Alcoa's Earnings and What they Mean to the Industrial Sector

While the market frets over the Government shutdown, aluminum producer Alcoa (NYSE: AA  ) quietly delivered a solid set of earnings. More importantly, its end-market outlook was surprisingly strong. In particular, its commentary on industrial conditions in China suggested some strengthening, when only a day previously, the World Bank had cut its forecast for Chinese growth this year to 7.5% from 8.3% in April.   Given this conflicting evidence, what does Alcoa's guidance really mean?

Alcoa can only report what it seesThe company will always be a good bellwether for certain key industries like automotive and aerospace, but it may not necessarily represent the global economy or the broader industrial sector. And this is especially true for China. Alcoa's outlook was good for China, but this might be due to some changes in the composition of China's GDP growth.

Indeed, the World Bank report noted that Chinese consumption is now contributing more to growth than investment compared to previous years. And if Chinese consumption is stronger, you can bet the automotive sales will benefit. Subsequently, Alcoa raised its forecast for automotive demand in China. All told, Alcoa raised its aluminum demand forecast from China to 12% from 11% previously, while keeping its global demand estimate at 7%.

To put all of this into context, here is Alcoa's updated 2014 end-demand guidance. The numbers in red and green are where it has downgraded and upgraded respectively.

source: company presentations

However, a word of caution needs to be issued here. Chinese car production and sales are both rising nicely, but note that production has outpaced car sales for the last eight months. So the likelihood is that either sales will accelerate in the future or else production growth will slow.

source:chinese association of automobile manufacturers

Interestingly, Alcoa argued the reverse could be true for North America. It stated that car manufacturers were running with 60 days inventory (the amount of cars in inventory totaled sales for 60 days) in April, but only 55 days today. This implies a pick-up in production is due provided sales growth holds up.

Alcoa's other segmentsThe second area of industrial strength in 2013 has been aerospace, and the long-term fundamentals on the eight year production backlog at Boeing and Airbus-look solid. Alcoa kept its outlook unchanged and referenced industry demand for newer, more fuel efficient airplanes. All of this is good news for General Electric (NYSE: GE  ) , because its second most profitable industrial segment is aviation.

But there was some less positive news for GE with Alcoa's industrial gas turbine outlook. The market was described as weakening, even though the forecast was kept constant. This is due to Alcoa's strength in supplying aluminum for spare part demand, but it implies a tougher outlook for GE, because its focus is on supplying the turbines.

Elsewhere, there was some good news for a company like Cummins (NYSE: CMI  ) that sells into the heavy truck market. Alcoa raised forecasts for Europe and China, with the main catalyst being the implementation of tighter emission standards in the respective regions. This outlook mirrors Cummins' raising of its full year sales guidance to five percent from flat previously. In fact, last time around, Cummins reported a 35% increase in the medium and heavy truck market in China. 

Another company that can take heart from this report is industrial machine vision company Cognex (NASDAQ: CGNX  ) . Cognex currently generates 78% from its factory automation segment. China is very important to Cognex, because as global manufacturing shifts eastwards, it will need to open up new markets in the Far East. At present, Chinese sales only contributes around 15% of Cognex's factory automation sales, but they grew 41% in the last quarter. In other words, good industrial conditions in China are very important to Cognex's growth.

Where next?Alcoa's report indicated a strengthening Chinese economy, but this needs to be put in the context of the industry sectors that Alcoa is selling into. Aerospace and automotive are doing fine, while conditions are better in the heavy truck market; but this doesn't mean that overall growth in the global economy is strengthening. The key conclusion that investors should take away from this report is to stick with the industrial sectors that are working.