Alcoa will report its second quarter results and conduct a conference call with analysts on July 8. We expect the company’s increasing emphasis on its high-margin value-added products to positively affect its results, and to offset the impact of lower aluminum prices as compared to the year ago period.

Aluminum prices on the London Metal Exchange, which fluctuated around an average value of $1,850 per ton in Q2 2013, averaged $1,800 per ton in Q2 2014. Though Alcoa’s products are sold at premiums over LME prices, lower LME prices this quarter as compared to Q2 2013 may negatively impact the company’s upstream businesses.

The company has steadily shifted its product portfolio towards value-added products, in order to reduce its dependence on aluminum prices. The company’s value-added products enjoy pricing premiums and higher margins as compared to its upstream businesses. The benefit of such a strategy is likely to be reflected in its results.

See our complete analysis for Alcoa

Aluminum Pricing

Aluminum has diverse applications in industry. It is an important input in the packaging, aerospace, automotive, construction, commercial transportation, power generation, capital goods and consumer durables industries. Thus, demand for aluminum is broadly correlated with industrial growth. The European debt crisis and slowing Chinese growth have contributed to the decline in aluminum demand, and consequently prices over the last few quarters.

On the supply side, production capacity has not been reduced corresponding to the fall in demand. Persistently high aluminum inventory levels relative to demand are keeping LME aluminum prices depressed. This inventory has been built up partially as a result of aluminum being tied up in financing deals, which were made possible due to low interest rates. Despite inventories being at a record high, market forces have failed to rationalize supply through the shutdown of smelting capacity. Though global aluminum majors like Alcoa and Rusal have announced smelting capacity cuts, the same cannot be said of the Chinese companies. This is primarily due to state intervention in the form of provision of subsidies or renegotiated power contracts to smelters, which serve as a disincentive to cut production. China accounts for around 43% of the world’s aluminum production and the expansion in production by Chinese producers has more than made up for capacity cuts by global majors. Thus, this oversupply situation is set to continue and is likely to keep prices depressed.

Alcoa’s Portfolio Transformation

Alcoa’s upstream businesses are comprised of the Alumina segment, which mines bauxite and refines it to alumina, the precursor to aluminium, and the Primary Metals segment, which smelts alumina to aluminium. The value-added business segments are the Global Rolled Products division and the Engineered Products and Solutions divisions. The GRP segment is mainly involved in the production and sale of aluminum plate, sheet and specialty foil. This segment’s products are sold to customers in packaging and consumer goods, aerospace, automotive, brazing, building and construction industries. The EPS segment’s products include titanium, aluminum and superalloy investment castings, fasteners, aluminum wheels, integrated aluminum structural systems, architectural extrusions, forgings and hard alloy extrusions. These products are sold to customers in the aerospace, automotive, building and construction, commercial transportation and power generation industries. The fortunes of the upstream segment are to a large extent dependent on aluminum prices. To decouple itself from its dependence on aluminum prices, the company has shifted its focus towards value-added products.

Alcoa’s shift towards value-added products is reflected in its revenue figures. The percentage contribution of the GRP and the EPS segments sales to the total revenues has steadily increased. This figure stood at 52.1%, 54.4%, 55.7% and 57.2% at the end of 2011, 2012, 2013 and Q1 2014, respectively. In calculating these figures, we have only considered third-party sales. The company’s value-added products accounted for 76% of its total segment after-tax operating income in Q1 2014.

Recent Developments

Alcoa has bet big on the aerospace segment, in keeping with its revised growth forecast for the segment from 8 to 9% during the Q1 2014 conference call. In Q2 2014 alone, several major developments in the aerospace segment have taken place for Alcoa. It recently announced the $2.85 billion acquisition of jet engine components manufacturer Firth Rixson. It recently announced the $25 million expansion of the Alcoa Power and Propulsion facility, located in Hampton, Virginia. The company had earlier announced the setting up of a $100 million facility in La Porte, Indiana for the production of nickel-based superalloy jet engine parts. Alcoa also signed a long-term agreement worth $290 million to supply aluminum sheet to Spirit AeroSystems over five years. Spirit is one of the largest designers and manufacturers of aerostructures for commercial, military, business and regional jets in the world.

Alcoa’s aerospace revenue of $4 billion in 2013, accounted for around 17% of its total revenue for the year. With several recent developments in the aerospace segment, its share of the company’s revenue is set to grow.

Expectations from the Earnings Call

In view of the company’s aerospace push, we would like to know from the company management, what the flurry of activity in the aerospace segment would translate into in terms of revenue from value-added products. Going forward, the impact of these value-added products on margins would also be of interest to us. It would help us understand how far the company is able to insulate itself from the subdued aluminum pricing environment.