Monday, April 15, 2013

Alcoa's Outlook Remains Positive

One of Sherlock Holmes’ greatest pieces of detective work was detecting the importance of the dog that didn’t bark in the ‘Hound of the Baskervilles’ and I think investors should follow his lead over Alcoa’s $AA latest results. In other words, the earnings were more important for what they didn’t say about the economy and end markets then what they did.

Alcoa Earnings Analysis

At the last set of results Alcoa gave a relatively bullish prognosis for the global economy and highlighted how much it is reliant upon China for its earnings prospects. Investors could be forgiven for being skeptical given the uncertainty surrounding political events in the US, the state of the European sovereign debt situation and China’s growth outlook in 2013. Of these three macro concerns the fears over the fiscal situation in the US seem to have subsided somewhat (even if the deficit reduction plans are unsatisfactory to many) and Europe appears to be stabilizing as everyone gets used to dealing with a succession of mini disasters.

The biggest question mark is over China, and longer term there are concerns, but if Alcoa’s guidance and commentary is accurate then the Chinese economy is on track.

In fact there weren’t any major changes in its end market outlook.

There was a slight weakening of the outlook for the European automotive industry and a trimming of the high end of guidance for Chinese heavy truck and trailer but otherwise nothing changed. Moreover, the color and commentary given around the results was positive.

Aerospace and Industrial Gas Turbines

It’s a mixed story for aerospace right now with commercial aerospace doing well but the defense sector remaining subject to a lot of uncertainty over spending. The interesting thing was that it saw a strong rebound in regional and business jets. The latter is one of the most cyclical industry segments in the economy and its strength is a good sign.

This outlook is also a good sign for a company like General Electric $GE, which has aviation as a major profit center. Its aviation equipment orders rose 13% in Q4, and some orders were pushed out so we can expect continued growth this year. Similarly industrial gas turbines are a common end market for both companies. Alcoa is seeing 3-5% growth, and as long as gas remains relatively cheap compared to other hydrocarbon fuels, then gas turbines will be run, thus creating end demand. GE will surely benefit too.

Automotive and Heavy Truck & Trailer

It was surprising not to see Alcoa raise forecasts for the US, but the weakness in European auto shouldn’t have caught anyone unaware. Automotive sales continue to be strong in the US, and the increasing willingness of credit providers to give loans should drive further growth. The ultimate arbiter of these factors is employment; this continues to grow in the US. Again the commentary on the Chinese automotive market was positive.

Furthermore Alcoa remains bullish on the heavy truck & trailer market in China. Meanwhile, Europe and the US remain in decline as manufacturers run down inventories. On a more positive note Alcoa described the fundamentals as ‘looking good’ with orders on the rebound.  It’s interesting to compare this outlook with what Cummins $CMI reported last time around. It is expecting the Chinese heavy and medium duty truck market in 2013 to be similar to 2012. It said that truck demand stabilized in Q4, but overall its tone was notably more negative than Alcoa’s. They can't both be right.

Beverage Can Packaging and Commercial Building & Construction

Rather like autos in the US it was surprising not to see forecasts raised for US construction. Alcoa is still predicting 1-2%, but other indicators such as the Architectural Billing Index are displaying strength. History shows us that the residential market tends to lead a recovery in commercial and industrial construction, and a good example of a company with global exposure to this theme would be Stanley Black & Decker (NYSE: SWK). The stock offers a compelling mix of heavy exposure to US construction spending, emerging market growth and company specific strategic growth initiatives. As long as Alcoa keeps reporting better conditions in this segment, then end markets look likely to be favorable for the tool maker and its growth program.

Last but not least, Alcoa reported a consistent outlook for its beverage can packaging end market and referred to the positive trend in China to convert steel cans into aluminum. This is good news for Ball Corp. The risk with the can manufacturers is that they will commit to capital expenditures on plants in order to service nearby customers only to see demand tail off as the economy slows. Therefore as long as markets are holding up well we can expect positive leverage from their investment programs.

The Bottom Line

In conclusion, while this report was nothing spectacular it was consistent and, given that Alcoa had been relatively bullish previously, I think investors can take heart from it. Overall it is a net positive and if it continues like this the economy will be in good shape in 2013.

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