Alcoa Debt Rating Lowered

S&P says the move reflects the company's plan to increase its holdings in Elkem ASA

On Oct. 3, 2002, Standard & Poor's lowered its long-term ratings on Alcoa (AA ) and affirmed its short-term ratings on the company. The company's corporate credit rating was lowered to 'A' from 'A+'. The rating action reflected reassessment of the company's financial policy in light of its recent announcements that it is increasing its holdings in Elkem ASA. The downgrade also reflects the likelihood that Alcoa's credit protection measures will not meet acceptable parameters for the former rating given the expectation of continued weakness in the economy and the decline in aluminum prices.

Alcoa's credit quality reflects its excellent business position as the largest integrated aluminum producer in the world, with broad product, business, and geographic diversity and efficient operations. The ratings also reflect its acquisitive growth strategy, the cyclicality of its end markets, low aluminum prices, and somewhat aggressive debt levels for the rating. In recent years, the company has pursued an ambitious growth strategy by pursuing internal expansion as well as strategic acquisitions with emphasis on upstream and downstream businesses.

Recently, Alcoa completed its $790 million acquisition of Ivex Packaging Corp. and announced the acquisition of Fairchild Fasteners from Fairchild Corp. for $657 million. Various strategic initiatives are also enhancing the company's ability to capitalize on expected growth in demand and supply for aluminum in the transportation and packaging markets of Europe and Asia.

Standard & Poor's views Alcoa's efforts to diversify from its dominant position in the volatile alumina and primary aluminum businesses favorably. However, Standard & Poor's recognizes that the Cordant and Fairchild acquisitions increase the company's exposure to the difficult conditions existing in the aerospace industry. Near-to medium-term prospects for the aerospace industry as well as Alcoa's other end markets are expected to remain weak.

Nevertheless, Alcoa continues to focus on managing through difficult business conditions by focusing on cost improvement. Following the completion of $1.1 billion annual run rate cost reduction program at the end of 2000, Alcoa announced another $1 billion cost improvement program to be completed by the end of 2003. As of June 30, 2002, Alcoa has reduced costs by approximately $500 million under the current program.

Owing to stock repurchases, dividends and bolt-on acquisitions, reported debt levels (not adjusted for operating leases) at June 30, 2002, have increased to $7.3 billion from $6.6 billion at the end of last year. Pro forma for the Ivex and Fairchild acquisitions, total debt will reach an all-time high of $8.7 billion. Although Alcoa is committed to achieving and maintaining a total debt to capital ratio between 25% and 35%, the company's pro forma total debt to total capital is a fairly aggressive 42%.

Following the Fairchild acquisition announcement, Standard & Poor's stipulated that Alcoa take tangible steps to reduce debt levels and improve credit measures before considering further acquisitions or other expansionary actions that would have an unfavorable impact on credit quality; notably, reducing debt to under $8 billion at year end through cash flow and asset sales and achieving a still weak funds from operations to total debt ratio of mid-40% during 2003.

However, without additional asset sales, the decline in aluminum prices, continued weakness in end markets and the albeit nominal $150 million to purchase Elkem shares, rendered it highly unlikely Alcoa will achieve these targets or maintain a financial policy commensurate with the former rating.

Despite the expectation for weak near-term financial performance, Standard & Poor's expects Alcoa will continue to focus on debt reduction and improve financial performance over the longer term. For the rating, Alcoa will be expected to generate a funds from operations to total debt ratio of 50% over a normal business cycle. Of note, this ratio for 2002 is expected to be subpar at slightly below 30%. Nevertheless, improved financial performance could be delayed and tempered by the timing and size of future acquisitions, the company's Iceland smelter project, or economic conditions. Standard & Poor's does, however, expect Alcoa will use equity for meaningful acquisitions. Also, debt reduction initiatives will be aided by management's decision to defer its share repurchase program.

Alcoa's liquidity remains strong with $4 billion of undrawn committed bank facilities and a $1 billion ECN program supporting its commercial paper program. Alcoa's bank facilities consist of a 364-day $2 billion maturing April 2003; a $1 billion revolving credit facility maturing in April 2005 and; a $1 billion facility maturing in August 2003. Alcoa has no rating triggers or concerns of covenant violations. Alcoa had cash and short term investments totaling $451 million as of June 30, 2002.

Despite difficult market conditions, Alcoa has consistently demonstrated the ability to generate strong cash flow, averaging $2.8 billion in cash from operations over the last three years. Indeed, Standard & Poor's expects Alcoa to generate approximately $1 billion of free operating cash flow during a difficult 2002 aluminum price environment. Alcoa's availability under bank lines, ability to sell assets, good access to capital markets and strong cash flow generation, provide the company with sufficient resources to meet debt maturities of $563 million in 2004 and approximately $750 million (net of commercial paper amounts) in 2005.

Despite Alcoa's expansion strategy and the likelihood near-term financial parameters are expected to remain weak, Standard & Poor's expects Alcoa to maintain a prudent financial policy and financial profile indicative of its rating.

From Standard & Poor's Credit Wire

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