Earnings Call Transcript - AA Q1 2020

Operator, Operator

Good afternoon, and welcome to the Alcoa Corporation First Quarter 2020 Earnings Presentation and Conference Call. All participants will be in a listen-only mode. The operator provided instructions. After today's presentation, there will be an opportunity to ask questions. The operator provided instructions. Please note this event is being recorded. I would now like to hand the conference over to James Dwyer, Vice President of Investor Relations. Please go ahead.

James Dwyer, Vice President, Investor Relations

Thank you, operator, and good day everyone. I'm joined today by Roy Harvey, Alcoa Corporation’s President and Chief Executive Officer and William Oplinger, Executive Vice President and Chief Financial Officer. We will take your questions after comments by Roy and Bill. As a reminder, today’s discussion will contain forward-looking statements relating to future events and expectations that are subject to various assumptions and caveats. Factors that may cause the company's actual results to differ materially from these statements are included in today's presentation and in our SEC filings. In addition, we have included some non-GAAP financial measures in this presentation. Reconciliations to the most directly comparable GAAP financial measures can be found in the appendix to today’s presentation. Any reference in our discussion today to EBITDA means adjusted EBITDA. Finally, as previously announced the earnings release and slide presentation are available on our website. With that here is Roy.

Roy Harvey, President and Chief Executive Officer

Thank you, Jim. And thanks to everyone for joining our call. We will discuss our first quarter results in a moment. But first I want to pause in memory of Paul O'Neill, the former CEO of Alcoa Inc. He passed away on Saturday here in Pittsburgh. Mr. O'Neill was a visionary leader and mentor including to many in our company today. His legacy lives on at Alcoa. His principle to always focus first on safety and the protection of human life is timeless, especially as we face the current challenges. Our sympathy goes out to all who loved and respected him. Now this earnings call is going to be different. While we had a solid quarter and we'll take the time to explain our results we are living in unprecedented times. So before we discuss the quarter, I will talk about the impact of COVID-19 and what we're doing as a company in response. The pandemic has affected not only the way we work and interact with our global economy as well. While a lot has changed in the world our Alcoa values serve as unwavering guideposts. Those three values are fundamental to everything especially in times of crisis. We've kept them at the forefront. There is significant uncertainty due to the pandemic and its effect on the world's economy. As such we’ve decided to withdraw our full year projections on global supply and demand balances while we expect aluminum demand to be affected by government lockdowns and temporary closures from some end-use manufacturers the range of scenarios is too broad to forecast projections with a high level of confidence. We are closely monitoring our markets and we'll talk today about what we're seeing in our three market segments and how these changes impact Alcoa. In addition to our third-party sales of bauxite and alumina we produce a final commodity product aluminum that can be sold into the terminal market. Thus, shipments can continue unlike some other downstream industries, but given the build of commodity inventories, current dynamics can create longer term supply demand impacts once we see demand return. Just as our values have guided our response efforts, staying on course with our strategic priorities has enabled Alcoa to enter this period from a position of strength. Over these last several years we’ve taken numerous actions to improve our business and we implemented a number of actions earlier this year to continue that momentum. Today, we'll detail some additional actions to effectively manage our cash in 2020 due to the uncertainty of this pandemic. Taken together these new and existing initiatives including the sale earlier this year of our former Gum Springs plant will total $900 million in cash actions for the year. This will enhance our ability to weather this crisis and continue to improve for the future. Finally, as you recall it has been our practice to report any serious safety incidents as part of our quarterly earnings announcement. I'm deeply saddened and disappointed to report a workplace fatality, a tragedy unrelated to the current health crisis. On February 10th a contracted worker died after sustaining injuries at the Poços de Caldas facility in Brazil. This is unacceptable and we are working to make sure this doesn't happen again. While much focus is currently on COVID we are reinforcing to everyone at every location that safety is our most important priority and I would like to thank all of our employees for their efforts through this health crisis. The everyday actions to protect the safety of their fellow workers and to keep our plants operating makes me proud. Now I will discuss Alcoa's specific actions related to COVID-19. Our first and most important objective is the health and safety of our global workforce. Across our facilities we have comprehensive measures to minimize the risk of exposure to this virus. We have implemented response and preparedness plans to protect our people, our business and our communities. We are following protocols that align with the US Centers for Disease Control and Prevention, the World Health Organization and other public health authorities where we operate. Measures to protect our people include adjusting shift patterns, instituting additional hygiene protocols and ensuring the exercise of social distancing measures. Most of our administrative offices are closed as we've authorized employees to work from home where practical and possible. We also acted quickly to restrict all non-essential business travel beginning in late February and currently continuing. Our company's global crisis response team is meeting frequently and is continuously tracking any reported cases and ensuring that those who may be ill or were exposed to the virus observe quarantine protocols. In addition to the protection of our employees and our operations we are supporting our communities. The Alcoa Foundation has allocated a total of $4 million that can be used in our local communities for humanitarian aid projects. Our locations are working with qualifying non-profits to allocate this funding for the greatest impact. Now turning to our operations, we are still running our current portfolio of bauxite mines, alumina refineries, energy assets and aluminum manufacturing facilities. We continue to provide essential products and materials that are fundamental for society in the world's economies. Given the uncertainty of the current climate we're taking prudent steps to manage costs without compromising the safety of our facilities. First, we have instituted restrictions on new hiring, focusing only on what is essential to support the continued safe and effective operation of our facilities. Second, we are reviewing all non-critical maintenance activities that can be safely deferred. And third, we are also stopping or delaying the relining on some of our smelting pots depending on the individual circumstances at specific facilities. At the ABI smelter in Becancour, Quebec for example we've slowed the restart which is currently 85% complete to comply with restrictions in the Canadian province. The return to full operation was originally expected to be fully complete in the second quarter of 2020. And the timing for the full completion will be evaluated in the months ahead. Now let's discuss our three product segments and the impacts caused by the pandemic. Starting with bauxite, throughout the first quarter we saw steady demand outside of China as refineries largely operated without disruption. From a cost standpoint most of our bauxite mining expenses are fixed in nature apart from diesel fuel which we purchased at market rates. As noted here on Slide 7, our bauxite shipments and pricing in the first quarter were largely unaffected and we expect Alcoa's third-party bauxite shipments and pricing for the second quarter to remain relatively stable. Turning to alumina, our shipments were largely unchanged in the quarter. We have a strong cost position due to our integrated bauxite position and given the quality of Alcoa's bauxite and Alcoa's refinery design that is specific to each type of bauxite we use less caustic soda on a per ton basis than competitors. We also have an advantage in that when customers are impacted with curtailments we have the ability and commercial presence to shift to spot sales. For alumina shipments are continuing but with substantial pricing decline in the second quarter. This is a dynamic I’ll discuss on the next slide as well. In aluminum, Alcoa prices its products using the London Metal Exchange aluminum price, having relevant regional and product premiums for delivering into the markets to which we sell. From