Alcoa Corporation
Q3 2011 Earnings Call Transcript

Published: 12 Oct 2011

[Operator:]

Good day, ladies and gentlemen, and welcome to the Third Quarter 2011 Alcoa, Inc. Earnings Conference Call. My name is Stacy, and I'll be your conference moderator for today. [Operator Instructions] As a reminder, this conference call is being recorded for replay purposes. I would now like to turn the presentation over to your host for today to Mr. Roy Harvey, Director of Investor Relations. Please proceed.

[Roy Harvey:]

Thank you, Stacy. Good afternoon, and welcome to Alcoa's Third Quarter 2011 Earnings Conference Call. I'm joined by Klaus Kleinfeld, Chairman and CEO; and Chuck McLane, Executive Vice President and CFO. After comments by Chuck and Klaus, 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 financials measures in our discussions. Reconciliations to the most directly comparable GAAP financial measures can be found in today's press release in the Appendix to 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. I would now like to turn it over to Chuck McLane.

[Charles D. McLane:]

Thanks, Roy, and we appreciate everybody taking the time to join us today. I would go to the first slide, and we look to summarize and evaluate this quarter's results. There were 2 significant developments. First, we have experienced significant commodity price deflation in our Alumina and Aluminum segments. While aluminum demand continues to grow globally and regional premiums remain strong, macroeconomic worries and various commodity investors have driven an 8% drop in the price of aluminum quarter-on-quarter. The result is a decrease in revenue and profits in both segments. Despite the price deterioration, both businesses were able to generate sufficient volume and productivity savings to essentially offset inflationary headwinds. Secondly, results in flat-rolled products were degraded by the continuing sovereign debt crisis in the Eurozone and the resulting market uncertainty. These conditions have driven falling confidence in both consumers and businesses. Fearful of a slowing economy, our European customers reduced their orders dramatically even into September and drove a significant reduction in this segment's profitability. The Engineered Products and Solutions segment experienced some seasonal weakness as well as the impact of a flood in its Bloomsburg, Pennsylvania, facility, which completely shuttered a building and construction facility. This segment continues to provide very strong results even in these uncertain times. It's difficult for us to see the slowdown in our mid and downstream segments following a record first half. Yet we are taking action to combat the demand destruction, and we have plans in place should the uncertainty persist. Now let's go to the third quarter overview. Income from continuing operations in the quarter was $172 million or $0.15 per share. This represents a sequential decrease of 47%, but an increase of 182% versus the third quarter of 2010. An 8% drop in the LME, combined with European weakness, contributed to the decrease in revenues on a sequential basis. On a year-over-year basis, sales remained strong with all of our major markets showing greater than 8% increase in revenue. EBITDA was $821 million, which represented a 13% EBITDA margin. Free cash flow in the quarter was $164 million, bringing the cash generated this year to $250 million. We continue to operate our businesses at lower levels of working capital with a drop of 5 days compared to the third quarter of 2010, roughly equivalent to $350 million in cash. Our debt-to-capital ratio stood at 33.7% or 200 basis points lower than the third quarter of 2010 and is within our 30% to 35% target range. During the quarter, we reduced our net debt by $109 million. Lastly, liquidity remained strong with cash on hand of $1.3 billion. Now let's review the income statement. The $166 million sequential decrease in revenue was primarily driven by the drop in LME. Higher volumes in the primary metal segment were offset by lower sales in flat-rolled products, primarily in Europe. On a prior year basis, higher prices drove about half of the $1.1 billion improvement with the remainder driven by improving volumes across all of our businesses. Cost of goods sold as a percent of revenue was 82.4%, an increase of 270 basis points from the second quarter but 110 basis points improvement from the third quarter 2010. SG&A as a percent of sales declined by 30 basis points sequentially driven by falling prices, but showed a 30 basis point improvement versus the third quarter of last year. Our effective tax rate for the quarter was 19.6% or 24.6% excluding the discrete tax items. This brings our year-to-date rate to 26.3%. With increasing uncertainty across our markets, we will continue to experience swings in the rate as profit drivers within each taxing jurisdiction remain volatile. Let's now move on to a review of the special items in the third quarter. Special items in the quarter totaled a favorable $7 million. We undertook restructuring initiatives in Europe and Australia, lowering headcount and capacity to meet declining demand and incurred uninsured losses primarily due to flooding at our Bloomsburg, Pennsylvania, facility. Still, these were more than offset by favorable noncash, mark-to-market adjustments on energy contracts and discrete tax items associated with finalizing our 2010 returns. We can now move on to the sequential earnings bridge. There's a couple of items I'd like to note on this slide. First, you would usually expect currency to be favorable when prices are unfavorable. In this quarter, rates on average were essentially flat quarter-to-quarter. The unfavorable amount specifically relates to currency translation in the quarter. Second, for the first time this year, ongoing productivity improvements across our businesses were insufficient to overcome slowing market conditions and prevailing cost headwinds. However, we continued the solid pace of improving productivity on a sequential quarter basis and captured $146 million of improved productivity compared with the third quarter of last year. To get a clearer understanding of these actions, let's move to the year-over-year view. As we look at this year-to-date bridge, you can see the effects of rising inflation, which is a marked characteristic for the entire aluminum industry. In contrast, we've been able to more than offset these inflationary pressures through volume, price and productivity actions. And in doing so, added more than $100 million in net profitability. Combined with the aluminum [ph] currency impact, 2011 results have been improved by $510 million. Now let's move through the segments. Alumina production remained flat this quarter as we scale back plans to increase production given weakness in the spot market. This flexible capacity remains available and ready to deploy as market conditions improve. We experienced $19 million in market effects during the quarter, including a 3% decline in alumina pricing, partially offset by positive currency impacts mainly driven by the strengthening of the U.S. dollar. Cost increases totaled $38 million, with increases in both caustic and energy prices. Still, we were able to