Alcoa Corporation
Q3 2007 Earnings Call Transcript

Published: 10 Oct 2007

[Operator:]

Welcome to the third quarter 2007 Alcoa earnings conferencecall. (Operator Instructions) I'd now like to turn the presentation over toyour host for today's call, Mr. Tony Thene, Director of Investor Relations.Please proceed.

[Tony Thene:]

Thank you, Sean. Good evening and thank you for attendingAlcoa's third quarter 2007 analyst conference. At today's conference, AlainBelda, Chairman and CEO will give an overview of the significant events in thequarter, as well as a view of current market conditions and strategicinitiatives. Chuck McLane, Executive Vice President and Chief FinancialOfficer, will then review the third quarter financial results, as well ascurrent and next quarter's anticipated business conditions. Before I turn it over to Alain, I would like to remind youthat in discussing the company's performance today, we have included some forward-lookingstatements within the meaning of the Private Securities Litigation Reform Actof 1995. Such statements relate to future events and expectations and involveknown and unknown risks and uncertainties. Alcoa's actual results or actionsmay differ materially from those projected in the forward-looking statements. For a summary of the specific risk factors that could causeresults to differ materially from those expressed in the forward-lookingstatements, please refer to Alcoa's Form 10-K for the year ended December 31,2006, and Forms 10-Q for the quarters ended March 31, 2007 and June 30, 2007filed with the SEC. In our discussion today, we have also included some non-GAAPfinancial measures. You can find our presentation of the most directlycomparable GAAP financial measures calculated in accordance with GenerallyAccepted Accounting Principles and our related reconciliation on our website atwww.Alcoa.com under the investors section. At this point let me turn it over to Alain.

[Alain Belda:]

Thank you, Tony and good evening, everyone. We certainly hada significant amount of activity and challenges in this quarter. We had a seasonalslowdown in Europe and the softening of key markets inthe U.S. andcontinued cost pressures with energy and the U.S. dollar devaluation, as wellas lower metal prices. To offset these external pressures, we continued to focus onproductivity improvement, market share gains and new products. In addition, wedid a lot of portfolio management and restructuring. We sold our 7% equityholding in Chalco and received $2 billion in proceeds. We withdrew our offerfor Alcan and took the charges related to that offering. We announced the saleof two businesses and continued to restructure our downstream. For the packaging and consumer business we've receivedindicative offers from several potential buyers and are confident enough withthe process to state that we intend to close by the end of this year or earlyin 2008. For the AFL business, the most prudent course of action hasbeen to implement a significant restructuring aimed at reducing the coststructure and returning this business to an acceptable return. We will thendetermine the best course of going forward with that business. Keeping it in perspective, on a year-to-date basis throughthese three quarters we have established all-time records for revenue,earnings, earnings per share and cash from operations. Lastly, yesterday theboard authorized a significant increase in our current share repurchase program,moving from 10% to 25%, underscoring our belief in the inherent value of the companyand its long-term potential. Let me take a minute and give you more details of thethought process concerning our Chalco decision. We do not normally takeminority stake, but we did participate in the Chalco IPO six years ago. We sawthis, at the time, as an opportunity for us and a way to help Chalco enter theequity market. The transaction yielded proceeds of $2 billion and a totalshareholder return of greater than 1000%, or 44% on an annualized return basis. This has changed nothing concerning our commitment to China.We look forward to continuing to work with our partners there to help theindustry realize its great potential. We opened our first office in Chinain 1993 and currently operate 17 manufacturing facilities there, and we are inthe midst of a major expansion of our Bohai rolling mill where we are investingapproximately $300 million in an advanced hot rolling mill. We anticipatehaving this mill commissioned early next year. Now, I'd like to give you an update on the aluminum marketand then close with a quick update on the strategic initiatives for ourcompany. Visible stocks are higher with the LME up to more than 100,000 tons inSeptember. Most of that increase came in the U.S.and Europe, while the Asia regionactually declined. Metal being placed in warrant should not be confused withmetal being sold to the LME cash market. This move from off warrant to warrantwas, in my view, driven by increases in the cost of credit which forced morevisibility on stock and kept off the warehouses. Even with these increases, total inventory defined in daysof consumption is still at a healthy level, more than three days lower than itwas at the same period last year of about 35 to 37 days total. On the demand side, Chinaremains a major driver of growth. We increased the projected growth rate forChinese primary consumption this year to almost 36% and we estimate Chinaincreasing their production by 34% this year, a total production number of 12.5million tons per year. There is no evidence that export bans have led toinventory build and we continue to believe that their growing domesticconsumer-driven market will absorb all of this production coming onstream thisyear and next. While the strong Chinese consumption garnered most of theattention, other countries are growing also. Latin Americais up 7.8%, driven by strong demand in Brazil;Asia excluding Chinais up 5%, driven primarily by India,Vietnam and Thailand;and the U.S. issoftening with a projected decrease of 6% in consumption year over year. Butthe whole world, pulled by Chinaand the other BRICK countries is estimated to grow in excess of 10% this year. Even with all of this smelter capacity growth in China,they are still not self-sufficient. They remain a net importer of aluminum andwhen looking at the whole picture and including scrap imports, which were morethan 200,000 tons in August, they've exceeded 1 million tons this year. So wecontinue to see robust demand in Chinaand strong markets fundamentals. At the same time, they continue to look foropportunities outside of their country for bauxite, for alumina, for aluminumindicating that the power situation and the high cost of alumina willeventually constrain their growth and create opportunities elsewhere. In summary, our latest supply and demand balance is asfollows

