DBRS Confirms Alcoa Inc. at BBB with a Stable Trend

DBRS has today confirmed the Issuer and Senior Unsecured Debt ratings of Alcoa Inc. (Alcoa or the Company) at BBB and its Commercial Paper rating at R-2 (middle), with Stable trends. The ratings reflect Alcoa’s geographically diversified and integrated operations, its position as a low-cost alumina producer and its technologically sophisticated mid- and downstream production operations (Global Rolled Products and Engineered Products and Solutions), which provide steadier profit margins than its upstream assets. A decline in aluminum and alumina prices since mid-2011 has reduced Alcoa earnings and cash flow, weakening credit metrics in 2012. However, these metrics generally remain within DBRS’s current rating category for Alcoa, and the weakness is considered cyclical.

Alcoa’s recovery from the deep 2009 recession continued through to the first half of 2011, as alumina and aluminum production increased and profit margins in downstream businesses improved. 2011 net income before non-recurring items of $797 million was double 2010’s earnings. A reversal of aluminum and alumina upward price trends in H2 2011, combined with higher input costs, significantly reduced Company earnings in the later part of 2011 and the first half of 2012. Large earnings declines were experienced in the Alumina and Primary Metals segments (combined five-year average EBITDA contribution of 63%, versus only 36% in H1 2012), were only partially offset by higher earnings in the mid- and downstream segments (five-year average EBITDA contribution of 37%, versus 64% in H1 2012).

DBRS expects that market weakness in Alcoa’s upstream operations may have bottomed out in the third quarter of 2012 and improvements are expected in Q4 2012 and 2013. Barring an unforeseen setback in U.S. and European economies, downstream operations are expected to maintain the bulk of the profitability gains achieved over the last couple of years, leading to a stabilization and gradual increase in Alcoa’s earnings. The European debt crisis remains a troubling wild card.

Alcoa is vulnerable to low aluminum prices, as almost all of its earnings are aluminum-related. A sustained period of low aluminum prices could severely impair its credit metrics (such as was the case in 2009). Although Alcoa has had some success in bringing down its cash cost in aluminum production as a result of restructuring programs and curtailing low-margin smelting capacity, its current aluminum smelting cost remains slightly above the industry median, exposing it to constrained cash flows during low-price periods. Over the medium to long term, Alcoa’s cost structure in alumina and aluminum is expected to come down once its $1.1 billion (Alcoa’s equity share) Ma’aden joint venture project in Saudi Arabia (Ma’aden) is in service, expected in 2013 (for aluminum) and 2014 (for alumina).

Over the longer term, aluminum demand is expected to grow in step with the industrialization and urbanization of developing countries. It is a key metal in the desire to reduce weight and conserve energy in the transportation sector, with a high level of recyclability and versatility in a wide range of end uses. The recovery of alumina and aluminum prices from current marginally profitable levels is expected as high-cost producers curtail operations or economic growth improves demand. Ongoing improvements in the cost-competitiveness of the Company’s upstream operations should contribute to the expected increased earnings.

Over the past few years, Alcoa has improved its ability to cope with the economic downturn by improving liquidity and preserving cash with non-core asset sales, curtailing capital expenditures, maintaining low common dividends and increasing its credit availability. DBRS expects Alcoa to remain flexible with its capital expenditure and dividend programs in the event aluminum and alumina prices decline.

Notes:
All figures are in U.S. dollars unless otherwise noted.

The applicable methodology is Rating Companies in the Mining Industry, which can be found on our website under Methodologies.