Alcoa's Most Troubled Segment Shows Signs of Life

Lately, Alcoa (NYSE: AA  ) has been extremely focused on its shift toward value-add products. The company's $2.85 billion acquisition of Firth Rixson, which bolstered its strongest aerospace segment, was the latest move on this front. In addition, Alcoa tries to convince the world that the future of auto production belongs to aluminum, threatening the likes of steelmakers like AK Steel (NYSE: AKS  ) , which relies heavily on auto demand. Alcoa's second-quarter earnings blew past analysts' estimates, and its value-add segment was the biggest contributor to this success. With all buzz on roaring aerospace demand and prospective aluminum autos, it's easy to overlook that the company's primary metals segment is back on track.

Volume sacrifices bring results
This year, the primary metals segment won't be the biggest revenue driver anymore, freeing up space for the global rolled products segment. Alcoa was active in curtailing and closing smelting capacity, and the results of this process are obvious. Aluminum production declined more than 11% in just a year, and they will decline further given the announced closure of the Point Henry smelter in Australia.

This strategy has finally brought positive results, and the segment brought $91 million of after-tax operating income in the second quarter. Going forward, one could expect further cost improvements as the Saudi Arabia joint venture smelter becomes fully operational. This smelter will be among the lowest-cost operations because of its access to cheap natural gas. Thus, the company could count on the continuing profitability of this segment if the pricing situation does not deteriorate.

High premiums signal demand is robust
The price chart of aluminum on London Metal Exchange tells a sad story despite the recent rebound. However, the world of physical buyers is different. If you want physical delivery of aluminum, you must pay a premium. These premiums have been soaring since the beginning of the year, benefiting Alcoa and its fellow aluminum producer Rio Tinto (NYSE: RIO  ) . Unlike Alcoa, Rio Tinto is not that active in aluminum production cuts. Rio Tinto's first-quarter aluminum production was down 2% sequentially and flat in comparison with the first quarter of 2013.

Premiums reached $430 per ton in the Midwestern U.S. at the end of the second quarter. The rise of premiums clearly signals improvements on the physical demand front. Alcoa estimates that there will be deficit of aluminum this year, while the aluminum market remains in surplus, although this surplus is shrinking.

In the long run, closures and curtailments will play their role and boost aluminum prices. However, Alcoa is already positioned to extract value from its primary metals segment. One can expect more improvements on this front given Alcoa's successful track record so far. The company announced an annual target of $850 million improvements in productivity, and it has already captured $556 million of them.

Bottom line
Alcoa's robust performance in the primary metals segment shows that not only value-add businesses could deliver profits. However, the role of Alcoa's value-add segment will increase over time as the company captures revenue from the newly acquired Firth Rixson. Still, the aluminum business is an important thing to watch in the coming years, as it will remain a big source of revenue for Alcoa. 

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