Alcoa Corporation (AA) Q3 2013 Earnings Report, Transcript and Summary

Good day, ladies and gentlemen, and welcome to the Q3 2013 Alcoa Incorporated Earnings Conference Call. My name is Jason and I’ll be your operator for today. At this time, all participants will be 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’d now like to turn the conference over to your host for today, Ms. Kelly Pasterick, Director of Investor Relations. Please proceed.

Thank you, Jason. Good afternoon and welcome to Alcoa's third 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 we begin, I’d 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 measure 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 the call over to Klaus Kleinfeld.

Well, thank you, Kelly. So let me quickly characterize the quarter for you. This is a strong third quarter driven by performance, our repositioning. As working, we increased the earnings sequentially and year-over-year strongly driven by the downstream profitability ATOI is up 22% year-on-year. Upstream improved performance now for eighth consecutive quarters, productivity stands at $825 million across all segments year-on-year, very good performance there. Days working capital, record third quarter low, five days lower than the prior year thus gave us $300 million in cash. Cash from operations stand at $214 million, negative free cash flow at $36 million. We executed all curtailments swiftly and safely and I will refer to that a little later. So with this, let me hand it over to Bill to go through the numbers more in detail though.

Thanks, Klaus. As Klaus just highlighted, we had very strong operating performance in the third quarter. I will start the financial review with a quick summary of the income statement. Revenue held steady on a sequential quarter basis at $5.8 billion, despite a $57 per metric ton drop, or 3% decline in realized aluminum prices. Compared to last year, revenues are also relatively stable with approximately a 1% decrease on a 2% drop in realized aluminum prices. Cost of goods sold percentage decreased sequentially by 110 basis points due to better productivity across the businesses and favorable currency impacts. The sequential change in other income and expense is largely due to favorable mark-to-market impacts on energy contracts. Note that this benefit is backed out of our calculation of net income excluding special items. As we said last quarter, we took additional restructuring charges in the primary business associated with the closure of the Soderberg lines at Baie-Comeau and one line at Massena. Restructuring charges totaled $151 million pre-tax which I'll detail in the following slides. Our effective tax rate for the quarter was 41.3%, and at 32% without discrete tax items. The ongoing operational rate should be assumed to be 33%. So overall the results for the quarter are net profit of $0.02 per share. But excluding special items, we have net income of $0.11 per share and improved metal sequentially and from prior year despite lower realized aluminum prices. Let’s take a closer look at the restructuring charges. Included in net income of $24 million is an after-tax charge of $96 million or $0.09 per share associated with special items primarily for restructuring. Restructuring costs of $109 million after-tax relate to actions taken to improve competitiveness in the upstream. $103 million is due to the announced closure of two…

Well, thank you Bill, well said. I’ll start with the overview on the end market. Lets go on to the composite slide up. Let’s start with Aerospace. We continue to see aerospace growing at 9% to 10% this year. The major segment here making up for the major part aerospace large commercial aircraft. We actually see a higher growth of roughly 10%. The backlog for Boeing and Airbus that play in the segment basically has increased further. We now believe which is at 10,000 aircrafts, so this is a good eight year production backlog. We’ve also seen that it's supported by passenger as well as cargo demand up and also supported by the desire from customers to have more fuel efficient newer planes that drives the demand as we -- basically we’ve been seeing every month. This also translates nicely into orders for new jet engines, that’s obviously important for us too because of our engine blade business, year-to-date the orders -- front order stand at 1280 new jet engines and the backlog stands at 19,100 units, so this is very, very nice. The very pretty picture gets a little clouded because we see a slight excess in inventory on the supply chain particularly on the structural plate and a little bit of a temporary inventory alignment in the third and the fourth quarter in some of the jet engines, so we think that, that part is recovering in the first quarter in 2014. Regional jets, business jets those segments, smaller ones segments here but both rebounding. We sense business is obviously impacted by the sequestration. We’re well positioned on future platforms, but we will see impact from potentially reduced operations because it has an impact on the spare parts. Next segment Automotive U.S.A. We confirm our forecast of 2%…

(Operator Instructions) Our first question comes from the line of Dave Gagliano with Barclays. Please proceed.

Great. Thanks for taking my question. It looks like Alcoa’s overall average premiums over the LME were up about a penny sequentially. Obviously, regional premiums declined during the course of the quarter and I’m wondering is that difference a timing issue and should we expect directionally premiums for Alcoa to decline in Q4 versus Q3?