a cost perspective energy represents one of the largest input costs approximately 70% of our smelting production is linked to aluminum prices or short term wholesale power markets. Also as prices fall other input costs typically do as well, such as carbon, which we purchase quarterly. We produce a mix of higher margin value add primary aluminum products as well as lower margin commodity grade products at our smelters and integrated cast houses. In our products we have seen demand impacts. So we have started to shift some of our sales from value add castings to commodity grade products, and we will see this trend continue. In the second quarter we anticipate converting around 20% of previously allocated production from value add product sales to commodity grade ingot sales as some customers request shipment postponements or declare force majeure. Most of the decrease in our value add product sales is due to weakening demand from customers serving the transportation sector followed by customers in building and construction. This mirrors trends in the broader market as these are the two aluminum end use sectors most likely impacted by the economic impacts of COVID-19, the shift from value-add to commodity grade adversely impacts our revenue. This loss of product premium will be coupled with the substantial decline in aluminum pricing over the first quarter which I will discuss next. Considering the current uncertainty in the markets I believe that it is appropriate to lay out the facts and trends from the first quarter to explain what we are seeing. Lower prices, inventories that are higher than last year and a growing number of producers underwater financially. Aluminum demand is likely to be impacted significantly by government lockdowns and plant closures starting in China and moving around the world to two of our major markets Europe and North America. As I noted earlier out of the different aluminum end use sectors this impact is likely to be felt most strongly in the transportation sector where automotive plants have been shut down for varying lengths of time followed by the building and construction sector where the projects have been slowed or delayed in the first quarter. While aluminum demand is likely to have decreased in the first quarter of 2020 in particular in China primary aluminum smelters continued to produce without significant interruption for most of the quarter. This resulted in an over 2 million ton increase in global inventories largely seen so far in China. While we normally see some stock building in China in the first quarter due to the Chinese New Year holiday this year's increase in inventories was likely three to four times the size of the Chinese stock build we saw during the first quarter of 2019. Given these dynamics aluminum and alumina prices decreased over the quarter. With the lower prices have driven significant levels of production into cash negative territory. We estimate that 60% of Chinese smelters and 20% of smelters in the world outside of China were in a cash negative position for the month of March. We also estimate that 40% of Chinese refining production was cash negative for the same period. In turn we have started to see the beginning of a supply response. In aluminum it has been reported that smelters have cut 1 million tons of annualized capacity in China and 400,000 tons of annualized capacity outside of China between March and April. In alumina Chinese refineries cut 6 million tons of annualized capacity in February with 2.5 million tons remaining in a curtailed status today. I would call your attention however to the fact that these dynamics and prices can change dramatically. Since March we have seen a decline in alumina prices which creates a larger group of underwater refineries but with corresponding input cost relief in smelting. Most important however is the relationship between supply, demand, inventories and pricing. There is near-term support to the industry given the ability to deliver aluminum into inventory. However this release can quickly become a long term drag given the new demand fundamentals. Looking forward what is clear is that the ultimate supply demand balances this year will be determined by a few factors. First and foremost how fast the spread of COVID-19 is brought under control. Second once the pandemic is under control the speed at which economies recover will depend on how governments lift lockdown measures and implement stimulus programs. With a return of economic activity aluminum demand will pick up across its broad set of end use markets which includes transportation, construction, packaging machinery, electrical and consumer durables. Third, the entire aluminum value chain will respond to the pricing and demand environment as it shifts and changes. This is where we could see further capacity curtailments depending on the strength and demand. It is clear however that the current market is in an oversupply situation. Alcoa will continue to monitor this situation and may need to mix further curtailments if this supply and demand situation persists. Needless to say we will discuss these trends in more detail as the year progresses and as more clarity develops about the ongoing situation. Next, I wanted to lay out a simple timeline that summarizes the actions we've been taking to further improve our company, including the most recent initiatives associated with our response to current market conditions. We have been consistently focused on acting smartly through the cycle including preparing for downside scenarios, and we have worked tirelessly to strengthen our balance sheet. We have initiated programs to strengthen our portfolio and company for the long term. I am pleased that we started deploying these actions during better times, they provide a solid foundation and clear pathway during the current challenges. Let's turn to the information on slide 9. First starting on the left, in October of 2019 we announced key strategic action that included a new operating model that reduced overhead and made us a leaner organization. That is important because it enabled faster decision making. The model is now fully implemented and will provide $60 million in annual savings beginning in the second quarter of this year. At that same time we announced a plan to generate between $500 million and $1 billion through the sale of non-core assets. In January of this year we completed the sale of our Gum Springs plant in a deal worth $250 million and we will continue to pursue the remainder of this target. Our other strategic action was the launch of a multi-year review of our operating portfolio focused on 4 million metric tons of global refining capacity and 1.5 million metric tons of smelting capacity which is approximately 50% of our aluminum portfolio. Today we're announcing an action connected to our portfolio review, the curtailment of the remaining capacity at our Intalco smelter in Washington State. While our employees have worked tirelessly to improve the facility, the smelter faces significant cost challenges that have only been exacerbated by these poor market conditions. In the first quarter of 2020 Intalco lost $24 million and aluminum prices have fallen more than 20% down 45% from highs in 2018. We recognized the impact this decision has on our workforce so we will ensure appropriate support as we work to safely curtail the facility. As I've said before we owe it to our employees and communities to work through this portfolio review as quickly as possible and we will strive to accelerate this process to provide clarity for the future. Next in the middle of this chart in February we announced two planned programs to further our improvement in 2020. First, driving leaner working capital that should result in savings between $75 million and $100 million by reducing inventory and optimizing contract terms. Second, we continue to expect approximately $100 million in sustainable and annual productivity improvements. These previously announced actions provided a head start on what we're doing next, implementing comprehensive actions to conserve and manage our cash during the current down cycle that is magnified by the impact of COVID-19. On the right hand side we have our COVID-19 related actions to date. We are reducing our annual capital expenditures effectively stopping work on most return seeking capital projects for the remainder of the year. We are evaluating various governmental programs in the jurisdictions where we operate and we intend to use provisions in the US Government CARES Act to defer this year's pension contributions. We will also implement other across the board spending cuts which Bill will discuss with more details shortly. Importantly, all of these initiatives including the one completed asset sale are expected to total $900 million in cash actions this year. Again, our work to hone our strategy gave us a head start to manage through this downturn and we will move aggressively to strengthen our company so we can thrive in the future. So, with that I'll turn it over to Bill to dig into the details on the first quarter results and our cash management strategies. Bill, please go ahead.

