Alcoa Corporation (AA) Q4 2013 Earnings Report, Transcript and Summary

Good day, ladies and gentlemen, and welcome to the Fourth Quarter 2013 Alcoa, Inc. Earnings Conference Call. My name is Jackie, and I will be your coordinator today. At this time, all participants are in a listen-only mode. Following the prepared remarks, there will be a question-and-answer session. (Operator Instructions) As a reminder, this conference is being recorded for training purposes. I would now like to turn the conference over to Ms. Kelly Pasterick, Director of Investor Relations.

Thank you, Jackie. Good afternoon, and welcome to Alcoa's fourth 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 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. With that, I would like to hand it over to Mr. Klaus Kleinfeld.

Thank you, Kelly, and good afternoon to everybody and thank you for joining us on our fourth quarter as well as our full year's earnings announcement. I am very conscious that we have been giving you a lot to digest today. Starting this morning with the announcement that we are resolving a legacy legal matter with the U.S. government, so before Bill gets into the details, let me give you a quick overview and you see it summarized here on the slides, so we took decisive actions of putting legacy matters behind us, clearing the way and continuing our transformation. When you look at the legacy matters, they really fall into two big buckets in the main, right? The one is, the legacy matter and we welcome this revolution. We worked hard to minimize the liquidity impact it's quite in form and over four years. Bill will talk more about that, so the second big bucket is really around the new reality. Unfortunately not a good reality in our smelting industry and there is a very fact that this has a consequence of us having to write-down the goodwill for two legacy acquisitions in smelting and also discrete tax items. Both of those are non-cash events and it's important to know, so that's the legacy part. Let's turn to the operational side, and the operational side continues to be what we have been saying all the time, we are repositioning the company, and at the same time we are facing some headwinds. How are we repositioning it? We are building out our value-add businesses and we are lowering our cost base off the commodity businesses, and this transformation is working out. You can see it by a couple of stats here. The value-add business today accounts for 57% of the…

Thanks, Klaus. I have a lot to cover. So I will try to move relatively quickly. A quick review of the income statement. Revenue declined on a sequential quarter basis to $5.6 billion, driven primarily by seasonally lower results in the value-add businesses, particularly the packaging markets, weakness in industrial markets and a weather related impact to building and construction. Primary metals revenue was steady, despite a 1% decline in realized aluminum prices. Compared to last year, revenue was 5% lower on a 7% drop in realized aluminum prices. These prices were the lowest realized prices in four years. Cost of goods sold percentage increased sequentially by 110 basis points due to lower metal prices and lower volumes. As you have seen, by now we took the series of restructuring and other charges that I will detail on the following page. Our effective tax rate for both the quarter and the full year was negative resulting from the fact that some of the special items had little to no tax benefits associated with them as well as the impact of the deferred tax valuation allowances. If you exclude discrete and special items, our operational rate for the full year was 34% and 43% for the quarter. So overall, results for the quarter are a net loss of $2.19 per share. Excluding special items, we have net income of $0.04 per share. Let us now take a closer look at the special items. The special items in the quarter totaled $2.4 billion or $2.23 per share and can be categorized into three areas; resolution of the U.S. government investigations, charges as Klaus alluded to associated with the market conditions in the smelting business, and other charges. As we have seen by now, we have resolved the investigations with the U.S. government…

