Are the Airlines a Value Play? Alcoa Suggest They Are

Parsing through Alcoa's (NYSE:AA) earnings call, several items caught my attention as being inconsistent with what we're seeing in the charts.  For longer term investors, the clues provided by AA suggest that the airlines industry may be a hidden value gem with serious growth potential over the next 18-months.  Take a quick look at the Airlines Industry Index weekly chart (XAL) and you'll see that, after a very nice run that started in early October, 2011, the entire industry entered a correction in January 2015 and that correction has been in progress ever since. 

XAL Weekly Chart

The industry did find support at its 200-period moving average.  That's especially significant because it is a long-term level that large institutions and mutual funds track.  They not only use it to determine if a long-term investment is in an uptrend (above its 200-period) or downtrend (below the 200-period) but they will also use that level to place automated buy or sell orders.  Remember, only the large players have sufficient capital to move the price, so when you see an industry like this bouncing off its 200-period average not once but three times, you can be sure that the major investment firms are buying at that level.

In their earnings call yesterday, Alcoa told us that large commercial aircraft deliveries were down in the first half of 2016.  While that sounds like a negative, it really isn't.  There's an oversupply in the market right now, with Airbus reporting that they have 36 wide-bodies sitting idle just waiting for engines.  This is also a transitional period within several of the major providers as airlines are adjusting their fleets between narrow and wide-body aircraft.  Read some of the trade press exchanges between Airbus and Boeing for more insight into that tug-of-war.

Alcoa also referenced a "careful ramp up of new models" and lower orders for legacy technology.  This is due to a shift within the industry to new jet engine technologies that experienced some significant technical problems in the first half of the year.  Those problems at this point have been overcome, however, and the forecast through 2017 is for double digit growth.

Most telling of all is a single line in the Alcoa slide presentation that accompanied their earnings call.  They said, "Airline profitability is at an all-time high."  Now, as a major supplier of product within that industry, Alcoa would be in a great position to know the inside scoop.  The charts for the airlines are all in correction mode, oil and fuel prices remain depressed, and the International Air Transportation Association (IATA) continues to report strong passenger demand into 2016.

This divergence between the stock trends and the underlying industry data suggest that the airline industry as a whole may be undervalued.  Delta Airlines (NYSE:DAL) reports earnings before the open this Thursday (July 14) and we will be closely monitoring their earnings call for confirmation of Alcoa's assessment.

The other major players that we'll want to watch are General Electric (NYSE:GE) reporting July 22nd, and Boeing (NYSE:BA) reporting July 27th.  GE is a major jet engine supplier and Boeing, obviously, is one of the major aircraft manufacturers.  Remember, it's not their earnings that we're interested in, per se, but rather their assessments of the overall industry. 

By the end of July, we should have a very good idea as to where the airline industry is headed in 2016 and the first half of 2017.  If Alcoa's assessment is accurate, however, it would appear the industry is number one on the runway and ready for takeoff.

Alcoa Kicks Off Earnings Season After the Bell on Monday

The Brexit vote is behind us, the UK's selection of a new Prime Minister is still two months away, the US election is still four months away, the Italian banking crisis is simmering, but not boiling over (yet,) and yesterday's jobs report has put both the specter of recession and of interest rate hikes on the back burner, at least for now.  So what's next?  Why, earnings season, of course, and right on queue, Alcoa (NYSE: AA) is poised to kick it off after the close on Monday, July 11th.

Alcoa is one of the companies we closely follow, not just to understand the commodity landscape, but because their earnings calls typically provide an outstanding view of most industries in the industrial sector.  They are heavily dependent, not just on commodity prices, but on the performance of major players in Aerospace, Transportation, Mining, Automotive, and a score of other industries that all contribute to orders of aluminum or aluminum based products.  Getting a bead on Alcoa's outlook on the first day of earnings season provides a tremendous amount of insight into how the remainder of the season will go for most other industries. 

This quarter's earnings call will be even more interesting, however, due to the impending split of Alcoa into two companies.  We expect to hear more regarding the timing of the split and additional details as to the quarterly and annual outlook for the new company, named Arconic and trading under the symbol ARNC. 

Since Arconic will be focused on the Aerospace and Automotive industries, ARNC will be added to our short list of quarterly earnings calls to study.  Remember, there are a handful of key earnings calls that you should follow to give a broad overview of each sector and the market as a whole, and AA (as well as ARNC when they go public) are in that category.

So, what can we expect on Monday?  Well, AA is traditionally pessimistic in their outlook, however this quarter they appear to have good reason to be.  In the first quarter of 2016, AA experienced a significant drop in after tax operating income both in alumina (40% y/y drop) and primary metals (26% y/y drop.)  Revenue year over year was down 15%, and you can expect those struggles to continue.

