Alcoa Inc. (AA)

Second Quarter 2008 Earnings Call Transcript
July 8, 2008 5:00 PM, ET

Executives
Greg Aschman - Director of Investor Relations
Charles D. McLane - Chief Financial Officer
Klaus Kleinfeld - President and Chief Executive Officer
William F. Christopher - Executive Vice President; Group President - Engineered Products and Solutions

Analysts
Michael Gambardella - J.P. Morgan
John Hill - Citigroup
Oscar Cabrera - Goldman Sachs
Anthony Rizzuto - Dahlman Rose & Co.
Mark Lanoma - Analyst
Charles Bradford - Bradford Research
John Redstone - Desjardins Securities
John Tamozli - Analyst
Joe Thorton - Analyst
Brian Macarthur - UBS
Leo Larkin – S&P Equity

Presentation

Operator
Good day, ladies and gentlemen and welcome to the Q2 2008 Alcoa earnings conference call. My name is Kim and I’ll be your coordinator for today. At this time all participants are in listen-only mode. We will be facilitating a question-and-answer session towards the end of today’s conference. If at any time during the call you require assistance please press * followed by 0 and a coordinator will be happy to assist you. I would now like to turn the presentation over to your host for today''s conference, Mr. Greg Aschman, Director of Investor Relations. Please proceed, sir.

Greg Aschman
Thanks, Kim. Good afternoon, everyone. Thank you for attending Alcoa''s second quarter 2008 analyst conference. On today''s conference: Chuck McLane, Executive Vice President and Chief Financial Officer, will review the second quarter financial results; Klaus Kleinfeld, President and Chief Executive Officer, will highlight current market conditions, industry fundamentals and review Alcoa''s strategic priorities. Bill Christopher, Executive Vice President and President of Alcoa''s engineered products and solutions business, will provide an overview of his business, including performance improvements and growth potential. Before I turn it over to Chuck, I would like to remind you that in discussing the company''s performance today, we''ve included some forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995. Such statements relate to future events and expectations and involve known and unknown risks and uncertainties. Alcoa''s actual results or actions may differ materially from those projected in the forward-looking statements. For a summary of the specific risk factors that could cause results to differ materially from those expressed in the forward-looking statements, please refer to Alcoa''s Form 10-K for the year ended December 31, 2007, or Form 10-Q for the quarter ended March 31, 2008 filed with the Securities and Exchange Commission.

In our discussion today we have also included some non-GAAP financial measures. You can find our presentation of the most directly comparable GAAP financial measures calculated in accordance with generally accepted accounting principles and our related reconciliation on our website at www.alcoa.com, under the invest section. At this point, let me turn it over to Chuck.

Charles D. McLane
Okay, thanks, Greg. Before I move on to the financials, let me first give you a brief synopsis of industry fundamentals. Aluminum prices have continued to show strength and those higher prices are supported by a host of factors. First, global supply and demand is essentially balanced, even though North America and Europe are experiencing significant weakness in specific end markets, global consumption remains robust. Secondly, energy costs and input prices have continued to escalate for the industry as a whole. In fact, as you know, energy supply constraints have caused smelter curtailments as well as postponements to greenfield-expansions, and lastly, global mega-trends will continue to increase the per capita consumption of aluminum, as well as provide a catalyst for material substitution. With that as a backdrop, let''s dive into the financial results.

Earnings for the quarter were $546 million or $0.66 per share, an 80% increase sequentially. All segments contributed to revenue and earnings growth and each segment had double-digit percent increases to profitability. Our Iceland smelter is complete. It''s running at full capacity and will reach mature profitability levels over the next couple of quarters. Russia is showing productivity improvements and our engineered products and solutions segment achieved record revenue and profitability results. Cash from operations generated $1 billion in the quarter, as we achieved significant reductions in ‘days working capital.’ We continue to operate within our target debt-to-cap range and our Bloomberg ROC stands at 12.1% excluding the growth projects.

Now let''s move to the income statement. Excluding the packaging divestiture, revenue increased to 11% on higher prices and volumes, and total segment ATOI increased 27%. Other income showed a significant improvement sequentially, yet most of the improvement is offset by items in the revenue and cost of goods sold categories. An example of that is currency translation. Currency translation was a favorable net income impact of $49 million in other income, yet this is essentially offset in cost of goods sold by a negative economic currency impact. For taxes, the operating tax rate for the year is now projected to be 28.6%. Lastly, the combination of higher prices and volumes led to a significant 80% rise in net income.

Turning next to our sequential bridge, improvements in volume, pricing and productivity more than offset input cost increases, as well as the energy disruptions in Australia and Rockdale. Higher LME prices improved results by $238 million and includes the impact of both alumina and primary pricing. Higher raw material and energy costs reduced profits by $107 million. Caustic, carbon, natural gas, fuel oil and transportation costs continue to climb. In addition, we had two significant events in the quarter, which exacerbated these results. First, the gas explosion on our supplier''s pipeline in Western Australia caused an immediate reduction in our production capacity, as well as requiring us to buy alternative fuels at a much higher cost than the natural gas it displaced. Meanwhile, unreliable electricity supply at our Rockdale smelter forced us to purchase power at market rates frequently during the six-week period. The combination of these two reduced profitability by $39 million in the quarter. We like others, have been communicating the rise of energy and raw material costs. Let me take a minute and review some of the specific price changes the industry is experiencing.

