Alcoa Corporation (AA) Earnings Call Transcript & Summary

Good morning, everyone. My name is Arjun Chandar. I'm the high-yield metals and mining analyst at JPMorgan. We're pleased to have with us today, Alcoa. From the company, we have Bill Oplinger. We're going to run this as a fireside chat. So I'm going to turn the floor over to Bill for some opening remarks and comments on recent activities and Q4 results, and then we'll go into some Q&A. As a reminder, please use the conference website in the audience Ask a Question link in order to ask a question, and I'll be keeping an eye on that throughout the session as well. With that, I'll turn it over to Bill.

Thanks, Arjun. So some overall comments around the company and the state of our markets. As we alluded to in January, our markets are seeing a very strong rebound. Demand globally has strengthened on a year-over-year basis. We're projecting global demand to increase by 7%. We're seeing strength in all of our regions, all of our industries. So in China and the rest of the world in places like transportation, electrical packaging seeing year-over-year growth. So the market story is strong for the company. In addition to that, we're starting to see some reduction in growth in primary aluminum in places like China. China is committed to their self-imposed 45 million metric ton capacity constraint, and they've shown that most recently with some of the curtailments that they're projecting in Inner Mongolia. So overall, the market dynamics are strong for the company. As we look out into the first quarter, we guided towards some higher costs in the first quarter. Since that time, we've been taking action with the resolution of the San Ciprián strike in the near term. We think we've been able to close probably $20 million to $50 million -- $20 million of the $50 million of higher costs. So again, not only with stronger market pricing, but better performance than what we had anticipated at the beginning of January. Combination of those 2 factors lead us to overall higher profitability than what we had expected, and we'll have a resulting slightly higher tax expense. We're projecting probably an $80 million to $85 million tax expense in the quarter, given that higher profitability. If I step back and look at some of the strategic activities that we have going on, we implemented the new operating model over the last year, very successful implementation of that new operating model, where we eliminated our business unit structures. We have executed upon the asset sale program and fully expect to close on the Warrick deal at the end of this month. Once we've done that between Warrick and Gum Springs, we will generate $700 million to $800 million of cash proceeds, so within the range that we gave ourselves. That doesn't mean that we're stopping on asset sales. We still have the Rockdale land for sale. And we'll be looking at the margin on smaller asset sales, especially in the transformation portfolio. And then lastly, we continue to execute on the priority of repositioning the portfolio. We announced back in 2019 an asset review. Since that time, we've curtailed the Intalco smelter, we've initiated the collective dismissal process in Spain, still working on the situation in Portland. The electric contract there ends in mid -- in June. So we're still working on that. So I would tell you that from -- both from a near-term operational perspective and a longer-term strategic perspective, we're executing extremely well. So with that, I'll turn it back over to you, Arjun.

So I want to drill down a little further on kind of the global supply-demand picture, specifically China versus the rest of the world. So what factors do you think could potentially mitigate the projected undersupply of primary aluminum do you anticipate both within China and outside in 2021? And do you see the rest of the world as a bigger risk to the global growth story than China?

Yes. As I said, we are seeing really strong demand across the board. In China, we're projecting that demand growth will be 10% on a year-over-year basis. And recall that their demand decline wasn't that large in 2020. So it's real demand growth over 2020 that wasn't that bad. In the rest of the world, we're seeing demand growth. And this spans the industry's transportation, electrical. We are seeing solid double-digit demand growth in the transportation businesses around the world. So from a demand perspective, it feels as if the economies globally are strongly recovering. That's reflected in the LME price. It's also reflected in some of the regional premiums that we're seeing. So for instance, in the North American market, regional premiums have increased over $0.16 per pound. We've seen stronger regional premiums in Asia. So the demand side of the story is good. As far as supply goes, we have not seen significant supply growth outside of China over the last few years. We believe that China is committed to hitting their self-imposed 45 million metric ton cap and not going over that. They've shown that recently with the actions in Inner Mongolia. So overall, the supply-demand picture for the industry looks very solid.

And then shifting gears to the bauxite market. Your guidance in the Q4 release for 1Q '21 called for lower quarterly results in bauxite. Is that a function of typical seasonality? Or are there structural considerations in that market that differentiate its outlook from primary aluminum?