Thank you, Bill. Let's go through this and let's start the usual session with the end markets. On aerospace, we have forecast another strong year, 7% to 8% growth, driven by continued strong performance in the last commercial segment, Boeing as well Airbus now have a combined backlog of over 10,000 aircraft and that is about eight years of production. We have been seeing strong demand recently coming from southeast Asia and the Gulf, Dubai Airshow in November showed a lot of this. We saw Boeing receiving the single largest commercial order $56 billion for 150 Boeing 777X by Emirates and Airbus got an order of $20 billion for 50 A380, also by Emirates, so also backed by strong fundamentals. Cargo last year, up 5.3%. We expect for this year, 6%, cargo demand, plus one last year, we expect another 2.1 this year. Airline profitability in 2012, it was $7.4 billion, last year $12.9 billion. For this year, the market expects $19.7 billion. At the same time, we see some inventory adjustments in one of our aerospace business. We talked about the excess inventory in the aerospace structural plate and that needs about two years to fully resolve and has an impact of about 10% lower aerospace plate revenues versus the 2013 level. The other segment that we talked about last time, the jet engine side we have seen an inventory adjustment in 2013 in the fourth quarter and we expect this to be finalized and normalcy returning back now with the first quarter starting. The growth in aerospace is also supported by growth into other segments in aerospace. Regional jets, we have seen an increase of 19.5%; business jets, another 10% last year and even on the defense side the last weeks have brought some clarity with the two-year…

Ladies and gentlemen, we are ready to open up the lines for your questions. (Operator Instructions) Your first question comes from the line of Sal Tharani with Goldman Sachs. Please proceed.

Hi. I just wanted to ask you on this, your realized price appears to be in the fourth quarter much lower than what we had expected. Even if you adjust for the lower $0.02 or $0.015 lower premiums, it seems to be lower than what you had been gaining -- getting in the past. I was just wondering if any mix change happened in the quarter?

No, Sal. No significant mix change. It's really just a function of metal prices having come down and premiums having come down on average, and it was a little bit of a strange quarter and that premiums ran up towards the end of the quarter, but on average premiums were down for the quarter, so no significant mix changes occurring.

Always keep in mind, you have the 15-day lag. Next question?

Your next question comes from the line of Brian MacArthur with UBS. Please proceed.

On the aluminum price that you used for the write-down.

Brian, we missed the first part of that question. Can you restate it?

Sorry. I just wanted to go back to – you talked about writing the goodwill down on the Alumax and Reynolds acquisitions. Can you tell us what aluminum price you used for that? What assumptions?

Sure. Let me just tell you about the methodology. The methodology is that we use a 15-year discounted cash flow with the terminal value. The first three years, we use what our planning assumptions are and which are very close to the market and the forward curve. Beyond the first three years, we simply use a forward curve, Brian, because that's probably the best estimate. If you look at the last couple of years, we disclosed how much headroom we have in each of the segments on the goodwill carrying value. That has been declining, and really three factors drove the write-down. The three factors are, metal prices, the margins, which are essentially a function of currency, and the discount rate, and as the discount rate went up, it also impacted the future profitability, so that's what the drivers were.

How do you deal with premiums? Do you include that?

Premiums do get included, right. So, you project out what your realized prices will be, so we use a forward curve on the LME and our best estimate of premiums.

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

Yes. Thank you. Happy New Year.

Happy New Year.

I just want to drill down a little bit to understand the global rolled product segment if I could, so just taking a step back, certainly all the end-market demand commentary on auto and aerospace sounds really strong, but it is kind of surprising to us to see the sequential decline and even the doubling into first quarter of ATOI would represent year-over-year declines by about half, so can you give us a little bit more color on what exactly is happening there and how much of that might be destocking, restocking or how much of that is other issues? Thanks.

Well, Timna, what you do see first of all typically in the fourth quarter in GRP on the packaging segment, you do see a seasonal decline in packaging. That's kind of in there. We saw that, that's one thing. The second thing that we saw is, we saw price pressures coming on the packaging segments, which basically led to a reduction in prices, which have a direct impact on profitability and will probably stay there for quite a while, right? This is one of the reasons why we are flexiblizing capacity and changing the industry structure. This is one of the reasons behind our decision to go with the investment for the second auto expansion to Tennessee, so that we have dual purposes for the hot metal part, right. So this has been the big ones and then you mentioned the third element which is the adjustments of inventory on the aerospace structural plate and that's basically in the main what you have been seeing there. At the same time, we believe and we said it I think it's in Bill's segment overview, we expect to rebound for the profitability, base profitability going to double in the first quarter of next year, and once we see, which we believe we will see also the general industry segment coming back, we also believe that the pricing level on that segment will improve.