[Charles McLane:]

Thanks, Alain. Goodevening, everyone. I'd like to take an extra few minutes with you today andprovide an enhanced level of transparency so that you can see the exact impactof many of the activities in the quarter; but first, a financial overview. Income from continuing operations was $558 million or $0.64per share. These numbers include both the gain on the Chalco sale as well asthe restructuring cost. Quarterly revenue of $7.4 billion was down 8%sequentially, due primarily to the lower metal price, the negative impact ofthe normal third quarter seasonality, and the elimination of revenue associatedwith the completion of the soft alloy extrusion joint venture. Each of the four downstream segments continue to haveimproved EBITDA margins compared to '06. Year-to-date, flat rolled productsstand at 6.8%; engineered solutions at 11.9%; extruded and end products at 5.2%;and packaging and consumer at 9.2%. Cash from operations was $592 million aftera $206 million pension contribution. On a year-to-date basis, we achieved all-time highs andincome from continuing ops, earnings per share, revenue and cash fromoperations. Debt-to-capital currently stands at 29%. We continue to exceed thecost of capital with an ROC of 11.8%. Excluding our growth investments, returnon capital stands at 14.6%. Lastly, as Alain noted earlier, the company took significantstrides in executing on its portfolio strategy by monetizing the Chalcoinvestment and by reaching decisions on the sale of the packaging and consumerbusiness and the auto casting business. In addition, we have initiatedsignificant restructuring plans for our AFL business. The net impact of theseactivities will give us flexibility in our capital structure as we look toincrease shareholder value. With that overview as a backdrop, let's look at the bridgecomparing second quarter to thirdquarter performance. As we do every quarter, this chart bridges sequentialincome from continuing operations, excluding restructuring and transactioncosts. Even with the current cost pressures, we were able to achieve asequential net productivity increase of $13 million, predominantly in thedownstream segments. Energy costs were up $32 million sequentially, primarily inour upstream segments. The weakening of the U.S. dollar continues to play asignificant role in our operating results, increasing the cost of our non-U.S.manufacturing base. Sequentially, the following currency has appreciatedagainst the U.S. dollar

[Operator:]

Your first question comes from John Hill – Citigroup.

[John Hill:]

Good afternoon and congratulations on all of the activities.It's really great to see the company being so responsive to shareholder preferences. Could you take a moment and describe the distribution ofthese charges as they relate to ATOI? We've talked a bit about them in terms ofnet income and such, but could you walk through where these charges live at thesegment level?

[Charles McLane:]

Yes, John. I think we've got that laid out on the one slidethat shows what categories, which segments they were in. Instead of going backand taking the time of everybody on the call to take each individual line itemagain, I think it would be better if you would just refer back to that slide,if it would be okay.

[John Hill:]

So the point is thatreconciliation applies also to ATOI, not just to net income?

[Charles McLane:]

That is correct, yes.

[John Hill:]

Perfect. As a quick follow-up, backing up to the market alittle bit, any opinions on what $360 spot alumina means for us out there?

[Alain Belda:]

It basically means that the Chinese are not moving as fastwith their alumina production as they are with their smelter; and that bauxitecosts, if you look at transportation costs, it is really going through the roof.Plus there is some difficulty exporting out of Indonesiaat the moment. I think it says goodthings about alumina, the spot price anyway.

[Operator:]

Your next question comes from the line of Kuni Chen - Bancof America Securities.

[Kuni Chen:]

Good afternoon, everybody. First a question on global acquisition,as far as the upstream businesses go. Nothing out there is for sale, so do youthink this really restricts your future growth to just organic opportunities? Again,just talking about the upstream part of the business.

[Charles McLane:]

I think the best way to look at that is that we're lookingfor obviously a host of organic growth opportunities but we are also taking veryseriously a long alumna position and think of that as a strategic asset. Welook for joint venture opportunities as well, so there are opportunities for usto grow organically as well as through joint ventures, not only on the organicside, but also through existing assets.