Yes. So we made about $120 million of EBITDA in the bauxite segment in the fourth quarter. We were projecting 2 large impacts in bauxite going into the first quarter. The first is simply a change of intercompany pricing between the Bauxite and the Alumina segment. So that would take about $45 million worth of earnings out of the Bauxite segment and put them into the Alumina segment. That's really a reflection of lower bauxite prices globally. The second impact was a $25 million cost increase that was related to some good performance that we got out of our joint venture mines in the fourth quarter. When I alluded to earlier in the conversation that we're seeing some better performance for the company, in part that will be in the Bauxite segment. So we will be able to offset some of the higher costs that we've seen in bauxite. So while we guided to a $50 million decline first quarter to fourth quarter, we're able to pick up, we believe at this point, at least 40% of that so good -- through good operating performance.

And then moving to alumina, what steps can be taken to mitigate the impact of rising power costs in alumina earnings? And can you talk a bit about the broad supply-demand dynamics in alumina?

Yes. Let's start with our aluminum -- our alumina position in aggregate. Recall that we make around 13 million metric tons of alumina. And we have a first quartile alumina position on the cost curve. Not only do we have a first quartile cost position, but we have the lowest CO2 intensity of any producer, any major producer out there. So we have a large, low-cost, low-carbon, which will become more important over time, alumina portfolio. As far as the input costs, we have seen increased gas prices due to a contract that we signed back in 2015. That resulted in increased year-over-year gas prices in 2020 and will result in higher 2021 prices. We are taking the opportunity to sign some shorter-term lower-priced contracts to offset that. So you've seen announcements out of Western Australia, where we've been able to lock in some lower-cost gas to offset it. As I step back and look at the supply-demand picture for alumina, a little bit different than aluminum currently in that the market is fairly well balanced. And we've seen prices hovering around $300 a ton, and that's really because there's enough bauxite in the world to meet demand. As the Chinese start to import again, and we're projecting that the Chinese will be importing over 3 million metric tons of alumina, that is taking up some of the supply in the rest of the world. So overall, a balanced market on alumina.

And then moving to ESG. Obviously, a big topic amongst the investor base over the last year to 18 months. What steps are you taking to increase operating efficiency and lower your carbon footprint at production facilities? And where do you believe that Alcoa has the ability to differentiate itself on the ESG spectrum in the eyes of investors? And are there any capital initiatives that are being deployed to stay ahead of the curve here?

Yes. So let me start with the second one first. I think that ESG is an opportunity for significant differentiation for our company. And if you disaggregate the words, ESG, I think that we do well on all 3 facets. I'd start with the simple one. From the very start, on the governance side, we launched the company with extremely strong corporate governance, shareholder-friendly governance. From having separated Chairman and CEO to a non-staggered Board, to proxy access, we started the company with very, very good governance. If I then move on to the sustainability side, for us, sustainability, it isn't, in large part carbon and environmental considerations, but it's broader than that. It's appropriate engagement with our communities. It's strong respect for indigenous people's rights. And if I then back up to the environmental side, we are in a very good position from a carbon perspective. We are the lowest carbon emitter from an intensity perspective in refining. We have line of sight to being the lowest carbon emitter in the metal area, in the aluminum side of the business. And on top of that, we're working on breakthrough technology with the Elysis project that we have with Rio Tinto, that would be a 0 emissions process for making aluminum. If we then go to the product side, we are trying to use that advantage that we have on the process to launch products, and we have a complete suite of carbon -- less carbon-intense products. And we've got the ECOLUM product, which is low-carbon aluminum. We have some really interesting charts in today's presentation that talk about how a carbon charge could impact the global aluminum cost curve. In addition to that, we're the only company who offers low-carbon alumina products. So we are now offering an EcoSource product, which is low -- certified low-carbon alumina, which our customers can get a certification to show how much carbon is emitted in the alumina process. So I think we're really well positioned from the ESG side. Your first question was specifically, what are we doing on an operational basis? We just recently, over the last few years, signed up for wind contracts in Norway to better position our Norwegian assets from a renewable energy perspective. And we actively look at carbon abatement projects throughout the system so that we can determine how we get the most carbon abatement for investments as we go forward. So in my view, overall, a really strong position for Alcoa, only getting better as we transition over the next few years.