What's worse for AA, however, is that China - the world's leading supplier of aluminum - is gearing up to increase year-over-year production by 4%, and that increase is expected to begin in the second half of this year.  According to Goldman Sachs, that will drive the overall commodity price of aluminum down from $1692 per metric ton as of yesterday's settlement price to as low as $1350 over the next twelve months.

The value-added business, however, is expected to see a boost, and it's that area in which we'll focus our attention since it will tell us the health of other industries. Sales to aerospace and automotives have been growing at a healthy pace and that is expected to continue with some reports looking at 5% to 8% growth in that division.

Overseas, expect the strength of the US Dollar - especially following the post-Brexit surge against the Euro and the British Pound - to produce negative headwinds for the remainder of the year.  The strong dollar hurts exports and also hurts earnings exchanges as goods and services flow globally.  Expect the impact of the strong dollar to be referenced in the reports of most companies in the S&P 500, as most have significant exposure overseas.

Towards the end of the week, we'll gain insight into the Financial sector when J.P. Morgan Chase (NYSE: JPM) reports before the bell on Thursday, however that's a topic for another post.  Stay tuned.

A Neutral Fed Announcement Spooks Markets

The Federal Open Markets Committee (FOMC) issued a statement today that sent the US markets into a nose-dive.  With earnings across most sectors disappointing the markets throughout January, and with economic data being a further disappointment, speculation on the street was pushing estimates of interest rate hikes out into the September time-frame.  The Fed dispelled those notions this afternoon, and the Dow tumbled 190 points in response.

In today's release, FOMC stated, "Based on its current assessment, the Committee judges that it can be patient in beginning to normalize the stance of monetary policy."  This is being interpreted as indicating a rate increase announcement no earlier than June, however it's not the dovish indicator the markets were hoping for.

It doesn't help that the FOMC's assessment of current economic conditions appears to be a bit rosier than those being seen by investors and traders.  Consider the following statements:

FOMC stated, "Labor market conditions have improved further, with strong job gains and a lower unemployment rate."  While it's true that unemployment has declined to about the 5.6% level, the Participation Index - a much more accurate measure of the workforce - has declined to its lowest level (62.7%) since 1978 and it continues to decline.  This would indicate that the number of eligible workers that are unemployed is increasing, not decreasing.  As to job gains, if you take Texas, Washington DC, Arkansas, and Utah out of the mix, the nation is actually shedding jobs at a rapid rate.  Almost all of the net national gains are coming just from the state of Texas.

Job Gains vs Unemployment

Here's the raw data just for Texas: Joint Economic Committee - Texas Economic Data

Next, the FOMC stated, "Household spending is rising moderately."  That's an interesting view, considering the Retail Sales number recently released was the largest decline experienced in 11 months.  If household spending is rising, one must question where they are spending it since it clearly wasn't in retail stores last month. 

They stated, "Recent declines in energy prices have boosted household purchasing power."  There's certainly more money in the consumer's pockets resulting from a decline in gas prices, however, as has been discussed several times over the past couple of weeks, there is no evidence that the consumer is spending that money.  In fact, there's evidence mounting that the decline in energy prices is about to have an extreme negative impact in the oil producing states that have driven the overall job growth since the recession.  With oil rigs closing, and oil companies starting massive layoffs, the conditions in states like Texas, Oklahoma, California, and North Dakota, among others, will quickly deteriorate.

Finally, FOMC stated, "Inflation has declined further below the Committee’s longer-run objective, largely reflecting declines in energy prices.  Market-based measures of inflation compensation have declined substantially in recent months; survey-based measures of longer-term inflation expectations have remained stable."  The problem with this statement is that both CPI and Core CPI are down.  This means that, even excluding food and energy, inflation is down. It makes sense, since wages are not increasing.  (Average in the latest release was a mere 1.7%.)  In other words, inflation is dropping, not because of energy prices, but because of a gradual softening of the economy as a whole.

What may have spooked the market the most is this phrase in their press release: "In determining how long to maintain this target range, the Committee will assess progress--both realized and expected--toward its objectives of maximum employment and 2 percent inflation." It's that "and expected" part that is disturbing.  Since their assessment of inflation to date is not accurate, the thought that they will react based on what they expect to happen implies a rate hike that will be premature in an economy that cannot tolerate it.