[Kuni Chen:]

Do you think at some point in the future that you wouldconsider a more diversified kind of metals portfolio approach, or is it alwaysgoing to be as a pure play alumina producer?

[Alain Belda:]

Over the years, we have looked at diversified portfoliosthat included items like titanium, magnesium, manganese; products that havesimilar functions and go to similar markets that we operate in. We haven'tfound anything that would add market value to the shareholders and we didn't doanything in those times. Doesn't mean that we wouldn't look forward to them.

[Operator:]

Your next question comes from John Tumazos - IndependentResearch.

[John Tumazos:]

Congratulations on all of the decisions. Concerning theshare repurchase, one of the developments, of course, is that when earnings aregood, the stock price is high and when earnings are a little weaker, the stockprice is a little less. If business were rough, would you be willing to sell anextra business or two to get the whole 25% of the shares bought back by 2010?

[Charles McLane:]

Our divestiture plans, as they are set right now, John, Ithink are pretty straightforward on the assets that we've identified and so Ithink the businesses that we're remaining in are earning better than cost ofcapital or in growth investments such as Chinaor Russia thatwill earn cost of capital in the future. So to easily answer your question, I don't think we would beentertaining those types of activities.

[Operator:]

Your next question comes from Anthony Rizzuto - BearStearns.

[Anthony Rizzuto:]

Alain, you talked about price caps on the can stock. I waswondering if you could talk a little bit about price caps or the fixed pricecontracts that maybe you entered into on the aerospace side? My understanding is that they were of long-term duration andI know some probably expired, maybe in the last couple of years. But could youtalk about that a little bit as you head into 2008? Also, if you could update us on the Russian aluminum assets.Are you aerospace qualified as we listen to you today, and how should we expectthe profitability or the performance of those operations? Have you changed yourview of when you think you'll be at breakeven on the Russian side?

[Alain Belda:]

Let's talk about the aerospace contracts. We have contractsand sometimes they will have a fixed price. When they do, we normally wouldhedge the underlying metal around those contracts. Sometimes you get intoissues where obviously if you have gotten a contract and you've done a hedge onit, you've got to take or pay on the volume and you might or might not get intoissues of delivery. I would say that 90% of the cases we will have a matchingmetal hedging deal done with a fixed price contract. Sometimes, there areissues related to the specific delivery in a specific quarter, and that's someof the MPM that you saw on this quarter. On the case of Russia,we've had some delays in Russiathat are related to the import of equipment into Russia.Those have delayed us, in some specific cases, for more than six months. So thedelay you're seeing in the turnaround of Russiaare related to that. The qualification, some of the products are qualifiedalready on the aerospace, on wheels by Ford and some European customers. So wethink that Russiawill be in a much better position next year; output is improving. We arebasically the sole supplier of can sheet in Russiaand that market is growing phenomenally. They have announced their firstregional jet and we'll be part of that, as you probably saw the release, whenwe signed the MOU, it was their company that will be building that. So ithasn't changed anything but the delay has cost us additional time.

[Anthony Rizzuto:]

I didn't notice in going through all the slides that youhave in the past broken out trailing 12 months, because of your internationaloperations impact on ATOI. Do you have that today? Could you let us know whatkind of equipment issues there are in terms of what kinds of equipment havebeen long in coming or difficult to get a hold of?

[Charles McLane:]

Well I'll take the first part of that, Tony. We did provideit. There was a slight increase in the amount of costs in the operations andthat basically had to do with some severance and the Bohai pre-operating costgoing up. From an operational basis, Russiawas pretty flat.

[Alain Belda:]

The equipment, we're heat treating furnaces and castingfurnaces that just took six months longer than we thought it was going to ingetting approval from the government for imports.

[Operator:]

Your next question comes from Charles Bradford - BradfordResearch.

[Charles Bradford:]

Yes, I'd like to ask a couple questions about how youaccounted for the Icelandfacility. Since it's really completed even though you didn't have the power,did you stop capitalizing the interest and did you start fully depreciating theunit?

[Charles McLane:]

It's done on a units basis, Chuck. So as it ramps up itsproduction, the economic benefit of that facility will be coming through and wewill start depreciating at a higher rate when that occurs.

[Charles Bradford:]

So it wasn't done in the third quarter then for an appreciableamount?

[Charles McLane:]

No, a minimal amount.

[Charles Bradford:]

Where do you stand today in Trinidadas far as a new site, environmental impact statement and so on?

[Alain Belda:]

We're completelystopped at the moment on Trinidad, depending on thegovernment making a decision as to what they want to do in terms of locationfor this potential smelter. Until they resolve what is an internal issue forthem, we are doing absolutely nothing at the moment.

