looks even better, Chuck. Better than it sounds, because it's pretty massive, pretty amazing. Okay, next question, if there is one.

All right, your next question comes from the line of Paul Massoud from Stifel. Please proceed.

I appreciate a lot of the color you have put into the slides on some of your cost and your productivity savings, but I guess I was struck a little bit by the fact that you sort of hit 72% of your target and you chose I guess not to increase your target for the year of $750 million. Should we assume that you are coming to the end of cost savings, or can we expect some adjustments there?

No. Yes. That's a good question, Paul. Yes. The target that we have in there is the target that we set at the beginning of the year and we set that target in light of seeing what the productivity improvements were in the last year. Then obviously I am not saying that it's easier to get these things, and then if you look at the last years I mean we achieved this $5.5 billion in productivity, so this year again we set an aggressive target of about $750 million which is a little below last year, but that's the target that we set. The reason why I showed you where we stand is, because you made the correct calculation. We obviously are ahead of it. What internally is happening, internally what is happening is, people typically are deployed much more substantially than what their target is. Because we know that in our process not every idea gets to realization, there are some things that fall out in this what we call degrees of implementation from idea to cash. That's why people over deploy and trust me I mean, I know for a fact that every one of the businesses already has a very, very different target and that this will not add up to the $750 million, but number will be higher and that's the reason also why we have come out higher, because people are executing against the higher internal target. That is absolutely fine with me by the way if people are giving themselves an additional stretch, because I believe the $750 million already was a quite a stretch and I know how hard people are working on it. That's why I mentioned also this to you to give you a feel for what's really going on, because this can only get done by basically every one of our 61,000 people working on that and I could have chosen another field. I mean, looking at the days working capital, bringing it down by additional six days. And, Bill said it, when we looked at the achievements that we had done by the end of the year, we thought this is already spectacular and frankly nobody would have thought that this would be possible and we thought if we maintained that we would already be world-class, but you see this is the hangover that is steered by when people see what they can do and people continue to go the next mile and that's what you see here. It chimes through in all of these facts, because it really is the DNA of the firm.

Okay. I appreciate that. Then maybe just a follow-up on Ma'aden. In the past, you said that's probably going to account for 2 percentage points of the 10 percentage point move in Primary Metals, and so I was just curious when you expect it to hit the low point of cost production? But, I guess you had said before it would be at the low end of the cost curve when it's up and running, but curious when you might get to that?

That's a good question, Paul. We expect it to be fully in operation for the whole next year. We are ramping it up now. Full operation is going to be next year.

Okay. I appreciate it.

Last question comes from the line of David Gagliano from Barclays. Please proceed.

Hey, Dave.

Hi. How are you?

Very good.

Good. I have a question regarding the profitability of the Primary segment. Just if we could get a sense as to the overall profitability of the segment at various aluminum prices? For example, we've got aluminum prices now below $0.80, but the Premiums are at $0.17. I was wondering, if you could just give us a rough estimate of what percentage of the current Primary aluminum production is profitable on an ATOI basis given those two metrics? And, then what would that percentage be if the combination of those two metrics drops by another $0.05 per pound, for example?

It's a tough question to answer, Dave. I mean, in aggregate, you can see that at these levels, primary metals lost money in the quarter. Our view is that that's symptomatic of the entire industry. We would say that on a cash basis and you can see that we still made a positive EBITDA in the segment in the second quarter, but if you look at the overall cash cost of the industry, we would say that there is around a third of the cash cost of the industry that's currently under water and that's including the higher premiums and the current metal price, so it's just difficult to answer a hypothetical question at this point but you can see the results that we were able to achieve in the second quarter.

Okay, but out of the portfolio that you have that was producing in the second quarter, against that same metric that you mentioned versus the industry and this is the third, how much of Alcoa's volume was not profitable on a cash cost basis?

If you go back, we have announced the 460,000 ton review. So you can assume that that 460,000 tons is very close on a cash basis at the current level. So that's why the 460,000 tons are under review. We have already taken action on 105,000 tons of the Soderberg in Canada. We will continue to evaluate anything on a cash basis to determine whether we shut it down over the next few months at the current price levels?

And Dave, it's also not that difficult to figure out which ones are the higher costs here.

It is very clear. We have got high cost capacity in Australia. We got high cost capacity in Southern Europe. We have got some higher cost capacity in parts in Brazil, depending on what power prices are.

Exactly and we are very committed to acting and I wish that this would be indicative to every company that's playing in our industry, if I might say that and add that as a nice closing remark to your question. Okay, good. I guess this is all the time we have today and thank you for joining us. We are continuing to turn in strong operating performances and growing our value add businesses, as you saw, as we are improving our competitiveness in the upstream business and putting also legacy issues behind us. So thank you for tuning in and I am looking forward together with Bill to continue to engage with you. Thank you very much. This concludes this call. Thanks.

Ladies and gentlemen, that concludes today's conference. Thank you for your participation. You may now disconnect. Have a wonderful day.