With the recent rating outlook warning issued by Moody’s, Alcoa is at risk of losing investment grade on its debts. The whole ordeal is all too familiar in the eyes of the business cycle; price tends to fluctuate in sync to booms and busts. Adding to the demand side story is the supply side, overriding supply and capacity additions overtime, and that leads to what people call supercycles.

But, what has really changed this time? Is it the cyclical revenue suppression that Alcoa is feeling right now? Is it the overall negative rating actions on profit-squeezed organizations or even indebted nations during bear markets? How about segment exposures to new emerging markets? Has that changed the business dynamics of multinationals such as Alcoa? Lastly, has the debt structure made any difference to the Alcoa business model, which led to a fundamental change in credit outlook?

The answer is no, not much has changed. Business cycle is operating like it has before, bear markets continue to dampen demand, bringing down commodity prices, drying capital liquidity and exposing companies to credit risks when revenues are bad. This is especially the case for a company like Alcoa, a commodity producing company. However, one can argue successful diversification into the semis business has helped Alcoa to weather bad times much better than a company that has put all its eggs in one basket.

Segment exposure reveals overweighting on the US and Europe

What about segment exposure? The truth is Alcoa sells almost 50% of its products to the US, 27% in Europe, Pacific 17% and 7% to other Americas. Alcoa has most of its exposure in the US and Europe, Asia only represents a small percentage. With the current slow recovery in the US and painful contraction in Europe, Alcoa is going to face, as Moody’s calls it ‘headwinds’.

Debt concern

Debt structure is a point that is raising concerns. With cost being structurally high, Alcoa has a debt level that is ‘not commensurate with the lower earnings run rate; that it has’. Essentially, Alcoa’s debt has increased increasing its asset, while interest expense goes up. Operating cash flow is under strain given the low prices in the primary and alumina businesses; capital investment is suffering from the ‘settlement with the Italian government for Italy recouping electricity tariffs.’ The ability to cover interest by earnings has worsened.

The primary market

The world is in a cyclical downturn, which means demand has weakened, affecting commodity prices and the demand for goods, both will affect the income statement of Alcoa (through Alcoa’s primary business and semis business). What will happen to LME price next year? Global growth will be weak in 2013, perhaps somewhat better than 2012. The US is recovering very slowly. While unemployment has come down, private consumption has not (an area of growth the US needs). While the Fed policy of additional quantitative easing and interest rate impotence is eagerly promoting inflation or even disinflation further down the line, investment has not grown all that much. industrial production activities are still weak, however, expansions are on the way; housing has also bottomed.

Europe continues to suffer, with some hopes that the more resilient economies such as Germany can perform better, perhaps Europe can pull itself out of the negative zone sometime in the next year. China is also coming back very slowly, end markets are gradually recovering, and however, this will not help Alcoa that much since it has a relative small exposure to Asia.

So global demand is still below par, except for China, where Alcoa has no primary aluminium smelters, but does supply alumina, We have seen production cuts as a natural response to weak demand, while price remains below par (as there is a historical correlation between production and price). While China’s supply addition will mostly affect the SHFE price, the rest of the world will only depend on the return-to-growth in major economies and emerging economies ex-china, which is not easy.

Here, we mention the China market again, and highlight its relative insulation from the international market. bearing in mind most of the aluminium in China is consumed domestically, so there is some insulation between the Chinese and international market. If the Chinese were to export, the resulting aluminium production increase in China would easily surpass the production cuts in the rest of the world, a frightening scenario to contemplate.

In any case, at AZ China we see an overall demand improvement in the next year, however, it will be very marginal. Coupled with production cuts, price may move sideways or even have some marginal improvements towards the end of 2013. This is not enough to support the entire yearly income statement of Alcoa in 2013.

The semis business is also under strain

One can argue that business diversification has benefited Alcoa, since 50% of its business is in semis. But we need to remember that semis demand is also depressed because of lower demand in end markets – construction, automobile, consumer products, electrical cables, packaging and machinery and equipments. Semis sales will also be suppressed, however, production cuts and price adjustments may boost sales. All these still put Alcoa on a negative outlook its semis business.

What is happening to Alcoa’s financials

We have witnessed Alcoa’s revenue decreasing more than 2.5% over the last 4 quarters; costs increased 0.7% in the same period; interest expense picked up in the 3^rd quarter in 2012, profit has naturally decreased as a result of these financial developments. On the debt front, debt increased in the 3^rd quarter of 2012. With more debts, more interest expense, increasing costs and lower revenue, the outlook would naturally become negative for Alcoa. Unless, these metrics change, our view is similar to that of Moody’s.