Yes, its largely a timing issue Dave. We are not going to project out what we think premiums are going to do for the fourth quarter at this point, because quite honestly with the new rule changes proposed by the LME, I don't know that anybody knows what the premiums are going to be doing over the near-term. So it’s largely a timing issue.

And also don’t forget Dave, I mean, this is a -- the realized price that you see there is a composite not just of the regional premiums, but also of the shape premiums. And keep in mind what I mentioned before; we’ve been very active in working better with the cast house and using our capabilities to optimizing the cast house and also getting the shape premiums there that's also reflected in there.

Yes and that actually is my follow-up question. Can you break out the kind of position of regional premiums versus shape premiums, and how those have changed in the last two quarters?

We certainly can Dave. It’s a fairly detailed calculation that I think -- I don't know that we want to go into on the call here, but we did see a little bit of a premium decline in the third quarter as …

He is talking about the regional premium.

I’m sorry, regional premium decline in the third quarter, and as you saw in the chart that we showed as far as overall premiums we saw that also.

Okay. Got it.

Okay. Who is next? Who is next -- next online?

The next question comes from the line of Brian Yu with Citi. Please proceed.

Okay.

Great. Thanks. My first question is just with the metal, I mean, I noticed in the primary metals the equity loss grew a little bit, and I know that it’s still starting, is there a way Klaus for you to or Bill help us think about where that projects profitability or where the breakeven point is, once it fully ramps up to capacity?

Yes, I mean, it will be Brian -- it will be the lowest cost facility in the world. So you can easily look at the crew data and pick out at the bottom -- to the very bottom and look at the bottom and slot this project in lower than that. So that should give you an indication of where the projects going to come in once it’s fully operational. We will be – we’ll have all [parts] operating at the end of this year and so we’ll expect to do much better next year given the fact that we’ll be through the start up phase.

Your next question comes from the line of Luke McFarlane with Macquarie.

Hi, guys. Thanks for taking my question. What I was interested in is, what percentage of your orders have been shipped to financial buys during 2013 and how that's changed recently as the contangos have widened?

I'm glad you're asking about the value-add business, Luke. So I don't think that we are breaking that out frankly.

Okay. Then in terms of your Ma'aden JV too; in terms of the power of constraints that you see through the Middle East, I mean are you seeing any of that or has that sort of just sorted itself out?

No. The Ma'aden project is particularly attractive, because by Royal Decree we have been given the rights to a gas field and there is a pipeline that comes directly to the facilities, the gas pipeline that will then split and part of it goes into the utilities there, which is getting built and there the electricity is produced. We pay a small conversion fee for this and the rest of the gas goes straight then into the refinery and the rolling mill to produce the heat. So there is no risk at all on that end.

All right, thank you.

Pleasure.

(Operator Instructions). The next question comes from the line of Tony Rizzuto with Cowen & Company. Please proceed.

Yes. Thanks gentlemen for taking my question. I've got two here. First is, you talked about the OEM inventory overhang in aero plate, and I think I heard you say, Klaus or Bill, I forget which, maybe you both mentioned it, that you expect it to continue. Did I hear you say you expect it to continue into 2014 and could you just reiterate what you said there? Then also, I think in the text you indicated price pressures in packaging. Is that customers fighting you over the premium over LME and the pricing mechanism? Where is that price pressure coming from?

All right, I'd be happy to address that. On the aerospace side, you have to distinguish between the structural materials and there it's basically – what happens all the time and Tony you know the market. When new airframes get made, I mean the OEMs typically load up the inventory to just make sure that in the startup phase that they are not running into any issues. So when the startup phase is done, you typically hit a little bit of too high inventories on the structural material side. So this is basically structural plate that I'm talking about. But we believe that the destocking will go on for quite a while, probably reaching – certainly reaching into the next year and probably reaching even into the year after that. But the impact of that is going to be approximately 10% and it will not affect wing skins and it will also not affect the regional and jets or our other airframe segments. So that's that on the structural plate. And then on the engine side, that's what I specified there. We see very temporary inventory alignment, which is affecting – which has been affecting the third quarter and we believe it's going to continue to go into the fourth quarter but the demand will recover in the first quarter of next year because we see that then there is a ramp up of the production rates and we believe it will then stabilize and go to normal levels again, Tony. And the second thing of packaging, no. This is not the discussion on pricing – these types of pricing discussions that we've had around the LME discussion. No, this is purely a question of the supply and demand and little bit probably of additional supply overhangs and the question of competitiveness on that end. That's a function of the industry not of these discussions there. Thank you.

