Friday, June 8, 2012

Alcoa's Results Give Mixed Signals

Alcoa $AA kicked off the main body of the earnings season and, investors poured over its results to try and garner an indication of where the economy is headed.

With regards to the earnings, the revenue numbers were surprisingly strong given that aluminum pricing has been weak recently. Management sounded bullish on the conference call, even though others in the industry have been making more cautious statements recently.

Alcoa has had to deal with falling aluminum prices and has cut capacity as a consequence. Ultimately, its profitability will be guided by the demand/supply balance in its industry. For this quarter, Alcoa did well as pricing pressures eased, but the key will be how end demand trends in future.

These are industry-specific questions, but Alcoa’s end demand has plenty of drivers in common with many market sectors. Consequently, Alcoa’s stock performance is not always a useful bellwether, however, the company’s end market commentary is interesting for the wider markets.

Stocks Correlated with Alcoa

For example, looking at the stocks that Alcoa has the highest correlation to, the usual mining and aluminum suspects are apparent. Interestingly, the typical plays on global growth such as DuPont and Caterpillar $CAT are also there.

CompanyCorrelation %
BHP Billiton87.5
Century Aluminum87
Rio Tinto86.1
Du Pont85.5

Investors should understand that correlation is not the same thing as co-integration. Correlation measure  the direction of the movements together, rather than the magnitude. Two stocks can be highly correlated but also exhibit vastly different price movements.

Nevertheless, investors do care about directional movements. With this in mind, I want to break down Alcoa’s end market guidance and, see which companies might be affected by the commentary that Alcoa gave.

Alcoa’s End Markets

Here is a table of how Alcoa has been adjusting guidance over the last four quarters including the latest commentary. The last column is my own interpretation.

The first thing to note is that I am only describing automotive and commercial transportation as being ‘slightly weaker’, because Alcoa lowered the high end and low end of their respective guidance. Secondly, Alcoa raised guidance for the long cycle industries of aerospace and industrial gas turbines, by way of contrast the weaker outlook was in the shorter cycle businesses.

Aerospace & Industrial Gas Turbines Stronger Growth Forecast 

The raise in guidance will be well received by an aerospace industry which is set for good growth in the next few years. Airbus and Boeing order books are both full for years to come. Moreover, with the growth of aircraft such as the popular A320 and Boeing 737, which have a large aluminum component, Alcoa has the opportunity to grow faster than industry growth.

Ultimately, the aerospace industry is cyclical. High fuel prices and economic recessions will ultimately effect growth. Indeed, according to the International Air Traffic Association (IATA) the outlook remains ‘fragile’.  Nonetheless, longer term aerospace growth is being driven by low cost carriers and emerging market passenger growth. The BRICs are all huge countries, whose intercity transportation is likely to have air travel as an integral part.

One company I like in the sector is BE Aerospace $BEAV which provides seating to airlines. It is attractive because it is a pure commercial aerospace play and looks set to benefit from a long cycle of growth in new build and retrofit. Typically, airlines order planes then they buy the seating and cabin interiors separately from the likes of BE Aerospace. However, BE Aerospace now working directrly with the aircraft manufacturers. The company recently announced a contract with Boeing to manufacture modular lavatory systems for the 737. This is exciting because it may presage a new area of growth for the company, particularly as its solution allows for airlines to gain a few seats on the plane.

Another, obvious beneficiary is General Electric $GE which is the leading player in the market. It is also the leader in commercial aircraft engines and would be an obvious beneficiary of Alcoa’s rosy economic outlook.

Beverage Can Packaging

Although the headline guidance stayed the same, it was noticeable that forecasts were raised in Europe. This is an interesting industry because there is rapid growth in emerging markets for can usage. However, in the US, plastic is increasingly replacing aluminum in the key beverage packaging sector. Therefore, companies like Rexam or Ball Corporation $BLL are increasingly shifting production towards emerging markets like Brazil. Ball Corp is worth a closer look, because its end demand remains positive and stable, whilst one of its key input costs (aluminum) is falling. The key for Ball will be in managing the consolidated decline in the US, whilst accelerating growth elsewhere.

The Weaker Segments Reveal Regional Differences

Within Commercial Building, all regions (US, Europe and China) were predicted weaker, although Europe was noticeably so. Frankly, I think there is good potential for China to disappoint in future quarters and, Europe’s economic growth will be weak this year.  Automotive was very enlightening. Europe was seen as notably weaker whilst China was weaker. The latter is not surprising, given the recent relative weakness in car sales in China. However, the US was noticeably stronger. This suggests that the way to play US auto sales strength could be via the US auto dealers rather than global production.

It was a very similar story with the Heavy Truck & Trailer segment. Alcoa sees the US trending higher and growth from China being weaker. One company that could benefit is Eaton Corporation which has good exposure to the aerospace and commercial transportation markets.

Alcoa Results

In conclusion, Alcoa’s guidance was mixed. The clear message is that China’s growth appears to be slowing but, the US is accelerating. I think this signal is a useful one for investors to digest and, an increased focus on domestic US inclined companies is called for. Perhaps the much talked about, but rarely seen, decoupling affect does actually exist?

No comments:

Post a Comment