offset these increases through our focus on improving performance through higher volumes and productivity actions. We will continue to focus on offsetting inflationary headwinds through productivity improvements. While EBITDA per metric ton was down sequentially, it did represent a $39 per metric ton improvement from the prior quarter last year. Volume increases in productivity more than offset energy and raw material costs. Days working capital improved 7 days versus third quarter of 2010, and that is on top of the 21 days from the previous 12 months. Moving to the outlook for the fourth quarter, we continue to focus on productivity actions to mitigate any inflationary pressures. Now let's move to primary. Production was up 2%, and third-party shipments were up 4% sequentially as we felt the full impact of our restarted plants in North America. Realized pricing was down 5%, although the drop in LME was more indicative of macroeconomic uncertainty rather than specific pressures related to global demand of aluminum. Regional premiums continue to remain strong. On a prior year basis, realized pricing strengthened 19%, but the U.S. dollar weakened considerably. As a result of sharp deflation of the LME aluminum price, Primary Metals experienced significant margin erosion this quarter. The benefits of the U.S. restarts and solid improvement of productivity were sufficient to offset increases in costs, primarily carbon products. We also incurred a structural increase in European energy costs that we communicated last quarter. As signaled last quarter, the U.S. restarts delivered profitable results this quarter. Despite pressure on alumina prices, these plants continue to operate profitably. In the fourth quarter, we expect to see higher energy costs at some of our locations particularly Norway as we enter the traditionally higher priced winter season in the northern hemisphere as well as a planned outage at our Rockdale power plant. As in Alumina, we'll continue to generate productivity benefits to combat these higher costs. Let's now move to the Flat-Rolled Products segment. European seasonal shutdowns in August were followed by an unseasonably slow September, causing significant volume losses as well as price and mix impacts. China also saw volume decline that unfavorably impacted results on a sequential basis. For China, this appears to be temporary slowdown in automotive, and we don't anticipate this to be a sustained trend as volumes are expected to return to growth in the fourth quarter. Significant drops in capacity utilization and the high fixed cost nature of this business led ATOI down sequentially and on a year-over-year basis. As in the past, we also utilize this period of slower demand to complete some nonroutine maintenance tasks, ensuring our operations are ready for ramp up when demand improves. We continue to drive productivity improvements across the business and expect to continue to make improvements into next quarter to partially mitigate the fall in demand. We also made solid progress towards the $2.5 billion incremental revenue target with increasing margins. We now project that we can achieve 50% to 60% of the 3-year targeted revenue increase in 2011. Next quarter, we expect to see continued demand strength in aerospace but with normal seasonal effects in beverage can packaging. We should see an improving product mix although the uncertainty remains high in Europe. Now let's move to Engineered Products and Solutions. While down sequentially, Engineered Products and Solutions delivered another very solid quarter. Revenue remained flat sequentially and improved by $200 million compared to prior-year quarter. EBITDA declined sequentially but increased by $31 million compared to the third quarter of 2010. While the general market environment has improved since last year, much of our improvement has been driven by management actions to improve our portfolio and better leverage the strength of our innovative products. Productivity improvements offset cost increases during the quarter, with an additional negative impact associated with the flooding of our Bloomsburg plant. Despite a weaker Q3, we continue to see further growth in our margins as we pursue our strategic plans. We are on target towards the $1.6 billion incremental revenue with increasing margins. We project achieving 30% to 35% of the 3-year targeted increase in 2011. Looking ahead, we anticipate incremental improvements in all of our markets except commercial transportation in Europe and building and construction in Europe and North America. We also anticipate productivity improvements to continue. Now let's move to the cash flow statement. Despite weaker operating results in the quarter, we continue to generate free cash flow. Year-to-date, we've reached $250 million, with the fourth quarter typically our strongest quarter. Debt to capital of 33.7%. We continue to remain within our target range of 30% to 35%, and with $1.3 billion of cash on hand, we move forward with a strong liquidity position. We continue to invest in our businesses including $165 million year-to-date invested in the Ma'aden-Alcoa joint venture. Let me give you a little more detail in our working capital. We continue to see sustained improvement in our days working capital across our portfolio. We achieved 11-day improvement against 2009 and are 5 days better than 2010. On a year-over-year basis, that equates to about $350 million in cash. Let's get an overview of the progress on our 2011 financial targets. We continue to track well against all of our financial targets for the year. Capital expenditures including our investment in the Ma'aden-Alcoa joint venture are well within the targets. Debt to capital remains within our target range, and we continue to generate free cash flow with our traditionally best quarter for cash generation yet to come. With heightened uncertainty in the market, I thought it would be good to review our financial liquidity dashboard. First, as you can see, our operating performance has improved markedly from the end of 2008 and 2009 time period. We're definitely in a different situation. We have been able to lower our overall debt position by more than $1 billion and our net debt position by almost $2 billion, and we currently sit on the $1.3 billion of cash. While this data provides the current view, it's also prudent to summarize the action we've been taking to improve our future maturity profile. Over the past 2 years, we've completed 2 capital market transactions designed to increase the weighted average duration of our maturities, while maintaining low interest rates. As you can see, we've been successful at both. We have also acted to optimize our maturity profile and to limit the size of near-term debt repayments. As a result, we have $1.5 billion coming due over the next 5 years. Finally, we recently entered a $3.75 billion 5-year revolving credit facility. This facility provides the stability we need in any time of uncertainty. We, like you, are not certain about how the market will unfold. What we do know is that we stand prepared to deal with the market uncertainty both from an operational and a liquidity perspective. Now I'd like to turn the presentation over to Klaus.

