Friday, November 30, 2012

What Alcoa is Telling You About Earnings Season

Alcoa (NYSE: AA) gave its latest set of results and as ever it’s time to pour over the numbers and commentary in order to get some clues as to the state of the global economy. In summary, the report was not a good one and confirms that the economy is slowing. The good news is that most people reading this are private investors who do not need to invest in the ‘global economy’. Our focus should be on surgically finding stocks that can outperform in any environment and I think there are some clues as to what stocks might work in this report.

Headlines Not Fundamentals

Alcoa’s CEO described the market as being driven by ’headlines not fundamentals’ and I think he is right. In fact, he is always right! In my opinion markets are usually driven by headlines and they set the tone for the fundamentals. If European CEO’s won’t invest because they are worried about Greece/Spain et al then this will show up in the fundamentals. It’s a similar thing with China’s housing market and its export industries. And neither is political uncertainty over presidential cycle helping things much in the US. Of these three issues I think the most problematic will prove to be China.

In any case we can see echoes of these issues in the progression of Alcoa’s outlook for the year. I’m going to split up its commentary in terms of geography. But first a few words on the end markets that Alcoa does not separate on a regional basis.

Aerospace and Industrial Gas Turbines

The commentary around aerospace was positive and as usual the full order books at Airbus and Boeing (NYSE: BA) were cited as evidence of good long term growth prospects. However, I think this is a line of argument that deserves a lot of circumspection. While it is certainly true that airplane orders are long cycle and Boeing won’t just stop making a plane midway through its construction phase, the truth is that the market doesn’t care.

What the market cares about is the flow of new or canceled/delayed orders and guess what folks?  Commercial aerospace is a highly cyclical industry. Orders do get canceled in a downturn and if Asia is headed for lower growth than that’s where the cancellations/delays will come from because that’s where passenger mile growth has been coming from. Indeed, if you look at Boeing’s order book, most of the orders are coming for Asian routes.

However, if aerospace is more cyclical than many think than the demand for industrial gas turbines might not be.  The sector is experiencing a strong uptick in demand thanks to the emergence of gas as the energy source of choice for electricity generation. In fact Alcoa has raised its yearly forecast for gas turbine demand through the year. This is good news for General Electric (NYSE: GE) who has gas turbines as one of its largest profit centers on the industrial side. If you couple that together with the aerospace commentary it’s easy to conclude that GE will report some decent numbers in the next quarter or so. Longer term the picture is more cloudy.

Alcoa’s Geographic Outlook

A graphical depiction of how Alcoa has been evolving its full year view throughout the year. All points represent the mid-point of guidance. I'm going to intersperse the charts within my remarks.

The progressive weakness in Heavy Truck & Trailer will be a recurring theme in this report. Growth has been significantly downgraded and this is not unexpected. This tends to be more short cycle and if freight and transportation companies are seeing slowing growth they will cut back on orders quickly.  Each region saw a downgrade to expectations.

On a more positive note North American automotive is doing well and strong US car sales are the probable cause. Unfortunately this is not an easy theme to get direct exposure but one interesting-if tangential idea- is CarMax (NYSE: KMX). The idea here is that the car auction company has found it harder to get stock in recent years as US car drivers have kept running older cars for longer. So if ongoing good new US car sales are seeing more second hand vehicles available in the market place than there is room for margin expansion at the dealers. I was slightly surprised to see China a bit stronger as car sales have not been great there recently and this is something to look out for in future.

Another area which looks a bit stronger in North America is beverage can packaging but this area was weaker in the other two regions.  In a sense this might be expected because both Coca-Cola and Pepsico (NYSE: PEP) have found things difficult this year in North America. Perhaps this signifies slightly better conditions for North American beverage? In this regard I would focus on Pepsico. Despite its global pretensions, the company generates over 77% of its operating profit from North America and 31% from Americas beverage.

The last end market is commercial building and construction and there was no change to any geographic outlook although my suspicion is that China will be downgraded in future and North America upgraded.

The Bottom Line

It was a negative report overall and I suspect things will get worse near term. Much hope is being pinned on China’s stimulus plans. We shall see how that works out.  You could buy the argument than Alcoa looks like a good value right now. If you prefer to monitor events for now then I think there are a couple of bright spots in this report. Specifically North American automotive sales look good and beverage can packaging prospects look better too.

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