REPEAT Rudi’s View: The Real Alcoa Result

This story features RIO TINTO LIMITED, and other companies. For more info SHARE ANALYSIS: RIO

(This story was originally published on Wednesday, 13th July, 2011. It has now been re-published to make it available to non-paying members at FNArena and to readers elsewhere).

By Rudi Filapek-Vandyck

Don't get bogged down too much about whether investors failed to appreciate a doubling in quarterly profits at Alcoa or whether it was merely a case of Alcoa's EPS for the second quarter narrowly missing already lowered expectations? The real take-away from yesterday's traditional opener of the US reporting season is all about stagnating margins and rising costs, with a general feeling among analysts both might move in negative directions this quarter.

Which brings us back to one of the central themes in my investor presentations since the start of this year: there comes a time that the pain from "everything up in price" does no longer remain limited to non-resources segments of the global economy. Alcoa's Q2 report proved exactly that: rising costs for energy producers and miners are becoming a prominent feature.

Traditionally, this is a time when earnings forecasts for these companies come under pressure because securities analysts, as was the case with Alcoa, tend to underestimate exactly what goes on with costs and delays. Resources analysts have daily spot prices to take guidance from and combined with regular production updates they have some concrete indicators to work with, but gauging what's going on with a company's cost level is something completely different. The real story from Alcoa's Q2 result is thus: rising costs. Which subsequently has translated into Wall Street analysts lowering their projections.

In Australia the dynamic is a little bit different as there is arguably more pressure from the workforce (note: strikes in all five coal mines operated by BHP and Mitsibishi) and the strong currency adds some more to the overall costs pressures as well. There were some weather related events earlier in the year and these still are expected to have as yet unknown impact on production volumes and costs. Then there is the impact from carbon pricing.

Despite all the media attention, and the noise generated by a fierce and loud opposition, fact remains the immediate impact in the next two years is going to be, uhhhm, benign.

I know, for those who live in Queensland, Western Australia or South Australia and feel a natural affection towards miners and gas producers, the previous sentence must look like a curse in the church, but I am only reporting what analysts at major stockbrokerages in the country (also major forces in the overall noise) print in their research reports.

To stick with the opening theme of today: in Alumina Ltd's ((AWC)) case, Alcoa's 40% AWAC partner in Australia, the Net Present Value (NPV) which is the most preferred manner to calculate the intrinsic valuation of a mining company, lost around 3% of its value this week. To put this in perspective: rising costs and downward pressure on margins as revealed by this week's second quarter report from Alcoa has triggered cuts to profit forecasts in double digits.

Under "normal" circumstances, such cuts to forecasts would have wiped off quite a lot off the Alumina Ltd share price. This time the share price actually went up. Note the Alumina Ltd share price is trading no less than 18% below consensus target.

All of the above pretty much sums up the situation for most energy companies and miners in Australia. Costs are on the rise and combined with ongoing strength for the Aussie dollar this means that most of the rises in product prices do no longer translate in rises to the bottom line. Detailed research done in the past by analysts at Citi has revealed that, on average, about 50% of price rises do not end up as profits for producers. This time around, however, there's the complicating matter that prices for many materials are down for the quarter.

Losses for most base metals are rather small, but this means that any spike in costs will have a big impact on profit margins and that increased sales are needed to book further progress in earnings per share terms. Enter nickel producers. Nickel experienced by far the weakest quarter, with prices down by around 11%. Not difficult to see why the market will be expecting the worst from nickel producers this month and next. Note: Minara Resources ((MRE)) effectively issued a profit warning today, which, after you read the above, probably doesn't surprise.

I have a suspicion Alcoa's report was also responsible for Rio Tinto's ((RIO)) share price underperforming today. Rio Tinto, as I am sure most of you will remember, is a major producer of aluminium and alumina through the acquired Alcan assets.

Investors should not automatically assume producers of bulk materials will be better off than peers in metals and energy with UBS analysts reporting this morning "dewatering" activities have continued well into April at various pits and mines. The key question then becomes how much impact this has had on sales and production volumes; and what about costs?

Uranium producer Energy Resources of Australia ((ERA)) has resumed production and management issued a (positive) profit guidance today, but then ERA is a bit of a standout in that market expectations were probably as low as they can get after some horrendous adventures in the Northern Territory.

Investors should also note the outlook for alumina producers such as Alcoa, Alumina Ltd and Rio Tinto remains much brighter than for many other base materials as the sector is still transitioning from legacy contracts to a spot price based system. Most of these benefits will be felt in a few years, not in the months ahead. This then leads to the rather awkward path in profit growth projections for Alumina Ltd. Awkward because for companies such as Rio Tinto and BHP Billiton ((BHP)) the pace of profit increases peaked last year and profit growth projections are falling from 112% to 79% to 20% as each year follows the previous one.

For Alumina Ltd, however, the best is yet to come, or so it seems and it has all to do with changes in the pricing of alumina. As an interesting twist: the shares are currently yielding 6% (FY12) on some stockbrokers projections and dividend payments are anticipated to make some big jumps in the years ahead. Never thought this would happen, but life sometimes can be much stranger than imagination. If present projections by securities analysts prove close to reality, Alumina Ltd is going to beat most dividend yielding stocks on their own territory in the years ahead, plus the incremental growth rate should ensure an appreciating share price is pretty much a given.

The heightened volatility (at times extreme) that comes with stocks such as Alumina Ltd is simply something investors will have to get adjusted to. Note that on consensus forecasts the prospective dividend yield for Alumina Ltd shares is "only" 4.9% next year (as opposed to the earlier mentioned 6%). As is typical when dealing with mining companies such as Alumina Ltd, forecasts for the years ahead are very wide and varied and likely subjected to a lot of changes in the foreseeable future.

Rio Tinto is expected to announce some capital management initiatives in August, which should be positively received, if accurate.

(Do note that, in line with all my analyses, appearances and presentations, all of the above names and calculations are provided for educational purposes only. Investors should always consult with their licensed investment advisor first, before making any decisions.)  

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P.S. II – If you are reading this story through a third party distribution channel and you cannot see charts included, we apologise, but technical limitations are to blame.

 

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