The only truly encouraging statement in the release is in the very last sentence: "The Committee currently anticipates that, even after employment and inflation are near mandate-consistent levels, economic conditions may, for some time, warrant keeping the target federal funds rate below levels the Committee views as normal in the longer run."  This is, from what we can determine, the only acknowledgement that there are global economic forces that are providing extreme headwinds to US economic growth.  The strength of the dollar, a crumbling European economy, the renewed threat of a Greek Crisis, and the evaporation of Russia's economy are enough to give even the most bullish investor pause.  Add to that a reduction in the rate of growth in China and India, and there's the prospect of a US economy barely able to sustain forward momentum.

We're nearing the end of this quarter's earnings season.  There are definitely very strong sectors that will provide excellent trading opportunities in this uncertain market.  Aerospace, Auto Parts, and Utilities are all looking pretty good right now.  Keep an eye on the remaining announcements, and trade into strength (or short into weakness, if that's to your liking.)  For now, though, expect volatility to remain high given the uncertainty around when the Fed will decide to move on rates.

GE Sees Strong Regional Growth, Large Impact From Oil

General Electric (NYSE: GE) released earnings yesterday, and provided a detailed sector by sector view of how 2015 should develop around the globe.  Confirming the outlook provided by other key global companies, they see strong growth in the US continuing through the next year.  Reading through their transcript, the forecast for India and China appears to be a bit more subdued, and the major drags on the world economy will be Russia, Europe, and Japan.

The two major forces dragging on profits continue to be the strength of the US dollar and the extremely low price of oil.  While the latter is helping a few sectors - primarily aviation and transportation - it is having a much more significant negative impact elsewhere.  In fact, GE is already implementing job reductions, restructuring in certain areas, and the execution of simplification projects all in an attempt to reduce cost structures.  The longer oil prices remain this low, the greater will be the impact.

The impact of oil prices can be felt in other areas as well.  Subsea orders dropped 38%, and orders for drilling equipment dropped 72%.  The decline makes sense, since oil is now trading below the break-even point for most types of extraction.  Expect this area to continue to be depressed well into 2015, and expect to see regional economic pressures in areas dependent upon oil exploration and production.

The one energy area experiencing tremendous growth, however, is natural gas.  Orders for turbo machinery related to natural gas were up 60%, primarily in North America, the Middle East, and Russia.  That's not much of a surprise given the amount of natural gas produced in those three regions.  It's a good indication that there are some plays out there in the exploration and production sector, since those companies were beaten to a pulp in the last quarter.  Scouring that list for companies with a strong natural gas presence should provide an excellent entry opportunity. 

As to the US dollar, there is no indication of weakening on the horizon.  With the ECB's QE announcement on Thursday, in fact, there's further strength being forecast, coupled with a significant weakening of the Euro.  This effect, however, is projected to be manageable.  GE, for example, is forecasting only a $0.01 per share impact in 2015 based on currency exchange.

Aviation continues to be a major success story in the US and around the globe. Passenger Kilometers revenue was up 6.1% internationally and 5.3% in the US.  If the price of fuel remains low, this revenue stream will continue to grow.  Airlines should be a strong play at least through the first half of 2015.  GE confirms what Alcoa told us a couple of weeks ago.  Demand is extremely high, and GE experienced aviation orders up 15%.  Equipment orders are up 8%, primarily from commercial engines.  Again, that confirms what Alcoa was seeing for new aircraft orders, and it has me considering a play on B/E Aerospace before they report this week.

Healthcare is another growing segment in the US, up 9%.  There is significant growth in diagnostic equipment orders for CT, Ultrasound, and MR.  Globally, however, the sector is extremely depressed. There were sharp declines in Japan, Russia, and the Middle East.  China is only expected to see modest growth in this sector for 2015.  It looks like the healthcare plays for 2015 are primarily domestic.

Transportation experienced its strongest growth ever in 2014, driven primarily by a surge of locomotive orders in the US.  That has to be great news for the freight industry, so we'll be taking a hard look at Union Pacific's forecast.  (They released earnings on Thursday, so their transcript is available now.)

An interesting item that came out of their lighting department is the report of 72% growth in their LED business.  LED comprised 27% of their revenues in that department, at a time when they saw a sharp decline in demand for traditional lighting products.  This warrants a closer inspection since LEDs are now being used in a wide variety of consumer products.  A surge in demand for LEDs implies very strong demand in consumer discretionaries as well as in technology, at least in the US.

Overall, the outlook from GE is similar to what we're hearing from other global companies.  The US is strong, China moderate, but Europe, Russia, and Japan are economic millstones.  Look to aviation, transportation, and healthcare for some strong growth.  Consumer discretionary may also provide an opportunity based on hints from the lighting market, but that's going to require a closer inspection.