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Alcoa Junk Downgrade Is Rare Trauma for Dow Stocks

Wednesday, 05 June 2013 09:21 AM

Alcoa Inc.’s relegation to a speculative-grade credit ranking makes it only the second junk-rated member of the Dow Jones Industrial Average in at least three decades. It took four years for the first to be ejected.

The New York-based aluminum producer was lowered last week by Moody’s Investors Service, following General Motors Corp. as the only Dow member below investment grade since at least 1980, according to Howard Silverblatt, an analyst at S&P Dow Jones Indices. While the guidelines don’t mention debt ratings, Dow companies become vulnerable when their finances deteriorate, says Richard Moroney, editor of Dow Theory Forecasts newsletter.

Alcoa shares have declined 67 percent in the past decade, leaving the company with the lowest share price and market value in the Dow, as surging aluminum production in China led to a supply glut. While S&P Dow Jones says inclusion in the average is not governed by quantitative rules, the index provider prefers “sustained growth.” Alcoa’s revenue has declined for four straight quarters and 2012 net income was less than a tenth what it was five years earlier.

The junk rating “is one more chink in the armor in terms of Alcoa fitting in there,” Moroney, who manages $175 million at Hammond, Indiana-based Horizon Investment Services, said in a phone interview last week. In the case of GM, the index provider “didn’t do anything for a long time. It seemed like GM was not a blue chip, but it’s still a bellwether. It’s hard to say the aluminum industry is truly a bellwether. I do think once they make a move, Alcoa will be gone.”

Dow Decisions

The Dow average’s stocks are chosen by editors of the Wall Street Journal, unlike most indexes maintained by S&P Dow Jones that are picked through an objective, rules-based process. While changes in membership are unusual, they often involve more than one company at a time, according to Dow’s guidelines.

Dave Guarino, a spokesman for S&P Dow Jones Indices, declined to comment on potential changes. Monica Orbe, a spokeswoman for Alcoa, declined to comment on the changes.

"Alcoa is focused on the things we can control,'' Orbe said in an e-mail response to questions. ``We will continue to execute on our strategy and remain focused on our 2013 goal of generating positive free cash flow.”

Alcoa’s market value of about $9 billion makes it less than one-third the size of Travelers Cos., the next-smallest company in the Dow, and smaller than 361 stocks in the Standard & Poor’s 500 Index, according to data compiled by Bloomberg. About $28 billion in products such as exchanged-traded funds are linked to the Dow and changes prompt money managers to buy or sell shares to match the adjustments. Almost $5.6 trillion is benchmarked to the S&P 500.

Shrinking Share

Alcoa, whose name was changed from Aluminum Company of America in 1999, joined the Dow in 1959. The company, which was the most valuable U.S. metal producer in 2002, has been overtaken in size and market clout by diversified commodities companies such as BHP Billiton Ltd. and Glencore Xstrata Plc. Its share of global aluminum production shrank to 9.1 percent in 2012 from almost 15 percent a decade earlier as production in China more than quadrupled to 19.7 million tons.

“China came on the scene 10 years ago and has really driven down global aluminum prices,” Jorge Beristain, a Greenwich, Connecticut-based mining analyst at Deutsche Bank AG, said in an interview yesterday. “In a more mature economy, commodities play less of an important role because you’re in more of a replacement cycle than a net fixed-asset investment cycle.”

Tumbling Prices

Alcoa has struggled to turn a profit as aluminum prices sag amid over-production. Aluminum for delivery in three months, the most active contract on the London Metal Exchange, has dropped 6.1 percent to $1,946 a metric ton this year and is down 41 percent from a peak in 2008. The lightweight metal used in beverage cans, car parts and airplane wings is the third-worst performer in the UBS Bloomberg CMCI Index of 27 commodities in the past five years, with a negative return of 45 percent.

Global production has exceeded demand for the past eight years, according to data compiled by Bloomberg. Worldwide output rose 2.8 percent to 45.2 million tons in 2012, according to the International Aluminium Institute.

