AA as bellwether
AA is the first major company in the S&P 500 to report earnings for the calendar year quarterly cycle. Market commentators often make a big deal about AA’s results on the idea that they set the tone for the earnings season. I don’t think that’s right, either in general or for this quarter.
I should probably confess in advance that aluminum isn’t my favorite metal and that I’ve only occasionally owned AA or any of its affiliated companies in my portfolios. But I’ve spent years analyzing metals and mining stocks. In fact, my first portfolio job was to manage Australian stocks at a time when half that market was natural resources.
Anyway, I view AA is an exceptionally well-managed industrial company. But, contrary to the images that “aluminum” and “mining” conjure up of machines taking special dirt out of a big hole in the ground, AA is an unusually complex enterprise, whose quarterly earnings are very hard to analyze. Most quarterly earnings surprises, positive or negative, are mostly due to how hard it is for an outsider to see the inner workings of AA. As a result, earnings surprises, including this one, have very little meaning, in my view.
As it turns out, AA earned $.15 per share for the September period. That was 2.5x the $.06 per share it posted for the comparable quarter in 2010. But it was also down 46% from the $.28 a share it earned in 2Q11. Results also fell short of the Wall Street analyst consensus of $.22.
As I’m writing this, AA shares are down about 4% in pre-market trading, while S&P futures are suggesting an opening gain for the index of about .9%.
More below about why AA results are so hard to predict. But first,
how AA sees the world today
In its conference call, AA drew a sharp contrast between the current situation and that during the dark days of 2008-09. The company is better prepared now for a possible downturn than it was then. However, right now it doesn’t see a downturn as likely. In AA’s view, the fall in London Metal Exchange prices during the third quarter is purely speculative, with short-sellers using aluminum solely as a proxy for world economic growth (which, when you get down to it, the metal is). But AA thinks the speculatros are making a mistake. Underlying demand remains strong, especially in emerging economies.
True, Europe is a worry. One reason for AA’s quarter on quarter weakness is that European customers pulled back their orders. At this point, it’s not that final demand has collapsed. It’s that companies have been shrinking their inventories to unusually low levels in order to raise cash in anticipation that EU political leaders may yet bungle their way into a banking crisis. As/when that rear abates, the European order flow should quickly reverse.
why so hard to analyze?
AA is vertically integrated. It mines ore, refines it into basic products, and manufactures advanced aluminum industrial components. It buys and sells stuff at every point in the production chain.
Its products are in everything from airplanes to toothpaste and soda cans, and in products that sell all around the world.
It has many sources of raw materials, some owned, some not, to choose from. Its selections are constrained by contractual relationships that can rival for complexity anything in the film or oil industries. While prices of inputs and outputs may be tied to industry benchmarks, there can be leads or lags of months before changes kick in. Contracts may require the buyer to pay for specified quantities whether he takes delivery or not (it’s a little more complicated than this, but nothing to worry about). All of this is difficult for an analyst to find out about and model.
Even more discouraging, the stock tends to move on changes in aluminum prices, which can occur far in advance of reported earnings.
To my mind, AA is giving a relatively upbeat view of the world economy–well, maybe ex the EU. And even there, the situation doesn’t sound too bad.
I don’t think the company’s earnings “miss” has any predictive value for firms outside the base metals industries. Given the stock’s severe underperformance of the S&P over the past three months, I’m a bit surprised that it’s down at all after the earnings report. It will be interesting to see how it fares in regular trading today.