Okay. Thanks.

Thanks, Timna.

And your next question comes from the line of Paretosh Misra with Morgan Stanley. Please proceed.

Hi, everyone. My question was on your primary metals guidance of $12 million lower energy sales in Latin America. Can you give us a sense as to how much this number typically is, this energy sales number, and if you had a similar sequential decline in the fourth quarter also?

No, that sequential decline that you are seeing is a sequential decline 1Q to 4Q. The energy sales were actually fairly strong in Latin America in the fourth quarter and we are projecting them to fall off in the first quarter. The reason why that is such a large impact is really two-fold. One is, we will have less megawatts available to us; and secondly, pricing on energy has eased a little bit in Latin America. So that's the two key drivers there, Paretosh.

Okay. Thanks, Bill.

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

Hi, great. Thanks. My question actually is a follow-up on Timna's. You have listed the various moving pieces and those were identified when you originally gave the fourth quarter outlook. So along those lines, what incrementally happened to drive ATOI profits down? I think it's closer to 7% versus the original guidance of down about 25%. What was different than what you guys were expecting?

Well, I think the biggest difference is on the packaging side. We saw a stronger impact on the packaging side than what we expected, and it hit on both fronts. It hit on the front of the volume and it hit also on the front of the profitability. For instance, in a place like Russia, which plays an important role there in the packaging business, we were surprised with the decline, the stronger decline in volumes and that also raised some more pressure in the whole industry which led to a pricing decline there. That's in the main, what happened.

Oaky, great. Thank you.

And your next question comes from the line of Jorge Beristain with Deutsche Bank. Please proceed.

Hi, guys. Jorge with Deutsche Bank. My question is for Bill. There has been a lot of talk, especially in the papers recently, about some pension relief potentially for companies as interest rates start to move up. Could you talk a little bit about what your year-end unfunded pension balance was? And if you expect any kind of tailwind to be reported into 2014 earnings because of higher discount rates or maybe the carryover effect of outperformance on your 2013 planned assets?

Yes, it's a great question, Jorge. If you look at the balance sheet, and I know we just released the results, we actually picked up a little bit of closure around the underfunded pension liability. We started the year at $3.7 billion. We ended the year at $3.2 billion. We also saw a similar decrease in the liability on the OPEB side. That's largely driven by the fact that interest rates are up and so right now we are assuming a 4.8% discount rate. And so I gave you the cash contribution that we expect next year from an earnings perspective, we would expect the expense to be somewhere between $450 million and $475 million and the only reason I am not nailing it down further from that is we have to settle on an expected return on assets which we will do sometime in the first quarter, so we are seeing a little bit of benefit on the expense side due to the higher discount rate, and clearly closed a lot of the gap, which is also really good news on the underfunded liability side.

Okay, great. Thank you.

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

Hi, good evening, guys.

Hello, Curt.

I have a question just on the aerospace performance in the quarter. The third-party revenue growth was 4%, which is the lowest you guys had all year and well below your market target of I think 9% to 10% this year, so I am just wondering is that a function of potentially lower metal pass-through volumes or some of the inventory adjustments you talked about on the plate of the jet engine side in the quarter.

Yes. That's in there. Absolutely. Yes.

Would that also affect your kind of the outlook for your volume performance relative to your market view on '14 as well?

Well, I mean, we believe that on the aerospace plate side, this is going to continue probably another, let's say, 15-month or so, right? So, we will continue to see some of that coming through, right? Whether it is at the extent that we have seen in the fourth quarter - difficult to judge, right?

Recall, we also had some OEM destocking on the jet engine side in the fourth quarter that we are not projecting to continue into 2014.

Yes. Exactly, and that goes onto the EPS side.

Okay. Thanks.

Your next question comes from the line of David Gagliano with Barclays. Please proceed.

