Tuesday, January 10, 2006

Alcoa (AA) sets Hurdles Low

Alcoa (AA) is the first large company to report in every earnings season, and as a Dow component, it tends to be viewed with some importance.

It’s not that many years ago that aluminum was considered a growth industry with high potential for broad applications for the light metal. The substitution possibilities seemed endless, and the use of aluminum in aerospace as well as potential automotive applications seemed to only increase. As time went by, aluminum became just another cyclical metal where international demand, particularly from places like China, recently indicated higher prices.

Aluminum stocks have responded recently to strength in basic materials in general and AA which had flat-lined for most of last year had moved up smartly since last October.

The earnings, which are just out disappointed the street, and deserve some comment.

I see this morning that “Random Stock Market Thoughts” expresses his/her frustration with the management. Who can argue?

Having listened to the conference call, management continues to blame its shortfall on one-time items. Three non-one time problems:

  1. Upstream cost pressures- Higher energy and raw materials costs

  2. Downstream margin pressures- Inability to pass through costs

  3. Disingenuous treatment of shareholders-More on this later.

Operating margins have declined in 4 of 6 segments YOY with primary metals the only positive exception courtesy of improving aluminum prices. In other words, management succeeded only through extraneous factors, and NOTHING of their own doing. The wind happened to be a tailwind, thereby propelling them!

In an aerospace environment that seems to be strong, with revenues up 16% and shipments up 10% margins fell to 3.5% versus 3.9% a year ago and 4.7% last quarter. Engineered solutions, which provides a lot of fasteners and castings for the aerospace industry, showed similar trends: revenues were up 10% YOY but margins were unch at 3.5%, though improved from last quarter’s 2.6%. I don’t get it, and apparently, neither do they.

My view of management perhaps being disingenuous with us comes from a comment in the conference call ballyhooing the improvement in return on capital for the fourth consecutive year. Absolutely true statement with return on capital in the last four years as follows:
8.3% (2005), 7.4% (2004), 5.4% (2003), 5.2% (2002).

Let’s have a look at the years prior to this:
8.7% (2001), 9.1% (2000), 11.7% (1999), 9.5% (1998)

Further evidence of management’s “head in sand “ attitude, at least in my humble opinion was another comment about this year’s ROIC of 8.3%. They commented that return on capital would have been 9.5% “when growth projects such as Iceland and Russia are excluded.” This is a little like an insurance company telling you that other than the hurricane or the earthquake, we’re doing fine. I can empathize with certain non-recurring events affecting a business…for an insurance business, hurricanes happen…that’s what you are in business for. The fact that management chose to develop projects to grow the business that will reduce ROIC initially is their choice, but should not be viewed as an excuse for where we measure the returns on capital.

It seems to me that for a business which is enjoying the highest aluminum prices in 17 years and with their views that “inflation is under control” that returns on this cyclical business should be higher.

If management is happy with their returns, they are playing what a friend of mine calls Mouse Olympics…the hurdles are really low.


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