William Oplinger, Executive Vice President and Chief Financial Officer

Thanks, Roy. We streamlined the financial results section and this first slide provides key financial highlights. Detailed slides are in the appendix. First quarter 2020 revenue was down $55 million sequentially on seasonally lower alumina volumes and by resell activity in aluminum and lower realized aluminum prices. Net income attributable to Alcoa Corporation was $80 million or $0.43 per share and includes the gain on sale of the Gum Springs treatment facility. Adjusted EBITDA excluding special items was $321 million generating an EBITDA margin of 13.5%. The adjusted net loss was $42 million or $0.23 per share also on an adjusted basis, the operational tax rate was 78.5%. Let's look closer at factors driving adjusted EBITDA. Adjusted EBITDA excluding special items declined $25 million in the first quarter. The strength of the US dollar combined with favorable energy impacts and lower raw material costs more than offset lower alumina and metal prices. First quarter EBITDA includes a $36 million benefit from revaluation of receivables and payables due to substantial changes in the quarter and currency rates. In the operating segments bauxite and aluminum EBITDA’s declined sequentially but were more than offset by improved alumina earnings. Lower bauxite prices on intercompany sales impacted bauxite segment earnings, but resulted in lower bauxite costs in the alumina segment. The stronger US dollar created benefits mostly in the alumina segment, which also saw lower caustic and energy costs. In the aluminum segment lower realized metal prices were partially offset by lower alumina and carbon costs. Price mix was unfavorable sequentially on the mix of smelter grade alumina contracts and lower chemical grade alumina pricing as well as lower external bauxite price. Volume was down in all segments on seasonal factors but driven largely by scheduled maintenance activities in alumina and bauxite. Production costs were unfavorable in aluminum primarily at work rolling. In other transformation costs were higher sequentially due to no longer receiving certain energy revenues and the addition of Point Comfort closure costs. Intersegment eliminations declined $48 million sequentially as more stable alumina prices meant no further profit was released from inventory. Moving to the key financial metrics and cash. Difficult for the first quarter are our days working capital increased sequentially up four days to 31 days but improved four days year-over-year and was an encouraging start to our working capital reduction efforts. Capital spending was $91 million up $22 million year-over-year primarily due to a mine move occurring in Australia. These factors combined with lower EBITDA to generate negative free cash flow less NCI distributions of $212 million. Our key balance sheet metrics, proportional adjusted net debt was flat this quarter and appropriately does not reflect the remeasurement of pension and OPEB assets and liabilities that occurs at year end. We ended the first quarter with cash of $829 million down $50 million sequentially. A quick review of our major cash sources and uses for the first quarter of 2020. Our total cash sources were $520 million consisting of $321 million in adjusted EBITDA and a $199 million in net proceeds from asset sales. Our largest outsourced cash were $150 million working capital use, $91 million of capital expenditures, $70 million of tax payments, including $32 million in payments of prior year income tax, net distributions to our joint venture minority interest partner of $31 million as well as $75 million of pension, and post-employment benefits funding made in addition to $15 million related expenses with an adjusted EBITDA. Outflows also include approximately $37 million in restructuring payments primarily for implementing the new operating model and smelter divestitures. Now let's take a look at our pension and OPEB net liability which has impacts on the balance sheet and cash flow. Based on many questions from you we have summarized the balance sheet and cash flow impacts from our pension plans, pension and other post-retirement benefits have important balance sheet and cash funding impacts. On the balance sheet there is three key points to consider. The net pension liability is completely re-measured at year end, not every quarter. Factoring in all payments funding, asset returns, demographic changes and discounted using year-end rates. The OPEB liability is similarly remeasured at year end using a similar year end discount rate. The pension funds are invested across numerous asset classes including fixed income, returns were negative approximately 7% in the first quarter. The pension OPEB discount rate approximate a 10 year to 15 year investment grade corporate bond even while Treasury bond rates fell in the first quarter, discount rate rose roughly 20 basis points from year end to the end of the first quarter. In sum our asset returns and discount rates are variable and subject to change. If we assume that we received our expected return on assets for the last three quarters of the year and we assume that no change in the discount rate occurs from March 31 and funding and other normal adjustments are in line with our outlook we would anticipate our year end 2020 pension OPEB net liability to be approximately the same as the balance at year end 2019. There are several factors that dictate the amount of pension and OPEB funding required every year and especially in 2020. Funding requirements for 2020 are set and based on smooth asset performance and 25 year average segment rates mandated by the IRS. This year the CARES COVID-19 stimulus package allows deferment of $220 million of pension payments until January 1, 2021, and we have elected that option, thus funding for pension and OPEB from cash flows in 2020 is estimated to be $108 to $180 million down from $400 million. Next year we could use our $382 million pension pre-funding balance instead of funding the pension entirely with operating cash flows. Let's now look at our debt and cash position. First we have a very solid credit position with no significant debt maturities until 2024. At quarter end we had cash of $829 million and no borrowing against our two credit facilities. This month we amended our revolver to temporarily increase borrowing base availability for the next four quarters. That change occurred while in February we disclosed working capital and production cost reduction programs targeting up to $200 million in 2020. And we just mentioned the CARES deferment until 2021 of $220 million in pension funding. We are taking several more actions to improve our cash position; they include reducing capital expenditures by $100 million, deferring environmental and ARO spending of $25 million and a number of other cash conservation measures that are expected to total $35 million. Let's see how it all adds up, our cash actions announced so far this year add up to an approximately $900 million benefit in 2020, some cash impacts are ongoing and have an annual run rate some are one-time savings and some are deferrals until a later year, but all of them are designed to improve our cash position in 2020. Of the $900 million of cash benefits related to our three key strategic actions totaled approximately $300 million and include overhead reductions, our Gum Springs asset sale and the Intalco curtailment. The 2020 programs for working capital and production cost reductions target another $175 million to $200 million. Another approximately $400 million comes from our newly announced COVID-19 response. While $900 million is an impressive start, we're not done. For example, while Gum Springs is our first completed non-core asset sale we continue to pursue the remainder of our $500 million to $1 billion target. We realize that these exceptional times require continued efforts to maximize all of our cash programs. Finally, let's review our full year outlook for 2020. Our full year 2020 outlook although being subject to change based upon the evolving COVID-19 situation is our best current estimate and reflects the actions described earlier. For example, the curtailment of Intalco is expected to reduce our full year aluminum shipments. So, we are adjusting that full year outlook approximately 100,000 tons to a range of 2.9 million to 3.0 million tons. Earnings related impacts reflect lower spending. We expect transformation EBITDA impact to improve $10 million to approximately $75 million. We also expect other corporate EBITDA impacts to improve $10 million to approximately $90 million. We expect interest expense to increase slightly to a range of $125 million to $130 million as lower capital spending will mean lower interest capitalized as part of major projects. Finally, until further notice we’re not providing an outlook for the full year operational tax rate. With the current situation so uncertain we cannot predict with sufficient confidence the 2020 taxable earnings across our businesses. The largest changes in our outlook can be seen in our cash flow impacts. Minimum required pension and OPEB funding is expected to decrease from $400 million to $180 million, a result of the CARES pension funding deferral until 2021. We're cutting our estimated capital expenditures by $100 million effectively stopping return seeking capital spending for the rest of the year and reducing sustaining capital spending. We are also reducing environmental and ARO spend of $25 million to a targeted $125 million. In the appendix we also listed additional consideration expected for the second quarter. They include, in the bauxite segment adjusted EBITDA it's expected to be $10 million lower primarily due to non-recurrence of an annual sales contracts true up. In the alumina segment we are expecting lower raw material costs to yield $10 million sequential benefit. In the aluminum segment lower alumina costs are estimated to produce a sequential benefit of $15 million and benefits from lower smelter power costs will be more than offset by lower Brazil hydro sale prices while lower value-add pricing and volumes will be partially offset by production cost improvements yielding an expected $10 million sequential decline. Due to an unusually large change in quarter end exchange rates first quarter 2020 adjusted EBITDA included a balance sheet revaluation benefit of $36 million and a $41 million sequential benefit compared to the fourth quarter of 2019. Currency changes related to balance sheet revaluations are not incorporated into the current key sensitivities provided for EBITDA. So now let me turn it back to Roy.

