Alcoa (NYSE: AA) Earnings Beat Boosts Stock, but Don't Expect the Same from the Sector

Alcoa Inc. (NYSE: AA) earnings solidly beat analyst expectations to kick off the season, but don't get too excited.

AA Earnings

For the third quarter, AA reported revenue of $6.2 billion, up 7% from the quarter before, and up 8% year over year. Additionally, AA posted a net income of $370 million, or $0.31 earnings-per-share. Analysts estimated revenue of $5.85 billion and an EPS of $0.23.

The results pushed up AA stock more than 2% after-hours.

Alcoa still holds bellwether status to many, but the truth is AA's positive financial results are not going to permeate throughout the basic materials sector...

In fact, Money Morning Defense and Tech Specialist Michael Robinson said that in this earnings season, you're likely to see "basic materials and energy dragging things down."

With the third-quarter decline in a number of commodities, it wouldn't be surprising to see commodity-driven industries take a hit in their bottom line.

Silver futures, for example, took a punishing 19.5% free fall in the third quarter. Crude oil futures fell 13.3%, gold fell 8.9%, and copper fell 5.9%.

aa earnings chart
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And as the chart to the right shows, the Continuous Commodity Index, a benchmark tracking 17 commodity futures, fell 10.2%. Money Morning Resource Specialist Peter Krauth sees the same difficulties plaguing the basic materials and energy sectors, with a slow rebound to follow its doldrums.

"The year started out okay, but they went into free-fall back in July," Krauth said. "I don't expect a V-shaped recovery in the sector, more like a 'saucer-shaped' one, where we get a slow and gradual improvement in shares."

All signs seem to point to a disappointing earnings season for this sector, so how did AA do so well?

Why AA Is the Exception, Not the Rule

Falling commodity prices will hit producers, as it diminishes the values of their inventory.

To counteract this, many producers in the sector will go short in the futures market as a hedge against falling prices. That way, if the spot price does fall and the value of their inventory shrinks, they mitigate losses by taking profits on the short contract.

But AA "does not engage in any significant hedging activities around price movements in aluminum," as it wrote in a report last year.

Instead there are two factors separating AA from other basic materials stocks...

The first is that AA's business is sensitive to the price of aluminum, a commodity that isn't found in the struggling Continuous Commodity Index. In fact, contrary to the broader commodities market, aluminum prices rose a modest 2.3%, from $1,983.48 a metric ton, to $2,028.87.

This was a boon to AA's so-called upstream business, which posted an improvement for the 12th consecutive quarter. The upstream business deals with mining the aluminum ore, alumina refining, and aluminum smelting.

The second factor is a luxury that many of these producers don't have.

You see, AA is not only a producer, but also a consumer for end-market aluminum products.

"Although higher aluminum prices are always beneficial for the company as a whole, low aluminum prices benefit Alcoa's downstream segments as long as demand is growing at or near a normalized rate," Morningstar analyst Andrew Lane wrote in an analyst note.

As both a producer and consumer of aluminum products, AA has effectively built a natural hedge into its business model. While it stands to benefit more from rising aluminum prices, as was the case this quarter, falling prices create cost savings on the downstream production of aluminum products.

"Encompassing every phase of aluminum production, which involves the mining of bauxite, the refining of bauxite into alumina, the smelting of alumina into primary aluminum, and the fabrication of primary aluminum into various products for end markets, Alcoa enjoys full vertical integration," Lane wrote.

Earnings season has begun. You can keep up-to-date on all third-quarter reporting with this Q3 earnings calendar...

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