Alcoa Results Highlight The Schism Between Debt And Equity Investors

Yesterday's Alcoa results were a disappointment because even after an 18% increase in revenues to $5.4 billion, the firm still missed consensus EPS of $0.06, coming out at $0.01 ex items. The take home message is that even with China in full ramp up mode, the margin contraction is fierce and getting worse. A simple observation of the ratio of AA stock price to ALUM price indicates just how far the stock had run ahead of itself.

Furthermore, on the call, the management team warned about continuing weak market conditions. If China is indeed scaling back on massive liquidity, AA future EPS will be hit with the double whammy of declining revenues courtesy of less stimulus cash flowing to the company, and still frothy commodity and raw material input cost inflation. Never a good thing for a company. For a great rundown of Alcoa's numbers, check out this post by Karl Denninger.

Yet what caught our attention yesterday were not the weak numbers, but the market reaction to them. While the stock price plunged in the after hours session, initially 5% and today it seems like it can be down as much as 10%, the company's CDS ripped tighter, moving from 160 bps to 140 bps, and ultimately stabilizing at the midpoint: an indication of improving credit perception, and, dare we say it, a return to market normalcy and fundamentals.

Why the divergence? While the earnings miss was impacting shareholders, the company did in fact manage to delever by over $750 million in the past year (how substantial this is with a still $10 billion debt load is debatable). More relevantly, for the first time since Q2 2008 the company was cash flow positive. All this benefits credit on the margin. Of course, as credit investors remember all too vividly, a very rosy equity picture usually ends up being negative for credit, with such gimmicks as dividend recaps sure to follow. Based on this reaction, AA at least has entered that goldilock mode, where a deterioration in equity is considered credit beneficial.

Yet what is oddest for us, is that whereas a few months back this response would have triggered a very correlated move across the entire capital structure, yesterday's response may indicate that fundamentals are finally, after many quarters, starting to reemerge. Could the market finally be getting back to normal? With the bulk of companies set to report Q4 results, and with stimulus benefits, both domestic and global, finally tapering off, could this be the equity topping event we have been waiting for?

Comments

[etrader]

I bet Hugh Hendry didn't like that CDS movement. (Going off his last market update posted on here...)

http://www.zerohedge.com/article/deep-thoughts-hugh-hendry-eclecticas-la...

[Steak]

As someone who looks at a ton of stocks fundamentals on a regular basis I can say this margin trend was expected.  The really well run companies foresaw the problems in 2008 and started cost cutting programs in late 2007 (lookin at you PG).  The slower ones really slashed costs going into 1Q09.  But looking at gross and operating margins charted over the past two years it seems that the vast majority of companies saw peak margins in 3Q09 or will in their 4Q09 reports. 

After the boost from increasing margins wears off IMO revenue growth will not be able to drive bottom line growth, as we have already seen with Alcoa.  I am firmly in Mr. Middleton's camp on the thought that we are entering a period where it will be harder to sell things for a profit and harder to buy things cheaply.

[Anonymous]

What's most notable are the production and shipments:
- Alumina production: Down 6.4% in 2009 FY over 2008 FY
- Primary Metals production: Down 11.1% in 2009 FY over 2008 FY
- Flat-Rolled Shipments: Down 17.6% in 2009 FY over 2008 FY
- Engineered Shipments: Down 30.0% in 2009 FY over 2008 FY

[Arco]

What's most notable are the production and shipments:

- Alumina production: Down 6.4% in 2009 FY over 2008 FY

- Primary Metals production: Down 11.1% in 2009 FY over 2008 FY

- Flat-Rolled Shipments: Down 17.6% in 2009 FY over 2008 FY

- Engineered Shipments: Down 30.0% in 2009 FY over 2008 FY

[Anonymous]

Here's an idea: Let's fire all of our workers! That'll reduce costs. Of course, unemployed people can still buy our stuff, that's why they have credit cards.

*puffs on 4-bit cigar; sighs* Ah, life is good.

[Anonymous]

free cash flow here is a little generous: all but one of the company's working capital accounts were a source of cash this quarter. this is just a tad unusual, suggesting management played some games with suppliers, customers and inventory. For the quarter, cash from operations $1,129mm with changes in working capital providing $1,356mm in cash. yes so on a pure operating basis, or as the reit boys like to call it, ffo, the company consumed capital this quarter.