Why You Should Not Bet On This Stock’s Q2 Earnings

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This season’s earnings results have impressed so far, with a majority of the companies meeting or beating analyst expectations. For some, it has been a major surprise to the investment community, while for others things came as expected. One of the main surprises came from Alcoa (NYSE: AA), the company that kicked of the second quarter earnings season after beating analyst expectation.

Many expected Alcoa to miss expectations in the most recent quarter, following its struggle to report meaningful margins from its aluminum production unit. The unit accounts for about 36% of Alcoa’s revenues, making it critical to the company’s performance. Over the recent past, Alcoa has been trying to reduce its dependence on aluminum production by cutting down its smelting capacity.

Alcoa is one of the companies involved in the production and distribution of primary molten aluminum, and faces stiff competition from China’s Aluminum corporation of China (NYSE: ACH).  Century Aluminum (NASDAQ: CENX)is also another competitor in the industry, but trails the big two. All three of these companies have been struggling against declining aluminum prices over the last two years, falling from about $1.25 per pound to about $0.80/lb, which is about a 36% decline.

“Positive” results?

Alcoa reported $5.8 billion in revenues from the most recent quarter against falling aluminum prices, as sales volumes improved massively year-over-year. The company’s realizable aluminum prices fell by $161/ton, triggered by a net cash price decline of 8% at the London Metal Exchange (LME). According to the company’s CFO, William Oplinger, the 2% decline in revenues and 4% decline in realizable aluminum prices was a subject of lower LME and improved productivity across other business units. The company posted a net loss of $119 million compared to a loss of $2 million reported the same period last year. In Q1, 2013, Alcoa reported a net profit of $149 million.

Reliance on aluminum must be trimmed

Alcoa is facing serious problems wrapped around its business model. These problems won’t be solved by reporting massive sales, or what others might refer to as overproduction. If anything, massive production will only continue to put aluminum prices down, which could result in margins declining to unmanageable levels. Nonetheless, Alcoa understands this very well, and is instead looking to cut down on its smelting business.

The company’s aluminum production unit is squeezing gains reported from other business units, which also include the production of aluminum-related products. Nonetheless, the future looks bright with massive Dreamliner preorders reported by Boeing, which presumably means increased demand for aluminum. However, the deliveries of the planes are expected to take place in batches, which means the real growth rates in demand over the short-term are likely to be minimal.

Competition

Aluminum Corporation of China engages in the manufacture and distribution of alumina, primary aluminum, and aluminum fabrication products in the People’s Republic of China, as well as internationally. Just like Alcoa, ACH’s business depends on aluminum prices.

More than 50% of the $4.53 billion cap company’s revenue comes from primary aluminum sales, which puts it at a much higher risk than Alcoa. Other products related to aluminum account for about 45%.

In the most recent quarter, the company’s revenues grew by 2%. The company is still unprofitable as it struggled to shake off the effects of declining aluminum prices. Its operating loss stands at 3%. However, with China accounting for about 46% of global aluminum demand, the company stands a chance to ride on the country’s massive population and economic growth rates.

On the other hand, Century Aluminum's revenues from the most recent quarter fell by about 1.5%. Just like its rivals, it continues its loss-making streak. Nearly the whole of Century Aluminum’s revenue comes from the sale of molten primary aluminum products.

The company also engages in the production of carbon anodes, which contributes insignificantly to the overall revenue. The decline in aluminum prices has affected the company’s margin, standing at just 3% compared to Alcoa’s 15%. Its operating loss of 1% means that the company is unable to sustain its operations without external funding.

The Chicago, IL-based aluminum production company’s stock has large insider ownership, standing at 42%. Its most recent quarter revenues declined by 2%--a statistic similar to the one reported by Alcoa.

The bottom line

While Alcoa remains impressive compared to its competition, the macroeconomic threat of declining aluminum prices spares no one. Nonetheless, if the company continues cutting down its level of exposure from the current 36%, then this threat could come down to tolerable levels.

Additionally, the Alcoa can also rely on a probable increase in demand following the current trends in the aerospace industry. These metrics give a more reliable assessment of the company’s future than betting on “positive” results, which came about just because it beat analyst estimates.

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Nicholas Kitonyi has no position in any stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. Is this post wrong? Click here. Think you can do better? Join us and write your own!

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