Hi. I just have a question regarding the auto opportunity. There has been a little bit of a talk with regards to the pace of the ramp up for the Ford F150 perhaps being delayed and I am wondering if you could comment on that and if this is something we should be thinking about in the next sort of 6 to 12 months?

Well, I mean, what counts for us is that we have been basically hitting every milestone that we said we are going to hit. I mean, I shared that just with you. We are happy that the Davenport auto expansion is done. It's producing auto material, the material is in the hands of the customers. Obviously, I can't comment on which customers, but don't make the assumption it's just one. I mean, this is a broad base change happening in the industry. It's a real massive changeover to light weighting going on here in the high-volume segments. Davenport is sold out so I am not concerned about any platforms there, plus basically also our Tennessee expansion is pretty much all committed, right. So, this is what's going on in the industry, so this is a very, very exciting moment there for automotive.

Okay. Just to clarify, are there any customers flying? Any issues to you with regards to the product that they are receiving?

From the side of the products that they are receiving from us, everything is going as we expected. I mean, this is a massive ramp up with a lot of things happening there and we are fully on-time, on-budget and very happy with the developments there. The rest, I really can't comment on that. You would have to ask our customers.

Okay. Perfect. Thank you.

Okay. All positive.

Your next question comes from the line of Tony Rizzuto with Cowen & Company. Please proceed.

Thank you very much. Happy New Year, gentlemen.

Thank you, Tony.

Thank you very much. Just a couple of questions. As a follow-up, Klaus, you sounded surprised by the declines that you saw in Russia in the packaging volumes, so I am just wondering if you could perhaps elaborate a little bit about that.

Well, it was really mainly a function of the relatively fast decline of the economy in Russia, which actually nobody expected including the Russians or probably nobody expected that, so we were hit by that then there were some legislation impact, the changes of pure legislation in Russia that came through there, but the question before was what happened unexpectedly and that was my answer to it, right, so these are the realities there and on top of it there was this seasonality, so that's what's going on in the market.

Could you just remind me of what your total capital investment has been in Russia? I know you have made a lot of improvements there and right size the workforce all those kinds of things.

Yes. If you look at everything all-in, I would say you are talking roughly about $800 million.

Including the acquisition and the assets.

Including the acquisition and the assets and the investment there, roughly $800 million, I would say.

Okay, and how am I to read the announcement recently with regard to VSMPO-AVISMA?

Yes, very positive. I mean, we signed an agreement with VSMPO-AVISMA, a memorandum of understanding that we are going to share our 75,000 ton press. There are only two of those presses around on this planet. One is in the hands of VSMPO and is used only for titanium forgings and the other one we own, it physically sits in Samara. It's an amazing piece of industrial machinery and we have, in the past, only used it for aluminum forging. So what we will do is, we will also upgrade it and use it also for titanium forging and basically put our competency together here in regards to forging and in regards to the knowledge about the aerospace industry. So we will continue to be the controlling owner and operator of the joint venture. There's a lot of details that still have to be hammered out but this is a very positive development. VSMPO is a good partner. It has established itself well. It gives us the opportunity to expand into titanium.

Thank you, Klaus.

And your next question comes from the line of David Lipschitz with CLSA. Please proceed.

Good evening.

Good evening, Dave.

Two quickies. On the pension expense, the $450 million to $475 million, that's for '14? And if that's so, what was '13?

It is for '14 and I will have to look at what '13 was. So if you give me a second I will tell you.

I will ask the other question, well. So Klaus, with premium spiking as much as they have been, have you been getting a lot of calls saying you have aluminum available?

If you refer to the last two quarters when I said anybody called me?

Yes.