Just a follow-up, if I may, just going back to that structural plate. Is any of this a result of plate coming in from South African sources and are you seeing any signs at this point of any material coming in from China in regards to those products?

No.

In a specific area?

No, it's purely a function of what I said the ramp up of new airframes and it's not uncommon at all in this industry, not uncommon at all.

All right. It's kind of the supplier readiness programs and going back to that.

Yes, exactly. I mean it's basically everybody – I mean nobody wants to be late on getting the plane out and having to tell the CEO I couldn't get it done because I ran out of material. And as they continue to make last minute changes, they rather load up on that and that happens all the time when you have new airframes coming on that's purely a function of that.

Very good. Thanks very much…

And the impact of that – let's be realistic on the impact. As I said, I mean probably next year and the year after that a little bit affected by that but not more than the 10% impact on that.

Tony, thank you.

The next question is a follow-up question from Brian Yu. Please proceed.

Great. Thanks. So, Klaus, this is actually a follow-up on Tony's question. Just with the flat-rolled products where you're seeing some pricing pressure because of the supply/demand imbalance. Did you answer when maybe that might be worked through or when the demand would accelerate to help balance that part out?

In regards to what?

In the flat-rolled products business and the pricing pressures because of the supply/demand imbalance?

I think my answer was specifically towards the packaging because Tony asked around the pricing pressure on that whether there were some issues around the discussion with the LME pricing, but it's not related to that all. It's purely around the normal negotiations between the customer and the supplier and we felt that we had to make a more competitive offering. That's all it is. I mean I would not interpret anything else into it because there is nothing else there. And in regards to the demand that we see there, I mean the big demand drivers continue to be – I mean very stable demand on the aerospace side, from skins to – on the GRP side from skins to structural plate continues on. You heard me talk about the strength of the aerospace market and then you see that the automotive market is coming in now. I mean I wish we had more capacity at this point in time. We could certainly fill it all in and then all our new capacity comes on line starting basically end of this year and you would see the impact of that already in the next year. So that's what's driving our excitement there.

And one last thing, Brian, around the Tennessee expansion is that it does gives us flexibility between packaging and automotive.

Yes, that's a good point.

Okay, great.

Thank you, Brian. Next question?

The next question comes from the line of Paul Massoud with Stifel. Please proceed.

Hi. Thanks for taking my questions. I actually just have two. On the auto expansions, I mean you've given us the investments associated with the three projects. But could you give us a sense of what the volume is; the capacity that might be associated with that in total?

We don't give out volume numbers, sorry Paul. I think that you can get a good idea. We have given you investment numbers. So I think you can triangulate a little bit from that.

Okay. And then I guess just as a – a question on the productivity gains. I mean obviously you've had a pretty good year. You've already surpassed your annual target. Is there potential for these productivity gains to continue into 2014? And if so, I mean can we expect the magnitude might be similar to what we saw this year? Has really all the low hanging fruit already been picked?

I think, Paul, that's a very good question. I really appreciate you asking this. If you look at the performance we've shown in productivity, basically since the downturn, since 2008, you actually see that we have in total I think $5.5 billion. I would say this is last year basically not including the more than $800 million this year and continuously every year somewhere between $700 million to $1 billion productivity. I think that all of our businesses have found a way that they don't accept the headwinds and that they are continuing to push back and they've made it part of their operating process. This is basically an ongoing and never-ending process and almost only limited by the creativity of our own folks. But it's a lot of hard work and I don't want to minimize this at all because this is a – we are very proud of this frankly. And to achieve this ongoing, I mean there's literally thousands of people working on these things everywhere and picking up. I mean sometimes an action that has a 1 million and sometimes something that is a couple of $100, you know nothing of that nature we leave unturned.

Just as an example, we currently have 14,000 ideas in the system that are being captured, monitored and hit the bottom line ultimately, there’s 14,000 across the enterprise.

Yeah, and what Bill is referring to; we have an operating system that includes that we know pretty much all of these action up to a certain size worldwide and can monitor them, not ask for the fact but once they go into from idea basically to execution. So we monitor them from the first idea basically until the cash comes and this gives us also a good idea on where is the next year going to go. Paul, thank you.

Thanks.

Next question?

And your next question comes from the line of Charles Bradford with Bradford Research. Please proceed.

Good afternoon.

Yes, Charles, hi.

Hi.

In the past you haven't been willing to crow too much about inroads into the automobile industry expect in sort of generalities. But now that the new models are out, do you have any updates on the success of capturing market share versus non-materials?