Roy Harvey, President and Chief Executive Officer

In closing as we move forward through this period of instability and uncertainty we will continue to execute against our company's three strategic priorities. First, we remain focused on being a low cost producer which means reducing complexity to better compete through all parts of the cycle in our commodity markets. Second we intend to improve our margins and invest to drive returns when markets offer us this opportunity. And finally we are working to advance sustainably which includes actions toward a strengthened balance sheet, a cycle proof portfolio, and an enhanced reputation for environmental and social excellence. There are three major points I want to leave you with today. Most importantly we are focusing on meeting the fundamentals of this crisis. That means continued vigilance and mitigating risks for our people and operations. We are prioritizing keeping our people safe and healthy, keeping our operations running, and helping our communities navigate this crisis. Next our early action helped us prepare for the economic challenges presented by the COVID-19 pandemic. With a stronger balance sheet, we are well positioned to act smartly and to continue executing on our strategic priorities and the actions that we announced prior to this crisis. Finally, we are adapting to this unprecedented situation quickly, having a clear direction ensures that our short term reactions will help accelerate our long term direction to enhance the competitiveness and profitability of Alcoa. And with $900 million of 2020 cash improvements already underway it gives us a solid foundation to continue to build our future. And with that, Bill and I are ready to take your questions.

Operator, Operator

We will now begin the question-and-answer session. The operator provided instructions. Our first question will come from David Gagliano of BMO Capital Markets. Please go ahead.

David Gagliano, Analyst

Okay, great and thanks for taking my questions. My first question is really just a bit of a clarification question, on the $36 million that was included in the $321 million adjusted EBITDA, where is that in terms of the segment results? Is it most of that in the alumina segment or if not can you break that out by segment too? That’s my first question.

William Oplinger, Executive Vice President and Chief Financial Officer

Hey, Dave. Yeah it’s mostly in the alumina segment. So let me give you a breakdown, $2 million in bauxite, $28 million in alumina and $7 million in aluminum and I know that it doesn’t round to $36 million but it's just around it.

