Stagnant Earnings at Alcoa Despite Chinese Demand

Updated from 11:05 a.m. EDT on Oct. 8.

Aluminum manufacturer Alcoa (AA - commentary - Cramer's Take) reported relatively weak third-quarter 2007 earnings earlier this evening on a mix of fact ors, including seasonal slowdowns, weak North American demand and a depreciating U.S. dollar, despite China being a demand powerhouse. Restructuring charges related to Alcoa's downstream operations also reduced earnings as did lower metals prices.

Overall, diluted earnings increased year over year by 3.3%, to 64 cents per share, and decreased sequentially by 22%, from 81 cents per share last quarter. Revenue increased by 3.6%, to $23.3 billion. The stock closed after hours to $39.81, up 9 cents per share.

It should be noted that the weak earnings result should be placed in the context of ever-increasing Chinese demand, which is expected to import 1 million tons of aluminum in 2007. Alcoa announced that it intends to rid itself of its 7% stake in Chalco, the Aluminum Corporation of China, as well as accomplish the sale of its packaging and auto castings business (6.4% of income). This segment, nevertheless, experienced a 50% increase in operating income despite weak demand emanating from the North American automotive sector, in particular light trucks. These results were partially offset by higher demand in the aerospace sector despite delays impacting the ill-fated A380 Airbus.

Most of Alcoa's key segments, such as alumina, primary metals and flat-rolled products were also down, income declining, respectively, by 22%, 39% and 34%. These three segments combined represent 75% of income, and disappointing results were primarily the result of unfavorable energy and currency factors. Extruded and end products fared no better, with income down by $33 million due to slow demand in soft alloy extrusions offset by strong demand in global hard alloy extrusions.

Looking ahead, Alcoa will continue to be buffeted by problems in autos and housing despite the fact that the company reported strong demand from nonresidential building in North America. This quarter, Alcoa already registered a small increase in aluminum production by 4% simultaneously with prices of aluminum per metric ton increasing by 4.3%, to $2,734. Alcoa anticipates about 300,000 tons of a net surplus of aluminum over 2007, which should put further downward pressure on earnings.

Operating margins increased considerably to 17.2% despite a 5.2% increase in the cost of goods sold. On the other hand, R&D expense increased by 14%, and restructuring charges negatively impacted earnings by approximately 47 cents per share.

Alcoa's debt continues to remain in relatively reasonable zones of 43.5%, while cash increased by 159%, partly due to the sale of the Chalco stake. As well, Alcoa reported the destocking of distributors' inventories leading to a slight 2% decline in inventories.

It's clear that Alcoa needs to remove some of the instability to its earnings from outside economic factors. The company is trying to focus on new strategic initiatives upstream in bauxite mine development in Brazil as well as greenfield smelter expansion in Iceland, China and the Middle East. Downstream, the company is focusing on proprietary technologies, especially relating to alloys. Investors are yet to be convinced that this will pan out in terms of increased future earnings.

Alcoa Preview: A Wrench in Restructuring Plans

Alcoa (AA - commentary - Cramer's Take) -- the world's largest aluminum producer, a position it will lose once mining company Rio Tinto (RTP - commentary - Cramer's Take) takes over Canadian producer Alcan (AL - commentary - Cramer's Take) -- will report its third-quarter 2007 earnings on Oct. 9.

The Pittsburgh-based company, in an attempt to face up to economic realities emanating from the declining American automotive industry, has been engaged in a continuing process of restructuring its downstream operations, which began in 2005. In particular, it is envisaging the sale of its packaging and automotive castings business as well as restructuring its electrical and electronic solutions division. In previous years, Alcoa cut jobs in its extrusion plants, which make fabricated aluminum, in the U.S. and Europe. The new entity created by Rio Tinto's takeover of Alcan, however, will throw a wrench in Alcoa's ongoing restructuring and attempts to regain efficiency.

Analysts are expecting earnings to be up a tad, to 66 cents per share from 62 cents per share last quarter, while revenue is expected to be down to $7.42 billion from $7.63 billion. This quarter, Alcoa's restructuring will cost investors an anticipated $845 million, or 96 cents per share. Alcoa's shares appreciated by 54% last year, while its dividends yielded 1.8%.

In the context of an almost continued increase in aluminum prices over the last five years (despite a recent stabilization), Alcoa has reported relative stagnation in aluminum revenue over the last quarter. Aluminum segment revenue (13% of revenue) reported approximately the same level of sales, with a 2% increase in production while the average realized prices of aluminum increased by 5%.

Another important segment, primary metals (30% of revenue) reported a 7% decline in revenue, offset by a 10% increase in flat rolled products (24% of revenue), due to higher demand in the aerospace sector. Investors can expect decreased revenues in this segment in the third quarter, however, due to a seasonal slowdown. Extruded and end products (10% of revenue) reported a 17% decline in revenue due to softness in the soft alloy extrusion business. Finally, revenue in engineered products (14% of revenue) posted a 10% increase, again due to continued strong demand in aerospace offset by weakness in the North American automotive customer base. The final segment, packaging and consumer products, is the object of a sale. All in all, despite demand originating from the aerospace sector, investors can expect continued weakness in almost all Alcoa's segments pending the company's restructuring results.

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At the time of publication, Vijayraghavan held no positions in the stocks mentioned, although holdings can change at any time.

Vasu Vijayraghavan was an academic finance professor at the University of Paris who has now turned to a new career as a financial consultant. As an academic, she wrote on corporate governance issues, especially in the European context, and she believes in a long-run and balance sheet approach to stock picking.

Currently, Vasu is working as a consultant for lawyers, doing business valuation. She is a Level II CFA candidate and enjoys writing long/short and earnings calls pieces for TheStreet.Com.

Vasu holds a Ph.D. from the University of Michigan and a B.A. from Harvard University.