We would like to make four major points to this slide: the composition of our costs, the magnitude of the increases, our relative cost position, and actions we are taking. First, the composition of the cost, as a reminder to you, caustic, energy and bauxite account for approximately 65% of our refining costs, while alumina energy and carbon account for approximately 70% of our smelting costs. Next, we''d like to point out the sheer magnitude of the increases. From the first half of last year to the first half of this year, these costs have increased between 35% to over 80%. In addition, the U.S. dollar declined versus a market basket of the A dollar, the Riyal, the C dollar, and the Euro by approximately 15%. So, the third point’s our relative cost position. Although external benchmark data has not yet been published for 2007, our own research indicates that the industry cost curves for both refining and smelting have seen double-digit increases in both 2007 and 2006. Through brownfield expansions and operational improvements, we see our position on the refining cost curve improving by approximately eight points, from 38 to 30 over the last two years while we maintained our midpoint status on the smelting cost curve. Lastly, what are we doing to combat these significant increases? We expect both of these cost positions to improve as expansions in São Luís and Iceland are fully reflected in our performance in 2008 and 2009.

We are also continuing to analyze the total cost of ownership for every one of our strategic raw materials. Examples include joint ventures, backward integration, specification optimization, and technology improvements to name a few, and as Klaus will reiterate later, one of our three strategic priorities is disciplined execution. We anticipate significant savings as we identify best practices, both internally and externally. Let''s now move to the individual segment results, starting with alumina. Production for the quarter decreased 50,000 tons, primarily as a result of the unexpected gas outage in Western Australia. ATOI in the alumina segment increased $21 million sequentially. The positive effect of higher prices was reduced by increased costs of caustic, natural gas and fuel oil, as well as a continued deterioration of the U.S. dollar to the A dollar. The impact of currency alone reduced profits by $17 million sequentially in this segment. The incremental costs in the quarter arising from the disruption to our gas supply in Western Australia cost the company approximately $17 million in net income.

We are working with our insurers to determine the recoverable amounts for the increased costs and lost revenues and we will net these reimbursements against any cost in future periods. As we look to the third quarter, our current estimate is a cost to Alcoa of approximately $45 million in net income. That estimate is dependant upon our gas supplier restoring partial supply midway through the third quarter. We are currently running at 100% of capacity, albeit at a higher cost base.

Now let''s move to the primary segment. Production improved 3.5% from the previous quarter as our new Iceland smelter reached its rated capacity and as I said, we are going to continue to see efficiency gains from this operation as we move through the year. ATOI increased to $121 million sequentially, driven by higher prices and volumes. The increase in the realized price in the quarter was $257 per ton, whereas the LME price on a 15-day lag increased $237 per ton. As you can see, we were essentially in line with the 15-day lag, which is where we stood at the end of the first quarter. Offsets to the higher pricing and volume were increased costs for energy, carbon and alumina. The impact of the weaker dollar reduced profits by $18 million on a sequential basis.

In June, we announced the curtailment of 120,000 tons of annual production in Rockdale. This was driven by an increasingly unreliable power supply that created financial and operational hardships to a point where we could not justify continuing full operation. The financial effect in the quarter of higher power costs, employee costs and lost production was $22 million. We intend to bring this production back online when we are confident that the power supply has been resolved and sustainable. If this outage continues through the third quarter, we estimate the effect to be approximately $22 million. Moving next to the flat rolled product segment, the flat rolled product segment experienced a 3% reduction in overall shipments. North American industrial products are extremely weak in advance of entering their normally weak third quarter. In fact, North America''s sheet and plate shipment levels through May were at their lowest point in this decade. In Europe, the latest data shows that new orders for sheet and plate products are down 10% compared to 2007. However, sequentially profits improved $14 million. Improved Russian results and productivity gains in North America and Europe helped to offset a negative volume impact of $21 million.

Looking ahead to the third quarter, we would expect a seasonal slowdown between European industrial holidays and North American automotive shutdowns. The effect of this typical seasonal effect is evident in the FRP segment results over the last two years, where on average the third quarter ATOI levels were approximately 35% lower than the prior quarter. Now let''s move to the engineered products and solutions segment. EPS continued its outstanding performance by once again posting all-time record revenues and ATOI results, this segment more than offset softness in the North American automotive market with market strength in aerospace, industrial gas turbine, commercial transportation and commercial building and construction. This combination led to a record revenue of $1.9 billion for the quarter. Additionally, productivity improvements in the aerospace and forgings business enabled the record ATOI performance of $157 million. To put in perspective, this quarterly performance would place this segment’s return on capital in excess of 13% on an annualized basis. Looking ahead to the third quarter, we would expect a seasonal slowdown between European industrial holidays and the North American automotive shut down.

The effect of this typical pattern is evident in EPS results for the last two years, where on average the third quarter ATOI levels were approximately 25% to 30% lower than the prior quarter. Now let''s move to the cash flow statement. Cash from operations was a $1 billion, driven by higher profits and improved working capital. Significant improvement was achieved in our ‘days working capital’ outstanding. On a year-over-year basis, ‘days working capital’ improved 6.4 days and on a sequential basis, the improvement was 5.7 days. Capital expenditures stand at $1.5 billion on a year-to-date basis and we are expecting to total approximately $3.6 billion for the year. Cash received from minority partners would take the net CapEx down to $3 billion. Growth capital represents 52% of the capital expenditures in the period and nearly 60% of the gross spend is invested in two projects; the São Luís refinery expansion and Juruti bauxite mine. Debt-to-cap stands at 30.6%, which is very positive given the spending on CapEx and shares repurchased through the first half of the year.

Let''s move to the next slide and summarize the share repurchases. We continued to repurchase shares in the quarter. On a year-to-date basis, we repurchased 18.3 million shares at an average price of $32.97. Total repurchases stand at 10% against our board-authorized level of up to 25%.