[Klaus Kleinfeld:]

Chuck, thank you very much. I think that provides a good foundation. So in the usual fashion, we've concentrated also in the part that I'm going to share with you to focus on some of the questions that are out there that we've heard regularly from you all out there, and let me address those ones. And let's start with our global aluminum demand forecast. You've seen this chart before. I mean, this is an update, and let me reiterate the first important point on this. We are reiterating we need a 12% growth that we have already set in the previous time for this year. So 12% growth, we believe, is going to happen in this year on the aluminum demand side. While you're seeing that the economy is slowing in some parts of the world, we also see strong growth in the emerging markets that basically offsets this impact. And that's why this chart really doesn't show you the whole picture, and we decided to make another one to show the delta between the first half of the year and the second half of the year and this is this one that you're seeing now on your screen. So what you're seeing here is that we are forecasting a decline between the second half and the first half in basically 3 regions

[Operator:]

[Operator Instructions] Your first question comes from the line of Sal Tharani with Goldman Sachs.

[Sal Tharani:]

Chuck, I wanted to just ask you...

[Charles D. McLane:]

Sal, we can't hear you. [Technical Difficulty]

[Sal Tharani:]

Chuck, just wanted to see how you -- what your thoughts are, so cash position going into the next year for the fourth quarter. If I look at the press release where you've mentioned how much CapEx you've already utilized or how much is left based on your target between CapEx and the Ma'aden facility, that's about $750 million or more if you fully go through your target by the end of this year. You obviously have $1.3-plus billion of cash, and then fourth quarter is generally more cash generation. But then you have a pension payment for next year. How do you feel you'll be able to manage that? Or are you comfortable that you'll be able to manage that going into the first quarter when you need the pension funding requirement?

[Charles D. McLane:]

Yes, Sal. We're fairly comfortable right now. I mean, as Klaus said, as far as whether you know or I know exactly when the market is going to hit from the situation it is today with the things going on in the world, we are a bit uncertain. But as far as our ability to manage cash, I think we've done an excellent job in the past. We've got $1.3 billion on hand, and we're entering the fourth quarter, which historically is our largest cash generation quarter. And we think it's going to be the largest this year as well. So if I had to look forward right now, I think we're going to enter the beginning of next year with actually more cash on hand than we had today, which we'd be well situated to deal with pension contributions next year.