Share price not supported

Alcoa has had an interesting run on its stock performance. Alcoa’s share price suffered a major dip in early 2009, along with the market index. However, where the index rebounded after the GFC and is now trading higher than the historical average, Alcoa’s share price continued to trade much lower, and lower than the index. Currently, Alcoa’s stock is trading at 1993 price level, a major pull back. A lot of this has to do with the overall state of the commodity market, as well as Alcoa’s own financials. Essentially, with an outlook on parts of Alcoa’s main business segments and financial indicators being negative, return to shareholder will likely deteriorate further. We expect the share price to trade sideways at best.

Almost as soon as the China Communist Party confirmed the appointments of Xi Jingping and the rest of the Politburo Standing Committee, current President Hu Jintao and Premier Wen Jiabao seem to have disappeared from public view.

In their place, Mr Xi has already started to put stakes down, using the phrase “Renaissance of the Chinese people” several times in public speeches. Recently he took a public tour of Shenzhen, the city made famous as the place where Deng Xiaoping launched the opening of the Chinese economy 30 years prior.

Indeed, much of the foreign press has been focused on the extent to which Mr Xi and the PBSC might be more reformist than Mr Hu in the last ten years. Some have referred to the previous decade as a lost opportunity, and it is not hard to picture that the reason why former President Jiang Zemin, who took over the reins from Deng Xiaoping, was so prevalent in the selection of the new PBSC. Clearly there was a mood for a restart of the previous policy objectives and a perceived need for reform.

But reform can have many dimensions. In China, there is no doubt that reform is needed on several levels – economic, political, human rights, environmental, social and so on. Before we call for reform, we better know in which areas reform is MOST needed, and in which areas is most likely to happen, or not happen as the case may be.

Reform is not a zero-sum game, but equally, the reforms that the new Chinese leadership team might make will have a certain priority among the various plans. For instance, we can call for environmental reform, but it is likely to come within a framework of economic growth, effectively limiting the chances of significant change in outcomes.

So, what sorts of reform might we expect to see?

On the economic front, the news from this weekend’s economic forum (called by the Communist Party, not the Government, and chaired by Li Keqiang, not Wen Jiabao) was that the focus will be on developing domestic consumption. This will be underpinned, according to the Chinese press, by continued development of infrastructure.

China needs to see an improvement in the balance of its GDP, with a boost of domestic consumption and a moderating of Government spend. We will get one but not the other, it seems.

But the problem with this announcement is that it puts the Party’s focus on accelerating existing conditions, rather than reforming anything. To give an automobile analogy, the Chinese leadership is planning to put the foot on the accelerator again, perhaps not as heavily as it did in 2009. But it is not going to steer the vehicle very far from its existing course. And it is not going to change the structure of the vehicle - we won’t be seeing greeener approaches for instance, or a trimmed-down version, nor will existing problems be addressed. Problems with bad loans and doubtful debts, unbalanced growth, unbridled development and so on are being given lip service at best.

So reform on an economic level is not likely to be reform to any significant extent.

In the next part, I will discuss political reform. Stay tuned.

A selection of tidbits from the Lobby Lounge of the Empark Hotel, where the Antaike aluminium conference was held.

• The prevailing question among those who populated the lobby lounge these last 3 days was, what will happen inside the China aluminium industry in the next few months? Despite power price subsidies and inventory purchases by Government, the SHFE price is hovering at a relatively bleak level. Several smelters are now under water even on a cash basis.
  In this environment, will governments extend subsidies (which are due to expire December 31), or increase metal purchases? Or will we see wholesale closures of capacity - in the order of 1 million tonnes or more? (Some people told us as much as 2 million tonnes will close.) Will the new projects in China’s northwest decelerate as capital becomes scarce and the market remains soft? It is fair to say there was a lot of gloom in the discussions we had.

  We hold the view that the recent announcement of inventory purchases was more significant in its message than in the quantity purchased. By intervening in the market and removing some tonnes, the government is telling the industry it will support them. While on a micro level we might see some old expensive plants close, on a big picture level, we still expect supply to grow by around 10% next year. New smelter projects currently underway will complete construction as quickly as possible, though additional extensions and phases may be deferred. We heard of one smelter that will use the winter conditions to do tunnelling work for its power station.