David Gagliano, Analyst

Okay, all right, great, thanks. I have a bigger-picture question. If you play with the sensitivities in plugs and spot, even after giving all the benefits for the operating model, the Intalco shutdown, productivity improvements and cost actions, it is still a very low run-rate EBITDA on the annual numbers. I'm guessing a lot of that is in the aluminum segments. So what other actions is Alcoa considering at the moment, given the backdrop of a big drop in all three of the main drivers, premiums included?

Roy Harvey, President and Chief Executive Officer

Yeah, let me hit that one first Dave and then probably it’s worthwhile for Bill to chime in as well. I mean the fact is that we’re trying to look at this in a very staged methodology. We’re trying to read a bit what we’re interpreting from the markets and then take actions that correspond to what we see both in the immediate term and further out. At this point and you've seen the list of things that we've already put into place I'm assuming you're looking for what else could be done. You know we've been trying to focus on doing what does not have long term or create long term issues or even medium term issues. So good example are the mine moves, we're continuing with the mine moves because those have immediate impact if you choose not to do them just on grades and then also on haul distances. So right now because we're in the cash position that we're in, and as we project that forward because of the liquidity, we feel that we do not need to take actions that cut deeper into some of those sort of emergency measures that we could take. Now the fact is and depending on when we start to see demand return, we're starting to see more of a supply response that starts to bring balance back in and then with the resulting change in pricing. We have a series of actions that we can continue to take, and those actions run the gamut from additional curtailments looking at each plant on a specific operation by operation basis, it also steps into further capital reductions, choosing to defer more maintenance, et cetera. So there is realistically a pretty large set of actions that we have chosen, specifically chosen not to move forward with and thus as conditions change and as that pricing environment changes we'll be ready to start stepping into those cases as that is needed. I don't know Bill if you want to add to that.

William Oplinger, Executive Vice President and Chief Financial Officer

I don't know there's a whole lot to add Roy, other than the fact that, Dave you've seen us over the course of about three and a half years now and we take action and we've laid out, and we started back in October where we announced the strategic review, we've taken action on the strategic review between the Point Comfort closure and now the Intalco curtailment. You know we're stripping out the overhead and then today we announced a series of COVID actions to enhance liquidity. And you know we’ll continue to do what needs to be done to improve the business. And as Roy said, we're doing it with an eye towards the long term, but we clearly understand the situation in the near-term. And it's just the management team that doesn't sit back and I think we've seen that over the last three and a half years.

Roy Harvey, President and Chief Executive Officer

I'm chime back in with one more comment Dave, if you don't mind. You know I think as we sat here a year ago, and we're really getting deep into some of those strategic reviews and thinking through where does Alcoa need to be for the long-term. And obviously and I'll be the first to tell you we had no expectation that there would be a global pandemic that would then create the knock-on market impacts. However when we looked forward we did really think about what is necessary in order to make our portfolio and stable of operations be as cycle proof as possible. And so I would argue that the fact that we started moving in October and that we have been taking phased actions since then, I am really, really pleased that we did that at that point because it helps us react more quickly and gives us more space and more liquidity so that we can make our actions thoughtful and also make them as powerful and impactful as they need to be. I think since separation I remember one of the things I had been consistently saying is that we as a company we want to do smart at the uptimes and we also want to do smart at the downtimes as well. And so that is exactly what we intend to do, and like Bill said I’m not thinking but he could say it better. We are a team that chooses to take actions on our own terms, so that we can make this company better.

David Gagliano, Analyst

I appreciate that. Thanks for those comments. Just if I could just jump in with one more the follow up there, if you know we've got an inventory problem, we've got a demand problem, and if that continues to bleed into a lower for longer pricing problem like we saw a while back, can you give a sort of a framework about how much capacity on the smelting side Alcoa is willing to take out of the market, either on a percentage or production basis? Obviously without going smelter by smelter but just can you give us a sense of things the way they are on pricing say for the next six months what should we expect in terms of the next moves on smelting capacity cuts.

Roy Harvey, President and Chief Executive Officer

Yeah. It’s hard to quantify Dave, and specifically because it’s very dynamic, and as you can imagine pricing changes depending on what's going on with some of our competitors and around the aluminum industry. The fact is that we announced a million and a half tons review. And so that is the list of places where we are where we need to be taking action and those actions can result in improvements to the bottom line. As you can imagine there is a bunch of changes going on in some of the input costs that can mean new power contracts but it can also mean curtailment or shutdown. So we take that very, very seriously, and as you’ve seen we've taken a couple of steps already Intalco being the one that has the impact on actual operated tons. We continue to monitor and will act as necessary.

William Oplinger, Executive Vice President and Chief Financial Officer

You've got to go back to the 1.5 million metric tons, out of that 1.5 million I believe around 900,000 is operating today. We announced Intalco. And you know we continue to move forward on the strategic review and the current market conditions make that strategic review even more important, and you know really push us to make decisions quicker.

David Gagliano, Analyst

Okay. That's helpful. Thanks very much.

Operator, Operator

Our next question will come from Curt Woodworth of Credit Suisse. Please go ahead.

Curt Woodworth, Analyst

Yeah. Thanks. Good evening. From a modeling perspective it's pretty challenging at least on the smelting side right now because you've got a lot of delays in your cost structure and from I think about 70% of your power costs are only linked, alumina flows through on a month lag, and then right now obviously you're going to see much better shape premium if you go more and get away from cast house products. So I guess the question and then you have Intalco on top of that. So could you estimate or give us a rough sense for if you were to assume kind of spot assumptions for these things what the profitability of the smelter business would look like today?

Roy Harvey, President and Chief Executive Officer

No Curt, we don't provide that. I think the best thing that you can do is what you alluded to and that is take a look at both the sensitivity page and the cost structure page, and the cost structure will help you model through how the cost flow through for the smelting system. And then on top of that we've given you an indication of how much profitability Intalco will contribute this year by the fact of having it curtailed. So you can factor that into the model and like you said unfortunately premiums and value-adds have come down so that's negative. But we don't provide necessarily a breakeven per se or a breakout specifically around the aluminum business.