[Operator:]

Your next question comes from Michael Gambardella - JPMorgan.

[Michael Gambardella:]

Chuck, in your primary segment it looks like the metaltrading business where you also have the power sales, the revenue was down over$100 million in the quarter. Can you comment on that?

[Charles McLane:]

On the revenueportion, Mike?

[Michael Gambardella:]

Yes.

[Charles McLane:]

I don't have thatwith me, but the metal price decrease that we talked about of $135 million hadthe impact of the mark-to-market activity on it. I don't have the revenuechange handy. Tony will be glad to give you that later.

[Operator:]

Your next question comes from Joshua Golden – JP Morgan.

[Joshua Golden:]

My question surrounds the debt-to-capital. You've stated inthe past a 30% to 35% target but it appears that you've been willing to deviatefrom that. Given the increase in the share repurchase that's been announced,possible future acquisitions, how should we think about the balance sheet goingforward? What are you committed to for bond holders?

[Alain Belda:]

Well, over the years,what we've given you as a guidance is that we like to have a balance sheet thatis somewhere between 25% and 35% debt to equity. Now, we have deviated, you'reright, we've gone above 40% when we've done some acquisitions. Depending on thevalue that we see in the acquisition, the moment in time when the opportunitycomes, we might take that kind of risk.

[Joshua Golden:]

Are you willing tocommit to mid-BBB rating?

[Alain Belda:]

We are committed tobeing at minimum a BBB company.

[Operator:]

Your next question comes from David Gagliano - CreditSuisse.

[David Gagliano:]

I was just wondering if you could remind us again what yourpolicy is towards hedging, specifically with regard to currency and energy? Ifwe could get a little more detail in terms of your A-dollar exposure, inparticular, that would be great. Thanks very much.

[Charles McLane:]

Let me give you thesensitivity first. What we said last time is a 1% change against our majorcurrencies to the U.S. dollar would be about $0.02 a share on an annual basis.Now that's on an economic basis. In other words, you've got a translation pieceof currency that impacts you based on whatever the exposures are, but theeconomic basis, the actual cost or revenue during the course of the quarter,you can use that $0.02 change for every 1% change on an annual basis. As far as our policy is concerned, we don't speculate,that's our policy. We may do some smoothing from time to time on a percentagebasis, but we don't take speculative positions.

[David Gagliano:]

With regard to the repurchase program, if we were to assumeeverything equal, share price stays flat for the next 12 months, I waswondering if you could just give us a sense as to where we should expect thatrepurchase authorization to be in terms of how much you have left to go, in saya year?

[Charles McLane:]

I think that would bea little too restricting to tell you the truth. We'll continue to look at ourcapital structure and our other growth opportunities, our CapEx, et cetera, ourbalance sheet is in an outstanding position today, we've got cash. We alludedto the fact that we will probably have repurchased at a little higher level inthe third quarter if we had not been so restricted. But with all of thevariables going into what might happen six months from now, a year from now,we're not going to restrict what we're going to do.

[Operator:]

Your next question comes from Jim Brown - JP Morgan.

[Jim Brown:]

Based on the capital spending in the third quarter, whichwas quite high, it seems as if you might have difficulty keeping capitalspending down to $3.2 billion for the year. Could you give us an idea of wherecapital spending will be and also, could you give us an idea of the Icelandramp-up schedule?

[Charles McLane:]

Well, let me take the capital spend. That's on a cash basisto us, and there's two different categories on our cash flow statement. One isour capital expenditures which if you just looked at that it would seem thatwe're going to have trouble hitting that; but the other category is the amountof capital calls we get from our minority partners. So you really have to netthose two to get down to a net cash impact. Taking that into consideration, what Alain said earlier isexcluding currency on our CapEx, which we think is going to impact us close toa couple hundred million this year, we would be within target. So the firstpart is you've got to net out the capital calls that we get and then take thecurrency into consideration of a couple hundred million that we would be withinthat range, a couple hundred million of our target.

[Jim Brown:]

Icelandramp up?

[Alain Belda:]

Iceland,we will be at about 30,000 tons at the moment and starting some time lateNovember or mid-November, we will, I believe, the plans at the moment are thatwe'll start ramping up. The people have been training pretty arduously now tobe able to start up at an accelerated pace, so we believe that we will be atabout 300,000 tons for the full year 2008.

[Operator:]

Ladies and gentlemen, that concludes our Q&A session.I'd like to hand the call back over to Tony Thene for closing remarks.

[Tony Thene:]

Thank you, Shawn.Thank you for your participation. That now concludes our third quarter 2007analyst conference call.