[Operator:]

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

[Paretosh Misra:]

So I was looking at, actually, at the table where you reconciled segment ATOIs with net income, and there's a $75 million other term. Just wondering if you could talk a bit more about that, if there are any major items there in this quarter.

[Charles D. McLane:]

Yes, the biggest item -- the 2 items in there is where corporate has taxes to reconcile back to our overall rate for the quarter, so whatever the taxes are in the quarter. And you can see a couple of the segments have a little lower tax rate than they had previously, so to get back to the 24% in the quarter that's in there. But the biggest portion that's in there is the currency translation piece that we had at corporate. And what I mentioned when I went through our bridge, I mean, even though if you look at the currency rates on our basket of currencies between the second and the third quarter, you'd see an average for the quarter they are pretty flat. But if you see how the dollar strengthened by the end of the quarter, which is where the translation it does, it had a negative impact on us and that's the biggest reason for the third quarter change.

[Operator:]

Your next question comes from the line of Brian Yu with Citi.

[Brian Yu:]

Klaus or Chuck, with the downstream operations, it looks like you've actually raised your revenue target progress towards the 2013 goals for both engineered and flat-rolled. But you've also mentioned that you're noticing a slowdown in Europe. So can you help me discuss what's offsetting the slowdown in Europe that's allowing you to raise your overall revenue progress targets?

[Klaus Kleinfeld:]

Yes, Brian, that's a very good question. And on the Engineered Products and Solutions business, I mean, what we -- there you have a business that on the one hand caters a lot to the automotive as well as the aerospace segment. So that's one thing, right, where we continue to see good strength in many of the regional markets. That's the first thing. The second thing is we have a lot of innovation in store, and the more you go downstream, the more we can work with innovation. So we believe that we are actually winning in this game and are pretty comfortable that with those 2 factors, I mean, we will be able to reach the $1.6 billion profitable growth target. And as you correctly said, we've raised how much of that, we will be able to get in this year and raise it also for the midstream for GRP. That's correct, Brian.

[Operator:]

Your next question comes from the line of Tony Rizzuto with Dahlman Rose.

[Anthony B. Rizzuto:]

Klaus, I was wondering if you could repeat again. I didn't get all of what you were saying about China and the curtailers. I think you indicated that China had throttled back a little bit mainly due to power cost increases. But are you seeing any smelter curtailments related to the lower price there and how that may be impacting the higher cost smelters?

[Klaus Kleinfeld:]

We do see that, and we do see a combination of a number of factors. One is the -- the basic factor I would say is the energy situation here, where the energy costs are increasing and the sustainability targets, I mean, that they put out in the 12 5-year program are real. And you can see that by what the provinces are basically doing and that was what I was going through. I mean, as I said, 15 provinces have an active power price increases. 15 out of 22, if I remember that correctly in China. So that's pretty much almost all of China has done that, and I would say the only ones that haven't done it are the ones that are in the Far West, right. Five, and those are the ones in the south, has specifically cut aluminum production by 20% in addition to their raising of the energy general [ph] prices. Seven provinces have cut the total industrial production so including aluminum. And so you get a picture of the situation there. And we have, Tony, we have talked about that I think. We have talked about that also specifically, I mean, what we do see in the midterm in China. I mean, if you look at the Chinese industry structure, I'm always puzzled by it. I mean, you see that basically around 40% of the bauxite now gets imported, 30% of the bauxite that's mined in country is mined underground. Roughly 37% of all the alumina refineries are in the top quartile of the cost curve, about 45% of the smelters that we have in China at the top quartile. I mean, that's not a sustainable industry structure, and that's why we said and that's why we also put our money behind it that there are opportunities of Chinese firms to cooperate with western firms. We signed a memorandum of understanding with the Chinese Power Investment Corporation earlier this year at the visit of President Hu in the U.S. And we just expanded that when I was over there a couple of weeks ago. So that's the picture that we're seeing there, and we also believe that over time, there will be opportunities to import alumina as well as aluminum into China. The time has probably not come yet. I mean, the China metal price has gone up, but it's not yet reached the threshold where it overcompensates the logistic costs and the regional premiums that you could get elsewhere. Tony, I hope that clarifies.

[Operator:]

Your next question comes from the line of Kuni Chen with CRT Capital Group.