That's very helpful. As we move forward, can you talk a little bit about your thoughts on aluminum import tariffs and Section 232, in particular in the U.S.? Where do you see the new administration potentially going with regards to restrictive measures around global trade relative to the old administration? And how are you preparing your business? And what areas are you most focused on with regards to adjusting to whatever impact may come on the import side.

Great. Let's start with the basics. We believe -- fundamentally believe in globally free trade. And with that said, we have not been supporters of tariffs into North America over the last few years. However, our primary belief is that the source of some of the disconnects on competitiveness is really around subsidies that have occurred in China and continue to occur in China. We referenced the OECD report from a couple of years ago, which showed that much of the subsidies in our industry are going to Chinese companies by the Chinese government. So we don't believe that necessarily 232 tariffs solve that problem. With that said, over the last couple of years with tariffs on and off and on again, we've managed through that process. We've got a very strong position in both Canada and the U.S. and outside of the world -- outside of those 2 locations, and we'll manage through whatever structure gets put in place. Lastly, I would make the point that we don't believe that necessarily this is on the top of the administration's list of things to do. They have a lot of undertakings with the things going on and probably not their first area of focus.

Great. And then shifting to value-add end markets. In 2020 with the pandemic, there's clearly been an impact to the aerospace sector. As you look at your exposure in the portfolio to value-add end markets, how quickly do you see demand recovery? And could demand growth potentially lag the timing of a broader global reopening post vaccine rollout as customers work through existing stockpiles? Or have inventory levels during the pandemic been fairly well managed?

Yes, so as we look at the market strength that I alluded to earlier, we are seeing our value-added product book business grow. And we saw -- the low point was in the second quarter of 2020. We saw that the third quarter, we had growth in the value-add products volumes. Fourth quarter was better than the third quarter. We're projecting first quarter to be better than the fourth quarter. So overall, our value-added products business is recovering nicely, and it's recovering in line with the overall growth and demand that we are seeing in the end markets. When you referenced the aerospace business, aerospace for primary aluminum is a really small part of the primary aluminum usage. We would put it probably at around 2% of the global usage of aluminum. So big changes in the aerospace market don't necessarily drive large changes in primary aluminum demand. So it's -- versus some of our customers, it's not that large of an impact.

Shifting gears to the balance sheet. We actually have a question from the audience I'm going to start with. What is the current thinking on making incremental pension contributions versus repaying your bonds maturing in 2024?

So again, let's step back and look at it in totality. We ended the year of 2020 with $3.5 billion of proportional net debt. And we have a target of $2 billion to $2.5 billion of proportional net debt. The $3.5 billion is the aggregation of the funded debt pension/OPEB, offset by the Alcoa share of the cash position. We are committed to getting to that target, the $2 billion to $2.5 billion. We think that with the sale of Warrick and some cash generation and contributions to the pension, we should be able to get to that over time. And it will potentially be a mix of further pension funding and funded debt reduction. We are committed to getting our pension funded. We believe that the pension liability is large in relation to the size of our company. We believe that it ends up being an overhang on the equity value for that large of a pension liability. That's why we're committed to getting to that $2 billion to $2.5 billion level. So it will be -- as we get towards that target level, it will be a combination of contributions to the pension and lower funded debt.

Great. And then you answered, I think, my asset sale question in your opening remarks with regards to where you currently sit within your $500 million to $1 billion target and what could be in the near term, additive to that asset sale program. I think from that perspective, we can move on from that question. You've been very clear on that. And then capital allocation, you just talked about the focus on funding the pension and meeting your expectations around target leverage. Are there any other comments you want to make with regards to broader capital allocation as you presumably generate a healthy amount of free cash flow and have money to put to work?

Yes. So we have a capital allocation framework that we've been consistent with over the last couple of years. And that capital allocation framework starts with keeping $1 billion of cash on the balance sheet. And we're committed to keeping that $1 billion. We've let that slide below to $1 billion occasionally over the last couple of years as market -- as the market situation has required, but we would like to keep $1 billion. In addition to that, we will spend roughly $425 million of CapEx this year to sustain the operations. But also to invest in some small return-seeking projects. The small return-seeking projects are a combination of creep, gaining incremental volumes out of the plant, but also cost savings projects. Beyond those 2 things, uses of excess free cash flow can go towards 4 areas. These are not necessarily in rank order, but we talked about the deleveraging. We are committed to hitting that $2 billion to $2.5 billion of deleveraging over time. So that's the first potential use of cash flow. Second potential use, again, not necessarily in rank order, is returns to shareholders. The third is asset repositioning. The portfolio of assets, the repositioning work that we're doing, it will cost money. When we curtail or close facilities, it costs money for the labor -- the labor costs, also for the environmental and demolition work. So that repositioning does take cash and we'll potentially use some cash for that. And then the fourth is our midsized value-creating growth projects. These are largely in our refining business. And at this point, we put all of our midsized growth projects on hold in 2020, and they remain on hold at this point. So those are the 4 potential uses for free cash flow. And as I said, we're committed to that deleveraging target also.

