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Tuesday, July 11, 2006

Alcoa Kicks off the Q2 Earnings Season ...Hardly World Cup, But Not Bad

Stocks: (AL)(AA)

From Value Discipline

Alcoa (AA) brings in the earnings season as a Dow component and has posted some pretty decent numbers this evening.

Though the press services ballyhoo the big 62% profit jump, it is important to keep things in perspective.

As some of you may recall, I have not been a great fan of this company, having preferred Alcan (AL) largely because of AL's energy cost advantages and what I believed to be continuing synergies (forgive me for using that word) from the Pechiney integration.

Cash flow from operations for the second quarter has come in at about $700 million as compared to the corresponding period last year of $384 million. This brings CFFO for the first half of the year to $486 million versus $145 million. Contrast this with earnings for the first half of $1.367 billion versus last year's $720 million. The improvement in CFFO is quite evident, yet still represents, because of working capital needs, a considerably less robust view than GAAP earnings.

Looking at capex, and resultant free cash flow, again, I am somewhat disappointed. Capex for the first half was $1.32 billion resulting in negative free cash flow of $835 million. This is the best that the company can show in a metals market that has screamed? Debt to cap remained steady at 32% within its guidelines of 25-35%.

Looking at individual segments demonstrated some very strong profitability. Alumina, for example showed operating margins of 39%. Primary metals similarly were strong with 30.&% margins. The company has pointed out that 1/3 of the third quarter production is already priced at higher than current price levels.

On the fabricated side, the company disappoints me. Again, despite the very healthy aerospace market, operating margins came in at 3.7% in flat-rolled products. Labor contract related costs have held back profitability presumably as a non-recurring cost. The extruded and end product segment had operating margins of 1.5%. Engineered solutions showed improved operating margins at 7%. Packaging and consumer showed a much improved operating margin versus the first quarter of 4.4%.

I am encouraged by the improved disclosure and transparency in the results. As I have said before, the management takes great credit for achieving what the L.M.E provideth. Natural for a commodity business, I suppose. Yet when I look at the improving volumes of business that the fabrication businesses are seeing relative to the operating margins that are being achieved, I come away disappointed. Results really should be better here.

Returns on invested capital have improved, but are not exactly heady. Management seems please with a first half ROIC of just over 15%. Using somewhat more conventional TTM figures, it looks more like 10% to me.

At the end of today's conference call, the Chairman and CEO, Alain Belda used as his final line, " And by the way guys, this was a great quarter. I would like you to think about it this way."

Sorry, Alain. It was not bad, but at least in my view and I suspect among some others', it wasn't great.

Disclaimer: Neither I, my family, nor my clients own a current position in Alcoa. Certain clients own a current position in Alcan.

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