Funny enough, yes, we are receiving calls from our normal customers but not people that are saying I can't get my hands around aluminum. So this has still not happened, but everything else that we diagnosed has happened. As you may remember, around old LME discussion, we always told them that we believe that their actions are not the right actions. We want more transparency. They thought that they can put pressure on the regional premiums. We told them that that might not be the way to do it and you see the realities are the regional premiums continue to go up, as we have said. The other thing which we always said, more metal is moving off-warrant. So two things which don't make much sense in regards to improving the marketplace and here is the LME putting these massive market interventions in. The most important thing and the thing that we are most happy about on the LME side is that they at the same time also committed to putting more transparency into the trading so that we can, like the Commitments of Traders report that the Chicago Mercantile Exchange puts out regularly, that we can get a better handle on how the market is structured and what's the role of the physical demand playing and what's the role of more high-speed financial speculators in our marketplace. So I hope that they will eventually commit also to a timing on this, which unfortunately has not happened yet.

So Dave, let me go back to your question around pension. Total pension expense in 2013, rough numbers, $610 million in 2013, of which $90 million was a special item associated with the Baie Comeau Soderberg curtailment. So underlying pension expense of around $520 million coming down, as I said, to $450 million to $475 million, depending on what expected return on assets we land on. And just a little bit more information, if you are filling in the model around OPEB, we would expect OPEB expenses to be fairly flat year-over-year and they have come down over the last few years as we have managed healthcare costs.

Okay. Thank you.

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

Thank you and good afternoon, everybody. I just had a couple of questions. In the past, you have given combined upstream ATOI guidance sequentially, and I apologize if I missed it, but could you give us a sense of what that is again?

Sure. There are a couple of things to realize on the upstream and I will answer the question fairly fully. The Alumina, I think we were projecting around $30 million of incremental cost. In the smelting side, we were projecting around $50 million of incremental cost, but there really are a couple of big drivers behind that. First of all, and you will laugh at this. There's two less production days. For a refinery and a smelting system, that's a big deal, right? So you lose incremental volume just because of the nature of the calendar. Then secondly, we have the ramp up costs in both, refining and smelting on the Saudi JV. As I said in my comments, those will reverse over time, and as Klaus said, that will be the best refining and smelting complex in the world, so those are two of the biggest drivers that are driving those results.

Just on the LME rule changes. Over the holiday or just before the holiday, we saw one of your competitors launched legal action against the LME, and I was just curious, one, if you had any thoughts about that and, two, how you are continuing to approach the situation? Is legal action something that you are considering or are there other discussions that are going on behind the scenes? Thanks.

Well, I think I referred to it a little bit, Paul. I don't know whether you heard my last comments. I mean, we were very happy that the LME picked up on a very strong point that we have made is we need more transparency on the trading side, right, so we need that and they committed to this. They said that they are going to put a committee together to put that out. Unfortunately, we have not yet seen the timeline or any commitment to a format. I much hope that that's going to happen fast, right. The second thing that we have said, which was their original starting point that they said, well, the consumers cannot hedge the regional premiums, so we suggested to have a regional premium contract. They kind of said that they will examine this and I hope that they will examine this fast, because obviously the regional premiums are not going away in fact they are increasing. In regards to the legal actions, yes. We have seen that, we understand where those folks are coming from. I have said numerous times that I caution against such very direct and massive market interventions that the LME has done. I think there are better ways to do it. At this time, we don't have any plans to file a suit against the LME.

Thanks.

Thanks, Paul.

Your next question comes from the line of Andrew Lane with Morningstar. Please proceed.

Hi, there. Thank you.

Hello, Andrew.

In your prepared remarks you mentioned the all out ban on bauxite exporting which is expected to be imposed on Sunday. Given that China imports a third of its bauxite and that the vast majority of that bauxite has historically come from Indonesia. Do you anticipate that this will result in Chinese refining curtailments? Could this potentially have a positive impact on Chinese smelting over capacity?