Let me put it this way. We cannot speak for our customers -- but I think that you can get a good feel for where we -- what we are doing in terms of investment. We would not have started our Phase 2 investment in Tennessee if the Phase 1 investment Davenport would not have been sold out, and if we look at the Phase 2 which we really just broke out a couple of weeks ago and I look at how is the capacity situation there, I would say that most of it is already also committed. So we have been very successful there in this market, and I think a lot of customers appreciate also our technical support as they are moving into changing from more steel intensity to aluminum intensity. You may have, Chuck you follow us very closely I know. You might have seen the press release that came out a couple of weeks ago where we talked about a coding technology that we have developed and it's this coding technology we are now offering up to all of our competitors because our OEMs have asked us to, because they realized in the manufacturing process that this is the only coding that really allows the conjoining of materials, and we obviously get royalties for this. So yeah, we do well and we will continue to do well there.

And what I was getting at, there had been rumors about the Ford F-150 becoming much more aluminum intensive in 2014, and I’ve not seen anything from Ford. I was wondering if you knew if those kind of thing’s came through or not.

Look, I mean 1994 Alcoa anticipated where the world was going and helped Audi to build the first aluminum intense vehicle. And without our help I mean the Audi folks would all admit that, I mean that would have never happened. They’re now seeing the same historic thing happening here in the U.S. We anticipated it, we’re right on it. We have the technology, we don’t just only deliver materials and we will drive it also to the next level because we already think about things that are behind the corner and we can look around the corner much like we do in the aerospace industry and this is what all customers appreciate and we’re pretty excited, really, really excited about this. I mean really, really excited about this.

Well, thank you very much.

(Indiscernible).

I agree.

Thank you, thank you. I knew you would. Who’s next?

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

Hi everyone, two questions. One, on your -- basically on Tennessee facility. As you allocate more rolling capacity from packaging to automotive, you think that can also improve margins in packaging business or you think there’s lot of spare capacity there already?

The flexibility -- we didn’t have flexibility before. So before you basically have a rolling mill that can only do one thing, and basically Paretosh you answered the question yourself, you’re on the right track here. Now in future we will have the flexibility the front end as I call it or the front end of the mill. The backend of the mill is specialized, obviously they’re the part that can only make can sheet and there will be a part that can only make automotive. But the whole front end can be used for multi-purposes now, so that gives us flexibility and it doesn’t force us to fall into this sort that the midstream industry has built up so nicely off build capacity that only has one purpose, right. That’s why I think the Tennessee, the way we do the Tennessee investment is not only great in regards to automotive but it's great also in regards to all flexibility and what that allows us to do in other segments, that’s exactly right Paretosh. What's your second question?

Just going back to the cast house value added that $200 million number, that’s after tax right? And can you give us what this number was last year, just to compare?

Paretosh, that’s a pre-tax margin number and the basis for that is versus how much value the cast house adds over making basic P1020 metal and so that’s the reason for that $200 million. I do not have the 2013 number off the top of my head, but I recall that it was something fairly sizeable.

Yes, I would say (indiscernible). Yes, well don’t -- let’s not speculate. We can get you the number. I mean Kelly can get you the number.

Got it. Okay, great. Thank you.

Pleasure Paretosh. Who’s next?

The next question comes from the line of Carly Mattson with Goldman Sachs.

Hi, good afternoon. Could you give us an update on any discussions you’ve had with S&P and Fitch regarding your ratings; and in particular has the Company done any preliminary analysis as to how much changes in rates this year could help produce the pension liabilities?

Yeah, Carly the way the rating agencies work is we’re in constant dialogue with them, and there are essentially insiders, so we give them a lot of information and keep them up to date on what's going on. So that’s the interaction that we have with the rating agencies. Clearly I’m not going to speculate, I’d be a fool to speculate where interest rates are going to end this year with everything going on in the world. But interest rates going up will help us close that under funded status fairly substantially and we’ll have a much better view of that as we get closer to the year when we see where the interest rates will be.

Great. Thank you.

Thank you, Carly. Next question?

And your next question comes from the line of Curt Woodworth with Nomura. Please proceed.

Yeah. Hi, good afternoon.

Hello Curt.

Hey, Curt.

Klaus, I was wondering if you could talk about sort of portfolio optimization as you look out to next year when balance fully ramped and you know you already curtailed the term loan of your higher cost smelting capacity. Do you see any opportunity either for potential asset divestitures or areas within the portfolio you could look to monetize you’re not getting value, do you see that maybe a potential to further reduce your footprint in high cost areas just to probably get a sense for any other changes that you could be looking out for next year?