[Kuni M. Chen:]

Just a quick question on costs. Obviously, some of the upstream costs are tied to the metal price, some of the costs are not. Of your costs that are linked to the metal price, can you just remind us which are the ones that are slowest to adjust on the way up or down?

[Charles D. McLane:]

Okay. Well, if you look at refining, let's start with that. You take -- it's not tied to the LME price. You take caustic soda, and that's usually a lag of about 3 to 6 months, and fuel oil is like 1 to 2 months. That's obviously also not tied to the LME necessarily, but that's the cost components and has flows through. Then if you went over to smelting, you would see coke going through on a 1- to 2-month basis and pitch going through on a 1- to 2-month basis. Power is also going to be about in the same time frame and it's tied in many instances to LME.

[Operator:]

Your next question comes from the line of Jorge Beristain with Deutsche Bank.

[Jorge M. Beristain:]

I guess maybe my question is for Klaus. I noticed in this third quarter you did not give specific volume guidance for the quarter ahead for Primary Metals as you did in the second quarter where you were calling for a 30,000 ton increase in third-party aluminum shipment. You exactly hit that number. Do you have a number that you could put out there for the fourth quarter? You're still standing by your full year guidance, but you obviously have 9 months of data already. So do you have an idea of what fourth quarter improvements could be of shipments?

[Klaus Kleinfeld:]

I don't recall that we gave a guidance there.

[Charles D. McLane:]

We gave some guidance around on both for alumina production and primary production, but we haven't given any guidance for the fourth quarter because we're still evaluating based on market conditions to tell you the truth.

[Klaus Kleinfeld:]

You have that in your slide, I remember now, on the right-hand side. Yes, that's true.

[Charles D. McLane:]

And so right at this point, I guess we would say we're not going to give any discrete guidance around production for those 2.

[Jorge M. Beristain:]

Okay. If I could just have a quick follow-up as well then. Given where aluminum prices are tracking right now on the LME close to $1 a pound for the first few days of the fourth quarter, that would still be down a further sort of 7% sequentially. So I'm just trying to understand why you have the confidence that the fourth quarter should be such a high cash flow generating quarter for you guys given the headwinds that we're seeing in the primary aluminum price.

[Charles D. McLane:]

Well, high level of confidence. Let me put a disclaimer out there that I mentioned to Sal earlier and that who knows what the market holds. But it's technically been a quarter where we've been able to generate significant working capital dollars, which is in the case in many businesses. And that if you looked at our prior years, you would find that to be true and the tracking. In fact, my slide that I look at our liquidity position in here, it shows you the fourth quarter. And you would see that that's held through in the last 2 years significantly and that's really what I based it on. It's cash from our operations not just from the income side of it, but from the working capital side.

[Klaus Kleinfeld:]

And I think it's also clear that what you saw in this quarter that the teams have been very good in ramping up the productivity to counter the cost inflation aspect that we've seen before. And obviously, we will continue to do that, and the folks will be working hard on that, basically going through every single piece that you have there from procurement to overhead.

[Charles D. McLane:]

But we still have 2.5 months left, who knows where the price is going to go from here, but like I said.

[Klaus Kleinfeld:]

And let's not forget, I mean, I think that's why I put this slide together, which I hope -- I mean, time was well spent on that. I mean, in our view, it is not as such. I think the biggest miss that we have today is the miss of confidence, less so on the market fundamentals. The market fundamentals are holding up relatively good, right, and the metal price decline is basically a speculative element. These things, I think, you have to dissect.

[Operator:]

And at this time, I'd like to turn the conference back to Klaus Kleinfeld for closing remarks.

[Klaus Kleinfeld:]

Okay. I guess that's all the time we have today. Let me sum it up. I mean, we've seen strength in many of our markets despite the sharp slowdown in Europe that hurt our sequential results. And I'm, as I just said, more concerned about the lack of confidence than about market fundamentals. It almost looks like the world is worrying itself into another recession and that should not be allowed to happen. I think the problems that we have today, I mean, around Europe and some of the discussions here, I think are all problems that can be solved. And I hope the solutions get accelerated and we'll be able to restore confidence. Confidence, I said many times, is the air, the oxygen that every economy needs to grow. We are, and that's the good news here, whatever lies ahead of us, we are prepared to take it. We are leaner. We have less debt. We have more cash. And I think those that have done their studies on Alcoa would clearly see that the long-term trends have not changed. The world is growing. The world is urbanizing. There will be more and increasing demand for aluminum, and those are the reasons why Alcoa remains a confident company in a very nervous world. Thank you very much.

[Operator:]

We thank you for your participation in today's conference. This does conclude your presentation.