Curt Woodworth, Analyst

Okay. And then with respect to the pension and OPEB liability the fact that there could be flat this year despite what we're seeing is pretty remarkable and I realize that part of that is the benefit of the CARES Act. But since quarter end S&P is up roughly 12% so it seems like they're in a pretty healthy position relatively speaking from what I think a lot of us have thought. Could you look to do anything further with your pension funds amortizations and as you get more proceeds from asset sales are there other things you're looking at with regards to derisking your pension exposure?

Roy Harvey, President and Chief Executive Officer

Yes. So and I'm glad to make the point. When we look at the March end discount rate and when we look at the March end asset return rate and we all know that the first quarter on asset returns weren't great and I believe our asset returns were about minus 7% and then we factor in that we think we can make our expected return on assets for the last nine months of the year. So we need to earn roughly 6% on the rest of the year assets which if you consider how low they were at the end of March is probably viable, and we bake all that in and assume the discount rates don't change the pension and OPEB liability would be pretty close to flat year-over-year. Now clearly in this very volatile market returns are changing daily, discount rates are changing by the minute. And so that's just a moment in time projection, but it gives you an indication of where our pension is. So could we do more? Yes, we have the opportunity to do more annuitizations, we consider it from time to time. And you know it's we've got a two year to four year plan to get our adjusted net debt down to $2 billion to $2.5 billion and the way we're most likely going to do that is through the pension. And so, I guess to summarize my comments the pension is a focus area for our company, it has been since the first day, we originated and we've continued to work it down and will continue to work on it going forward because it’s part of the capital allocation model that we've laid out pretty clearly.

Curt Woodworth, Analyst

Okay. And then just one follow up. You said the pre-funding balance, I think was $382 million close to $220 from CARES act, I was under the understanding that you could use a $500 million pre-funding from the debt you got in 2018 so is some of that pre-funding effectively being completed by the CARES number or if you just kind of update from that?

Roy Harvey, President and Chief Executive Officer

A little bit of the pre-funding was used during the course of the year to keep the pension at the level that they're at. Just to make it clear the CARES Act allows us to defer any contributions into the US pensions without using the pre-funding balance. So we will come into the year with not having made the pension contributions this year we'll have to catch them up next year but we will have our full $382 million pre-funding balance available to us. So as you look at next year if we, if we do choose to push out all of our pension contributions the pension contributions next year are high and then we can use that pre-funding balance to offset much of the pension contributions next year.

Curt Woodworth, Analyst

Okay, thank you very much I appreciate that.

Operator, Operator

Our next question comes from Timna Tanners of Bank of America. Please go ahead.

Timna Tanners, Analyst

Hey, good evening and hope everyone is healthy and all right. I wanted to ask two questions. The first one is heading into this call we were struck, our whole metals and mining team was struck with how aluminum was the one commodity maybe with the least supply response so you've taken a dent to that with the Intalco difficult decision, but I just wanted to first ask if you could explain or remind us when you curtail that is it permanent or is that temporary and how to think about that. And then in the same vein do you expect other actions by other participants because that has been kind of striking how little supply response we've seen relative to other commodities?

Roy Harvey, President and Chief Executive Officer

Thanks for the question Timna. Intalco is a decision to temporarily curtail so it doesn't mean or we don't mean to project forward and say whether it will return to operations or won't return to operations. What I will say is, is that when we make a curtailment decision we do it not just with the current pricing in mind but also looking forward a number of years and so it is not necessarily just meant to represent the world as we see it right this very second, and we do look forward at least 12 months to 18 months. And so when we then transition it over to a broader view of the market, we certainly can't project or indicate where our competitors are going to act. When we look at the facts as they sit today, and you see it with the 2.5 million tons of inventory that was put into place over the course of Q1, the fact is that we are in an oversupply situation. And you are seeing the price response which is complex but the most important long term aspect is supply and demand. It means that we as an industry are producing more than required by our customers. And so that would argue with basic economic theory that pricing is going to incentivize curtailments. And when we look around the world and as you can imagine this moves pretty quickly because as we saw alumina prices come down over the last couple of weeks, it changes the dynamics inside of smelting. But as you look around at what's happening with pricing on both China and the rest of the world, the fact is there is a pretty significant chunk of underwater capacity. So you see curtailments and reductions. We do expect and hope that demand will come back as social distancing measures are lifted, treatments improve or a vaccine is found. But as we look at it today there is an incentive because of pricing and the oversupply condition that will create a significant issue if we don't see that supply response.

Timna Tanners, Analyst

Thank you. And the other question I wanted to ask and hopefully just get a little more clarification on is the comments you made about the cast products premium and to get a little more color about how long that could last. That transition moves — is it just a function of some of your higher end applications for aluminum not demanding as much like auto and aerospace for example and therefore you are making more commodity grade because there is demand there or does that just last as long as that condition lasts, or is there anything I'm missing?

Roy Harvey, President and Chief Executive Officer

So on that one you have to divide it into two pieces. There is the premium impacts that we were seeing particularly on cast product sides. We were seeing some pressure on premiums coming into 2020 even before COVID because of supply dynamics in North America and Europe. COVID has exacerbated that because of demand reductions. You have seen a number of downstream customers pause production which lowers demand for value-add alloys. Some of that will correct itself if curtailments occur across smelters and cast houses, but the timing is uncertain. Also, in Europe premiums are negotiated quarterly and in the US annually, and there are distortions this year because of many customers pushing out shipments or citing force majeure. In short, premiums are under pressure for multiple reasons and we will see how the market balances out as curtailments and demand changes occur.

William Oplinger, Executive Vice President and Chief Financial Officer

If I can add simply, it’s showing up all over the place. Automotive manufacturers are curtailing production so foundry alloys and extruders don't need product. Instead of making foundry alloys or value-add products, some producers are producing commodity grade ingot for traders or warehouses. That means you're not earning the value-add premium. We noted converting roughly 20% of allocated production to commodity ingot in Q2, which reflects that dynamic.

