Commodities

Liam Denning is a Bloomberg Gadfly columnist covering energy, mining and commodities. He previously was the editor of the Wall Street Journal's "Heard on the Street" column. Before that, he wrote for the Financial Times' Lex column. He has also worked as an investment banker and consultant.

Alcoa's results sure put the gap in GAAP.

The company's latest set, released late Monday, was no exception: Net income was $16 million in the first quarter or, excluding special items, $108 million. Just how special those adjustments are at this point is debatable. Since the start of 2014, Alcoa's cumulative net profit under generally accepted accounting principles amounts to all of $73 million, according to data compiled by Bloomberg. The pre-specials number? $1.95 billion.

That Special Something
Alcoa's cumulative net income available to common equity
Source: Bloomberg

The fact that the shares trade lower today than they did at the end of 2013 suggests the GAAP measure has had a little more influence. 

Unconvinced
Alcoa investors have been focusing more on GAAP figures than the company's adjusted ones
Source: Bloomberg

Lately, the picture has become even murkier because Alcoa intends to split into two. This is a sensible step but also means investors now require guidance on two different proto-companies, each made up of several distinct operations.

And Monday's numbers didn't help on that score.

Alcoa's split has always had a Jekyll-and-Hyde quality to it. The legacy business, which will retain the name, contains all the upstream operations of mining, smelting and refining metal. This is not a good business to be in, chiefly because it competes with Chinese producers that seem hellbent on covering the world with foil, profitability be damned. Revenue from sales to third parties in this business fell by almost a third in the first quarter compared with figures in the period a year earlier.

The other business, called Arconic but previously dubbed "Value-Add Co.," turns aluminum and other lightweight metals into useful engineered products such as turbine blades. This is a good business to be in. Unfortunately, Monday's updated guidance suggested it is not quite as good as was previously thought. 

Arconic's results were not terrible. Revenue was down slightly, but Ebitda (adjusted, of course) actually rose and, the company said, hit a record margin of 16.4 percent. The outlook took a bit of a dent, though. Revenue and margin targets were tweaked down for the Engineered Products & Solutions division, in part because of problems with the Firth Rixson business Alcoa acquired in 2014. But it also reflects a slightly weaker outlook for demand in some end markets, notably aerospace. And as fellow Gadfly David Fickling points out, even value-added metal beaters aren't immune to competition.

So, nothing earth-shattering there. But when you are trying to pull off a split like Alcoa's, it matters.

For one thing, it should bother investors in all commodity-related companies that Alcoa has cut its expectations for aluminum demand this year, mainly because of weakness in China and North America. Sure, taking 6 percent growth down to 5 percent is a mere trim. But aluminum was a terrible market even at 6 percent growth. So when one of its chief cheerleaders drops the "robust" adjective it was using to describe demand just three months ago, it is a bad sign (especially as the IMF just cut its global economic forecast -- again.)

A Growth Market
London Metal Exchange primary aluminum price
Source: Bloomberg
Note: Three-month rolling forward price

In Alcoa's case, doubts about the outlook are magnified because of the impending split. Sometime between now and the end of June, the company is expected to publish detailed financials for the separate businesses and the all-important capital structure.

Alcoa's CEO said on Monday evening that one business would raise new debt to help pay off some at the other. One probable scenario is that Arconic, the stronger business, takes the bulk of the existing debt and legacy Alcoa issues new bonds, giving the cash to Arconic to relieve its burden.

Yet if the outlook deteriorates further, this would get harder to pull off. Alcoa's net debt of $7.69 billion is 2.8 times trailing Ebitda. The current consensus estimate for free cash flow this year is about $400 million and for Ebitda it is $2.58 billion, according to data compiled by Bloomberg. That implies the ratio of net debt could rise to 2.9 times Ebitda by the end of the year. 

How this gets apportioned and, in particular, how much new debt the legacy business could take on are critical questions. Say Ebitda came in as analysts expect this year and was split roughly along the same lines as the first quarter, with Arconic accounting for 75 percent. If legacy Alcoa took on debt of 1.5 times Ebitda -- which seems about right for a commodity metals business -- it could raise about $1 billion on that basis. This would imply Arconic's net debt being about 3.4 times Ebitda -- which seems feasible but not entirely comfortable. And none of these numbers factor in $3.25 billion of existing pension obligations.

Until more details are revealed, these calculations are speculative. Indeed, this uncertainty is a big obstacle to getting excited about Alcoa's plans (the stock now trades slightly below where it was when the split was announced in September.) One thing investors do know, though: Alcoa's math just got a little bit harder.

This column does not necessarily reflect the opinion of Bloomberg LP and its owners.

To contact the author of this story:
Liam Denning in San Francisco at ldenning1@bloomberg.net

To contact the editor responsible for this story:
Daniel Niemi at dniemi1@bloomberg.net