Yes. It could. At the same time, I would put a word of caution in there. We are talking about Indonesia, right? So, you are right, I mean the dates that you have to keep in mind is January 12th is the date where they are supposed to basically implement the ban on exports for unprocessed ore. If you listened or see what communication has been out there from the government officials in Indonesia, I mean, the Director General of Mining had said quite a while ago that they might execute on the ban, but also might grant some exceptions if people have some kind of plan to build a refinery there, so we would have to see what exactly happens there. I mean USAID has come out with a study last year which looked at how good Indonesia is in terms of having refining and their conclusion was that the infrastructure was not adequate to support that industry, nor could Indonesia be cost competitive in refining, where those other worldwide locations, so there are a lot of issues around this. We would have to watch it. We will see it end of this week. At the same time China is nervous, and you can see that by their actions. I mean, China currently imports 67% of all their bauxite and 65% of this comes from Indonesia, right. What have they done? They have massively ramped up their bauxite imports. You have seen it in the numbers, right. And they currently have a stockpile that is around basically a year of consumption. Our info says 280 days, but basically a year of consumption. So they are preparing for something happening in their market and we will have to watch it. At the same time, the thing that it underlines again, for everybody who's looking at our market is that China is not the place ideal for making aluminum because they don't have the necessary ingredients that make a competitive aluminum industry, starting with bauxite. And you can go next to energy. You can then ask yourself, I mean, in terms cleanness and sustainability and that's one of the encouraging things here. China, for us and I have said it many, many times, is an opportunity, not a threat and we would see it again here on the bauxite side.

Okay, Klaus. I appreciate the color. Thank you.

It's a pleasure, Andrew.

And your next question comes from the line of Harry Mateer with Barclays. Please proceed.

Hi, guys. Thank. Just two questions on the debt side. First, do you see any opportunities for debt reduction this year beyond the convert into equity? And then just to clarify, Bill, I think you said the OPEB unfunded balance declined by $500 million as well as the $500 million decline in the pension balance, is that correct?

No. I am sorry. I said that the pension balance declined $500 million. Off the top of my head I can't tell you what the OPEB balance declined. So we will have to get back to you one that one but it did also decline for similar reasons.

Okay and then in terms of additional opportunities for debt reduction this year beyond the --?

Yes. There are a couple of areas that we can pay down debt. There is obviously the convert, but also we have got some Brazilian debt that we can pay back if there is excess cash flow. Then we also have an account receivable securitization program that we can pay back also. So those are the areas that if we have excess cash flow we will continue to pay down debt.

What's the size on that Brazilian debt number, if you can do it?

I believe it's around $500 million.

Thank you.

Next question, please.

And your next question comes from the line of Sal Tharani with Goldman Sachs. Please proceed.

Thanks, again. I am looking at slide 25 of the automotive opportunity. And from 2012 to 2015, it's increasing by four times and if I look at the two expansions you are doing, actually North America and the Ma'aden which my guess is will also target the U.S. market, and if I back out, it looks like you have gotten a decent market share of this growth. I was just wondering, how prepared you are to go to the next level when you are going from 14 to 136 or from 55 pound to 136 pound and how much CapEx would that require? Would you be participating at the same ratio in there or do you think that you are done with the bulk of your investments in this field?

Sal, to clarify that, the Saudi Arabia auto expansion will not go to the U.S. marketplace. That's more focused on the European as well as the Asian markets, right, and quite a bit might actually stay there in country. You might have picked up that the Saudis have been negotiating, are continuing to negotiate with some automotive firms to also attract some automotive manufacturing there or at least aluminum intense basics there. So it's really, there is the Tennessee expansion and then that's coming on as a next one after Davenport that comes on mid '15. For us, it is not the most important thing to have market share, right. Market share is not the primary one. For us, it's the quality of the growth, right, and that's why it's so important to put these pieces together. I mean, the three year targets show you, the new three year targets as well as the old ones, but I mean the new three year targets give you a good guidance of what we are intending to do. We are very conscious in regards to using our capital for expansion as well and also looking at how much we put into one basket. As much as we love the automotive industry, right, and at the same time look forward to this growth. But at this point in time, we do not have any plans for another expansion here in the U.S.

With that ladies and gentlemen, thank you for your participation in today's conference. This concludes the presentation. You may now disconnect and have a great day.