Curt, absolutely and the way we do it, we will basically look at the whole portfolio. We look at how does that add value to us and how can we add value to this. Can we be a good parent to this, and you have to look at the results and how we do it relative to our competitors. And as we have done in the past also we’ve used good opportunities if we saw them to monetize that. I think part of this is that you really don’t talk about that publicly because otherwise I mean you’re destroying shareholder value but I can tell you I mean we constantly are looking into this and there are constantly opportunities. Some turn out to not make sense because they just are too low and you were saying this is not worthwhile doing it. And others like, when we sold the last one that we did is, is the (indiscernible) it turned out to be a very good deal for us. So this is how we look at it.

Okay.

Thank you.

And then I believe Alcoa put a letter out to the LME last month regarding some of their proposed changes that we’re looking at on the warehouse side and I think that your position was that it wouldn’t really help the customer base in terms of increasing metal availability, but it seems like it would increase the availability and premiums are already coming down, so I was just wondering if you just could kind of elaborate on your position and if you don’t -- if you haven't …

Yeah, I’d be happy to do that and it's probably timely because these folks are sitting at a little bit before midnight at metal – at LME Week in London and debating over things. I mean the way we see that and I think Bill said that before, the reason for the premiums having come down a little bit is because of this market confusion that really was caused by this very irresponsible way how the LME has steered the process. I mean to announce rules outside and as a proposal to be discussed publicly without hearing the market participants before or hearing some market participants before was pretty irresponsible. We commented on it, made that public. I mean it's a major market intervention. By the discussion alone leads to a major market intervention. We are very clear. We believe that if this is not done in the right way, it can actually lead to a reduction of transparency. And the reason for it, you see part of it by the way are happening in the chart that Bill showed and as what I always call the mountain chart, which shows how much is already outside of the LME and how much is off Warren and the amount is getting bigger and bigger. So it takes off the radar screen. So we have made – and on top of it, the transparency in the LME pricing, that's the big issue here. This makes 90% of the total price and that has substantial flaws in it. So we've made some very, very specific recommendations. We've said, improve transparency. There is no reason why you can't do it tomorrow. Commit to a timeline, do it immediately along the line of the CFTC traders report. And then if you want to do improvements,…

Thanks.

Okay. Next question?

Next question is a follow-up question from David Gagliano with Barclays. Please proceed.

Okay, Dave, go ahead.

Hi. Just a quick one on CapEx. I might have missed this. It looks year-to-date, your CapEx is running about $900 million and I think your target for the year is $1.9 billion. Are those numbers…?

Our target for the year is $1.55 billion and so that's the combination of growth and sustaining; $1 billion in sustaining, $550 million in growth and we're currently under spending on a run rate basis both of them.

I just don't think you're going to hit the $1.55 billion number?

We will not hit the $1.55 billion at this point. We're under-spending on a run rate basis, but we haven't given out a lower range at this point.

Okay, fair enough. Thanks.

Okay. That's concludes – and let me also make another comment as a recommendation, because I think we have a strong interest also for you to understand to what is going on inside of the company. When I look at reports that I've seen, my impression was – obviously I've been seeing where we were going throughout the quarter. So how can we bring these things closer together? And I think that I would recommend that the questions today that came around productivity, I mean we have made that a constant, so built that in. We will continue to show strong productivity. The other thing is what we call the strategic repositioning, which is basically you have to build in the different on the value-add business side. You are a more strong contributor and much more meaningful on the top line as well as on the bottom line. I mean just look at the number. We tripled ATOI in the value-add businesses in the last 10 years and now they make up for 79% of the profit and 57% of the profitability. And also don't underestimate two things on the upstream side, which is the second part which is basically the decoupling that we are well underway from the LME on the alumina side, the alumina and mining segment, we are really well positioned. The one that needs restructuring and we've always said that is the smelting segment. That's why you see 60% of the capacity curtailed, but it's a smaller part of our business. So I think I would highly recommend you look at these things because then I think you'll get a better feel where the company is going. And I hope that you agree with me that you've seen a quarter where we've really been firing on all cylinders. I mean nothing has stopped us, not even the headwinds, the strong headwinds that we seen, record downstream margins and the commodity business gets better, repositioning is on the right path. You see the results there. And I believe we're focusing on the right things, those that we can control and we are delivering. That said, thank you very much for listening. I hope that I will see or have many of you listening in at the investors meeting which is on the 5th and 6th of November, I believe. Kelly is that – 6th and 7th, I got it wrong – 6th and 7th of November. Okay. Thank you very much. That concludes this call.

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