• There were some old friends at the conference carrying new business cards. Greg Baxter led the Glencore team, fresh from his time at RTA. Holger Ellmann now represents MRI trading, no longer at Alaska Metals. Same for his former colleague Roger Pillai, who now works for Euromin. David Zheng reminded me that he moved to Alba about 12 months ago. And Fifi Wu, who used to work with us at AZ China, is now an analyst at Hydro in their Beijing office.
• We also met some new friends, though they are not in new jobs. I had an excellent discussion with John Hannagan, Chairman of Rusal Australia. We spoke in Australian, so nobody around us could understand…
• One aluminium smelter told us they wanted to build a new smelter in Xinjiang, but all the good locations are gone. Interesting viewpoint.
• We heard that there is a new push by the NDRC to establish new standards for environmental emissions. Some work is currently being done to define new limits on the maximum levels of greenhouse gases for new projects.
• Perhaps the most interesting comment of the last 3 days came from one senior Chinese aluminium insider. We were talking about what the government might do, and what the role of the NDRC was in relation to control of the industry. He pointed out that it is too simple to think of the NDRC as a unified voice. He told us that within the NDRC there are widely conflicting views as to how industry policy and development goals. It’s no wonder so many smelters and indeed even provincial governments ignore the announcements from the NDRC, knowing that the announcement could be overturned at any time.

Here are some thoughts on two books I have just finished reading. I recommend both, for those interested in modern Chinese history.

Tombstone: The untold story of Mao’s Great Famine, by Yang Jisheng. Published by Penguin.

Winston Churchill once said, “Those that fail to learn from history, are doomed to repeat it”. This is so appropriate to this book, for the patterns of behaviour before during and after the great famine are still evident today.

The tombstone in the book title refers to the writer’s own father. Mr Yang’s father died in the great famine, but at that time and as a young lad, he failed to realise that the cause of death of his father and another 36 million people was entirely man-made. The book is Mr Yang’s tombstone for his father.

The book was originally published in Chinese, in Hong Kong in 2008, but has recently been released in English. It describes in painful detail the deaths of countless people, some of whom died as people killed their children and parents for food. The book examines the situation in various provinces, ranging from Henan to Gansu, Anhui to Sichuan.

The author also spends some time discussing the causes, failures of policy and failure to acknowledge or rectify the situation. He looks at the political environment at the time, and the role of several people, from Chairman Mao down.

I found the book disturbing on several levels. The account of the deaths of so many people was harrowing - bodies left lying on the roadside, people keeping dead relatives hidden in the house to claim food rations, people beaten, tortured and killed for failing to produce enough grain, or for raising the plight of the starving to the authorities, not to mention the numerous examples of cannibalism given in the book.

But even more disturbing is the number of parallels to 21st century China.

• Official statistics being deliberately inflated.
• Communist party cadres enjoying benefits while peasants starved
• Those who raised the alarm punished as “right deviationists”
• Government policy misinterpreted or deliberately magnified, altered or completely ignored
• Similar to the previous point, the targets set at the highest levels being accepted as the minimum to be reported, regardless the truth
• Problems in the real economy being interpreted as failure to adopt socialist philosophy, rather than as problems of policy or execution
• Mass suppression of the media, and the media being used as a tool of the party or its cadres.

This book is a long read - 1600 pages, and is banned in China. that in itself says something of the lessons available from the book, and from China’s recent past.

The Rise and Fall of the House of Bo, published by Penguin, by John Garnaut.

Australian journalist John Garnaut, whom some readers will recall has spoken at AZ China events, and who broke the story on Rio Tinto executive Stern Hu (and won Australia’s highest journalistic award for doing so), has published an e-book on the recent scandal around political heavyweight Bo Xi Lai.

Called “The Rise and Fall of the House of Bo”, John puts the story into a historical perspective. Given John’s excellent connections and his very good grasp of the Chinese language, he is able to bring a very detailed level of knowledge about the who and what and when of the rise of Bo Xi Lai in Dalian and later in Chongqing.

John shows that the origins of the story go back to Bo’s father, Bo Yibo, who was at Chairman Mao’s side before and after the establishment of the communist regime in 1949. John also shows that one of the elder Bo’s adversaries in Mao’s cabinet was Xi Zhongxun. In 1987 for instance, Bo Yibo led the attack on popular leader Hu Yaobang, who was a reformist. The only person to stand up to Bo Yibo in defence of Hu Yaobang was Xi Zhongcun. Today, as the younger Bo awaits his fate at the hands of the Communist Party machine, it is Xi Zhongcun’s son Xi Jinping, the new Secretary General of the Communist Party and soon-to-be President of China, who will ultimately decide Bo Xilai’s fate.

Personally, I found the book to be a little rushed in the writing style, and in the proofreading - there were numerous punctuation and grammar mistakes, which is probably Penguin’s fault. Perhaps John was trying to get the book out before others dealing with the same subject. And let’s face it, the story is not finished yet - Bo’s trial has not yet taken place. (John closes the fall of the house by discussing the plight of the youngest Bo, Bo Guagua, who is currently living in the USA.) But for a lesson on how deeply personal politics is, even in a country whose politics are as opaque as China’s, this is an excellent read.

I suspect this book is also banned in China. I bought both via Amazon, where I have an Australian address.