And then just a follow-up to that, thinking about the broader aluminum industry, do you see M&A consolidation as part of the narrative over the next year or 2?

It's really difficult to speculate. There's not been a lot of consolidation in our industry over the last few years. So I am hesitant to speculate on what type of consolidation could occur. Where I won't -- where I will speculate is that we have a very defined course laid out for our company. And it is the 3 things that I talked about earlier: It's focusing on cost reduction, stability in our plants, generating earnings from the plants that we have. The second is repositioning of the asset portfolio. We're well on the way of repositioning that. Once we've repositioned the portfolio, just to be clear, we will have a first-quartile bauxite position, a first-quartile refining position that's large and extremely low carbon intensity and a high first-quartile aluminum smelting position that will also be very low carbon intensity and also have the joint venture with Rio Tinto for the Elysis project, which is a no-carbon-producing process. And we will continue to sell noncore assets on the periphery. We continue to work on smaller sales of noncore assets to streamline the portfolio. So as we look out 3 to 5 years, the balance sheet will be in much better shape. The pension will be in great shape, and we'll have first-quartile cost positions in all 3 of our business segments.

Great. And then a question that we get a lot, especially in a supportive commodity price environment with regards to high BB issuers like yourself is, as you think about the next step from a rating agency perspective, what type of motivation within the financial policy and capital allocation priorities that you outlined earlier do you have to go investment grade? And have you had recent conversations with the rating agencies in this regard?

So let me answer the second part of this first. We have had recent conversations with the rating agencies. We also have recent conversations with our Board of Directors, where we actively talk about capital allocation and the optimal capital structure for our company. We like to think that we have a good deal of science behind our targeted capital structure. Our targeted capital structure comes back to that $2 billion to $2.5 billion of proportional net debt. We think that, that level of indebtedness, including pension and OPEB, provides for the optimal weighted average cost of capital. We actually plot out the optimal weighted average cost of capital versus the total indebtedness. And the lowest point comes to between that $2 billion to $2.5 billion of indebtedness. The theory behind that is that we create the largest shareholder value at that lowest WACC. So we will continue to target the lowest WACC. Whether that results in IG with the rating agencies, that's out of my hands. I think that our metrics, when we get to that level, will look very good. I think our metrics will be IG-level metrics because we're able to model the rating agencies' models themselves. Whether they determine that we are investment grade, that's up to Moody's and S&P. And quite honestly, I spend no time thinking about whether Moody's and S&P will rate us as IG. I spend a lot of time thinking about how do we get to our lowest WACC, and what do we need to do to get to our lowest WACC. So if in the end, we're rated IG, hey, that's great. If not that's fine too as long as I can look my shareholders in the eye and say, I think we've gotten to our optimal capital structure.

Perfect. That ends my list of questions. I'll just turn it back over to you, Bill. If you've got any closing remarks before we wrap it up.

No, Arjun, I appreciate the opportunity to talk to you and the people at your conference. I think that we, as a company, have done a great job being focused on significantly improving the company over the last 4 years. We've regained a very good level of operational stability in the company. We've implemented the change to the operating model, which I believe makes us much more agile, makes decision-making much quicker. We have a market tailwind today, and we're enjoying that market tailwind for the first time in quite a while. As we look forward, we think the dynamics in the industry between the sustainability drive and some of the things that we see in the marketplace are shaping up for a nice period of time where the market is strong. Our company is getting stronger. And as I laid out earlier, over time, our company just gets better and better. And so we're pleased with the progress that we've made, but really striving to continue to make more progress, especially in these stronger markets.

Excellent. That concludes our session. Thanks a lot, Bill. Really appreciate the time.

Thanks, Arjun. See you.