Alcoa Chairman and Chief Executive Officer Klaus Kleinfeld has responded to falling prices by trimming production. Last year the company idled 13 percent of its smelting capacity and is now evaluating another 11 percent for curtailment or permanent halt by the end of next year.

The company is boosting sales at its engineered- and rolled-products divisions as Kleinfeld bets that record backlogs at aircraft makers and growing aluminum use by car producers will shift the sales mix to more-profitable products.

‘Down Cyclically’

“Alcoa is still a major industrial company,” Lloyd O’Carroll, an analyst at Richmond, Virginia-based Davenport & Co., said by telephone yesterday. “They are down cyclically, but that’s not necessarily for the long-term. Aluminum will not always be a negative.”

Moody’s lowered the long-term rating on Alcoa’s $8.6 billion of debt on May 29 by one step to Ba1 from Baa3, citing a decline in aluminum prices and a lack of “significant” recovery in the company’s profitability. The company is still rated above investment grade at S&P and Fitch Ratings.

While GM’s lead in the auto industry helped the company remain in the Dow despite a junk status until its bankruptcy in 2009, Alcoa’s membership may be more precarious because of the diminishing importance of aluminum to the U.S. economy. GM also was removed from the S&P 500 in 2009 and will return after the close of trading on June 6, S&P Dow Jones announced this week.

‘Relative Health’

“I don’t think the change in credit rating itself is enough a reason to remove a company, but the fact its credit rating has declined does provide an observation of the relative health of Alcoa’s business,” Michael Sheldon, chief market strategist at RDM Financial Group in Westport, Connecticut, which oversees $600 million, said in a June 3 telephone interview.

Alcoa’s shrinking role in the Dow bucked a trend of growing share by other commodity companies. At $8.38 a share, the aluminum producer now makes up 0.4 percent of the Dow, down from 2 percent 10 years ago. During the same period, energy and raw-materials producers increased their weighting to 14.1 percent from 11.2 percent.

Alcoa’s removal would leave Exxon Mobil Corp., Chevron Corp. and DuPont Co. as the only commodity stocks in the Dow. The three companies represent 13.6 percent of the gauge, in line with the industry’s 14 percent weighting in the S&P 500.

1896 Creation

The Dow Jones Industrial Average was devised in 1896 by Charles H. Dow, co-founder of Wall Street Journal publisher Dow Jones & Co. It originally included General Electric Co., American Tobacco and 10 other companies before expanding to 20 companies in 1916 and 30 in 1928. Its value is determined by its companies’ stock prices, unlike most benchmark gauges that rank companies by their total market value.

The average was last reshuffled in September, when UnitedHealth Group Inc. replaced Kraft Foods Inc., which spun off its North American grocery business.

Two notable omissions from the Dow are Apple Inc. and Google Inc., both of which would command outsized weightings in the gauge because of high stock prices. Apple closed at $449.31 while Google traded at $859.10. That’s more than double the price of International Business Machines Corp., the Dow’s largest component with a 10.4 percent weighting.

A financial or technology company may be favored to replace Alcoa because the industries are under-represented in the Dow, according to Horizon’s Moroney. While banks and computer makers are the biggest groups in the S&P 500, comprising a total of 34.8 percent, they make up only 27.5 percent of the Dow, data compiled by Bloomberg show.

“Alcoa isn’t really a bellwether indicative of U.S. industrial activity any more,” John Goltermann, who helps oversee more than $900 million at Obermeyer Asset Management Inc. in Aspen, Colorado, said in an interview on June 3. “Its share price can suffer from a global aluminum supply glut, even at a time that U.S. industrial activity is picking up, so the signal it sends can easily be counter to what the Dow Jones Industrial Average is intended to reflect.”

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Alcoa Inc.'s relegation to a speculative-grade credit ranking makes it only the second junk-rated member of the Dow Jones Industrial Average in at least three decades.
Wednesday, 05 June 2013 09:21 AM
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