Timna Tanners, Analyst

Okay great. Thanks a lot.

Operator, Operator

Our next question comes from Carlos De Alba of Morgan Stanley. Please go ahead.

Carlos De Alba, Analyst

Hello. Good afternoon, everyone. First question maybe Bill can you clarify on the slide 16 the comments about leaner working capital that one-time $75 million to $100 million and presumably this is for this year. We saw in the first quarter working capital change what's driving to cash flow generation so can you maybe give a little more color as to how you see these playing out throughout the year?

William Oplinger, Executive Vice President and Chief Financial Officer

Sure. It's really two things. With lower alumina and aluminum prices and raw material prices we should see our inventory values go down. Essentially we're suggesting that if you look at the hard dollar days working capital at the end of 2019 we should be able to see $75 million to $100 million reduction off that working capital level which results in cash generation for the year. We call it one-time because we don't know what we'll do in 2021. On top of that, our new operating model looks at supply chain end-to-end—raw materials, work in progress, finished goods, receivables and payables—tasked with driving out working capital. The combination of naturally lower prices and this program is the source of the $75 million to $100 million. First quarter was up as usual due to seasonality but we expect to recover and get to a lower level by year end assuming prices stay roughly where they are.

Carlos De Alba, Analyst

Great. And the second question is other than the reduction in net cash flow generation and performance of the business is there any room for reducing distributions to the non-controlling interest given what is going on in the market and economy?

Roy Harvey, President and Chief Executive Officer

Carlos, the non-controlling interest relates to our joint venture with Alumina Limited (AWAC). AWAC makes distributions to its partners based on JV cash flow and there is limited flexibility. We receive dividends eight times a year from AWAC and the structure of those payments is well established. So there is very little room to alter those distributions in the short term.

Carlos De Alba, Analyst

Right okay. And if I may squeeze one more. Roy any comments you can make on ongoing conversations with potential buyers given what is happening right now? Are you able to engage potential buyers or has that process been pushed out until when things normalize?

William Oplinger, Executive Vice President and Chief Financial Officer

Gum Springs closed in January and was a good outcome at $250 million in value with $200 million cash received and $50 million contingent. That was pre-COVID. As for further asset sales, COVID has made things slower and has added volatility; it has made outreach and transaction processes more difficult because you can't have normal in-person meetings and asset reviews. We continue to pursue our $500 million to $1 billion target, but processes are slower in the near term.

Roy Harvey, President and Chief Executive Officer

Thanks, Carlos.

Operator, Operator

Our next question comes from Chris Terry of Deutsche Bank. Please go ahead.

Chris Terry, Analyst

Hi, Roy and Bill. A couple of questions for me hopefully short and sharp. On the $100 million that you highlight in reduced production cost year-on-year, is that your forecast of what will be the benefit from low overall materials being caustic, carbon, diesel etc., or is that something you've achieved regardless of that and there's more potential cost cuts beyond that if raw materials decline from here? Thanks.

William Oplinger, Executive Vice President and Chief Financial Officer

I'll jump in: the $100 million is not purely raw material price decline. It is productivity improvements: blocking and tackling, improvements in MRO and services spend, carbon consumption improvements, and productivity that yields more tons for the same cost base. Separately we would expect lower raw material prices year-over-year to provide a couple hundred million dollars of benefit. So the $100 million is the sustainable productivity program and lower raw materials are an additional benefit.

Roy Harvey, President and Chief Executive Officer

To complement Bill's comment: this program was constructed prior to COVID and pre-existing pricing pressures. With the new operating model we are focused on what is within our control at the plant and department level. These are sustainable improvements that reduce complexity and drive us down the cost curve over the long term.

Chris Terry, Analyst

Thanks. On slide 16, the $225 focusing on the run rate bucket, how can you split that up into what's inside the AWAC JV and what's not?

Roy Harvey, President and Chief Executive Officer

We don't provide that level of split detail for that bucket in the public presentation.

Chris Terry, Analyst

Is the $100 million of CapEx reductions deferred or permanently saved from previous guidance?

William Oplinger, Executive Vice President and Chief Financial Officer

Some of that will be deferred. We're being aggressive in lowering capital spending and have stopped return-seeking projects for the remainder of the year, prioritizing sustaining projects and cash preservation. We'll assess deferred versus permanent changes as we finalize year plans.

Chris Terry, Analyst

Last one: you pulled the total market outlook but retained your own volume guidance. Is that because you have visibility on your internal operations and portfolio and will adjust guidance if you take further curtailments?

Roy Harvey, President and Chief Executive Officer

Yes. The guidance provided is based on our current portfolio actions, including Intalco. If we take further curtailments we will update the shipment guidance. The outlook reflects current operations; we will modify it as we take new, definitive actions.

Operator, Operator

Our next question comes from Alex Hacking of Citi. Please go ahead.

Alex Hacking, Analyst

Thanks. You mentioned converting about 20% of your value add sales to ingot. Is that a proxy for where you see US and European alloy demand right now? And could you quantify how you see the different end use segments performing? You also noted construction demand was weak—some other construction suppliers have been relatively stronger, any color there?

Roy Harvey, President and Chief Executive Officer

The 20% conversion is a second-quarter indicator based on orders and visibility we have two-thirds into the quarter. It tells us how customers are behaving early in Q2. We expect to see some return as social distancing measures ease, but we don't have confidence in timing yet. On construction, we do see some weakness in project activity which impacts aluminum demand from that sector in Q2. Other sectors such as consumer durables, electrical and packaging have been stickier year-over-year.

Alex Hacking, Analyst

One housekeeping: last quarter you guided bauxite EBITDA down ~$35 million. You did better than that—was that FX or other factors?

Roy Harvey, President and Chief Executive Officer

It was a combination of a stronger US dollar benefit and an annual sales contract true-up payment that increased realized bauxite revenue. The true up was about $7 million and the FX benefit helped as well.

Operator, Operator

Our next question is from Lucas Pipes of B. Riley. Please go ahead.

