Our Take on Alcoa's Fourth-Quarter Results

 Alcoa  generated an adjusted net loss of $0.03 per share in the fourth quarter on lower aluminum prices, but the top line held up much better than we expected. Revenue of $5.99 billion was up 6% year over year in the seasonally weak quarter even while aluminum prices ended the year on a weak note, with realized pricing falling 12% in the fourth quarter and 7% compared with the same quarter of 2010. While there are pockets of weakness, namely in Europe, aluminum consumption appears to be holding up quite well, particularly sales in Alcoa's primary metals and engineered products segment.

The company forecasts global demand growth of 7% for the metal in 2012 (including no growth expected in Europe), which represents a slowdown from last year's 10% but is still stronger than our outlook for steel and other base metals. While input cost inflation continues to be an issue, productivity improvements and cost-control measures have yielded operating margins at or above 2010 levels with the exception of the primary metals segment, with weak aluminum prices serving as the constraint.

In the last few days, Alcoa announced the permanent closure of 291,000 metric tons of U.S. capacity that has been idle since 2009 as well as curtailments of 240,000 metric tons of capacity in Europe, which will be completed in the first half of 2012. We think this is reflective of a dismal pricing outlook rather than weakening demand. With aluminum prices hovering around $2,000 per ton, much of Alcoa's smelting capacity is unprofitable on a cash cost basis. Unless the company expected aluminum prices to rebound by at least 15% in the next several months, it doesn't make economic sense in our view to keep running at current operating rates regardless of how strong demand might be.

While curtailments should help provide a price floor, we believe that aluminum prices move more closely with global economic sentiment than the supply/demand balance for aluminum tonnage. Management expects 1.8 million tons of global smelting capacity to come off line this year overall. Combined with demand growth, this should offset Alcoa's forecast for 4.5 million tons of additional supply added to the market, primarily in China. However, we think more clarity around global economic growth, particularly in Europe and China, will be the catalyst for stronger aluminum pricing in 2012.

We do not see much room for aluminum prices to fall below current levels, given our estimation that about one third of all smelting capacity is unprofitable at current prices, most of which is in China, but we think curtailments alone will not significantly move the needle to support the metal price.

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