Lucas Pipes, Analyst

Hey. Good evening, everyone. What percent of revenues is aerospace including value-add and everything? And what sectors are stickier on demand—maybe packaging—what percent of revenue is that?

Roy Harvey, President and Chief Executive Officer

Aerospace is a small part of the overall aluminum market, roughly 1% to 2% of total aluminum demand in North America; it's important for value-add alloys but not a large driver of total metal demand. Packaging and other consumer-oriented sectors are generally stickier compared to transportation and construction at this moment. I don't have the precise percentage of revenue for packaging off the top of my head; we can follow up with that detail.

Lucas Pipes, Analyst

And in terms of international trade flows, are you seeing changes or distortions in trade patterns due to COVID—any notable shifts?

Roy Harvey, President and Chief Executive Officer

Early on there was concern about supply chain disruption from China, but as China ramped back and the rest of the world slowed, we didn't see major long-term distortions in bauxite, alumina, or aluminum flows beyond normal freight issues. Material is still moving; we haven't seen a systemic disruption to our ability to get raw materials to plants. For more granular component flows you would need to ask downstream manufacturers, but from our perspective flows have continued.

Operator, Operator

Our next question comes from Paretosh Misra of Berenberg. Please go ahead.

Paretosh Misra, Analyst

When you look at the aluminum futures curve and low interest rates do you think this is an attractive market for commodity traders to put on financing deals either in China or outside China similar to what happened in 2008 or 2009?

Roy Harvey, President and Chief Executive Officer

In contango markets where the futures curve is upward sloping and rates are low, the economic incentive to store metal exists. Historically these warehouse financing plays emerge when contango persist. We haven't seen a bottleneck that would prevent traders or banks from storing metal if the economics justify it. So the structure of the curve and low rates can make warehousing attractive; whether it happens depends on how long the contango persists and financing appetite.

Paretosh Misra, Analyst

And on bauxite pricing—any contracts coming up for true up in the next six to nine months, and how do you see bauxite pricing for the rest of the year?

Roy Harvey, President and Chief Executive Officer

Many bauxite contracts are longer term, though we do sell some spot cargoes that price to market. Domestic Chinese bauxite prices did come down with logistical normalization and domestic alumina changes. Import bauxite prices have been relatively steady but could see downside if global alumina prices weaken further. For Alcoa historically our bauxite pricing and volumes were steady in Q1 and we expect a relatively stable second quarter on third-party shipments, though the wider alumina market will influence prices.

Operator, Operator

Our next question will come from John Tumazos, a private investor. Please go ahead.

John Tumazos, Private Investor

Can you give us a flavor of what are some of the asset sales that might be possible 6 months or 12 months or 18 months out when things warm up a bit. Maybe the Point Comfort property in Texas is big and valuable for example and would you be a candidate for federal bailout funds that's intended for airlines or other hard hit industries and are there any other federal initiatives that might be practical for Alcoa?

Roy Harvey, President and Chief Executive Officer

We haven't announced specific asset sales beyond Gum Springs and the Rockdale land listing. Rockdale land is publicly for sale with a list price of $250 million and has been marketed for some time. As for Point Comfort, it's in closure and we will look to maximize value from that site over time. Regarding federal bailout funds, the items we discussed in the presentation reflect our current view of programs available, including CARES Act pension deferral options. At this point we are taking advantage of programs that are available and appropriate; we aren't aware of other specific bailout programs for our sector in the same way some auto or airline programs were structured.

John Tumazos, Private Investor

So we shouldn't assume there's another $100 million or $500 million loan potential like airlines or automakers have had?

Roy Harvey, President and Chief Executive Officer

Not to our knowledge at this point. These programs evolve, but what we've presented are the options we believe are available today.

Operator, Operator

Our last question will come from Andrew Cosgrove of Bloomberg Intelligence. Please go ahead.

Andrew Cosgrove, Analyst

Hi gentlemen. Thanks for taking my question. Just real quick on alumina, it came in quite a bit above where you thought it would land pricing-wise. Could you elaborate if there were any fixed costs or index lags associated with pricing in the first quarter?

Roy Harvey, President and Chief Executive Officer

No. Nothing unusual. The alumina segment benefited from the stronger US dollar which helped results. There was no unusual lag or fixed cost effect to explain the first quarter performance beyond the factors we've discussed.

Andrew Cosgrove, Analyst

Okay, great. And on the pension—just to clarify, next year contributions are between $350 million to $400 million in base; you have the $220 million deferment. Is there a limit to how much of the pre-funding balance you can use to apply against that and if returns and discount rates hold as discussed, how does that affect use of the pre-funding balance?

William Oplinger, Executive Vice President and Chief Financial Officer

Let me parse this. The balance sheet projection I described would result in a similar year-end funded position if returns and discount rates held as assumed. On cash contributions, the minimum required $220 million can be deferred into 2021 under CARES without using the pre-funding balance. Next year we do have a larger cash contribution requirement—approximately $350 million to $400 million. At that point we can use our $382 million pre-funding balance to offset those contributions. There is no specific legal limit to how much pre-funding we can use in a given year for the US plans; it is a tool we have to manage next year's cash needs. Pre-funding applies to US pensions only, not overseas plans.

Andrew Cosgrove, Analyst

Okay, great. Thank you so much for that. Very clear. Thanks and stay safe.

Operator, Operator

This concludes our question-and-answer session. I would like to turn the conference back over to Roy Harvey for any closing remarks.

Roy Harvey, President and Chief Executive Officer

Thank you, Andrea. And I'd like to thank everyone for your time today and for your questions. We're acting aggressively to improve Alcoa and make it through this uncertain time better and stronger. And as I said, I’m pleased that we were able to get started early to drive improved competitiveness for this company, and that we can build on that strong foundation. With that we look forward to discussing our second quarter 2020 results in July. Please stay safe and healthy everyone. Back to you, Andrea.

Operator, Operator

The conference is now concluded. Thank you for attending today's presentation. You may now disconnect.