UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
FORM 10-Q
(Mark One)
For the Quarterly Period Ended September 30, 2004
OR
Commission File Number 1-3610
ALCOA INC.
(Exact name of registrant as specified in its charter)
Investor Relations 212-836-2674
Office of the Secretary 412-553-4707
(Registrant’s telephone number including area code)
Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months, and (2) has been subject to such filing requirements for the past 90 days. Yes x No ¨
Indicate by check mark whether the registrant is an accelerated filer (as defined in Rule 12b-2 of the Exchange Act). Yes x No ¨
As of October 21, 2004, 870,478,696 shares of common stock, par value $1.00 per share, of the Registrant were outstanding.
PART I – FINANCIAL INFORMATION
Item 1. – Financial Statements.
Alcoa and subsidiaries
Condensed Consolidated Balance Sheet (unaudited)
(in millions)
September 30
2004
December 31
2003
ASSETS
Current assets:
Cash and cash equivalents
Receivables from customers, less allowances of $97 in 2004 and $105 in 2003
Other receivables
Inventories (G)
Deferred income taxes
Prepaid expenses and other current assets
Total current assets
Properties, plants, and equipment, at cost
Less: accumulated depreciation, depletion, and amortization
Net properties, plants, and equipment
Goodwill
Other assets
Assets held for sale (E)
Total assets
LIABILITIES
Current liabilities:
Short-term borrowings
Accounts payable, trade
Accrued compensation and retirement costs
Taxes, including taxes on income
Other current liabilities
Long-term debt due within one year
Total current liabilities
Long-term debt, less amount due within one year (B)
Accrued postretirement benefits
Other noncurrent liabilities and deferred credits
Liabilities of operations held for sale (E)
Total liabilities
MINORITY INTERESTS
COMMITMENTS AND CONTINGENCIES (H)
SHAREHOLDERS’ EQUITY
Preferred stock
Common stock
Additional capital
Retained earnings
Treasury stock, at cost
Accumulated other comprehensive loss (I)
Total shareholders’ equity
Total liabilities and equity
The accompanying notes are an integral part of the consolidated financial statements.
2
Condensed Statement of Consolidated Income (unaudited)
(in millions, except per-share amounts)
Third quarter ended
Nine months ended
Sales (N)
Cost of goods sold
Selling, general administrative, and other expenses
Research and development expenses
Provision for depreciation, depletion, and amortization
Restructuring and other charges (F)
Interest expense
Other income, net (K)
Total costs and expenses
Income from continuing operations before taxes on income
Provision for taxes on income (L)
Income from continuing operations before minority interests’ share
Less: Minority interests’ share
Income from continuing operations
Loss from discontinued operations (E)
Cumulative effect of accounting change (M)
NET INCOME
EARNINGS (LOSS) PER SHARE (J)
Basic:
Loss from discontinued operations
Cumulative effect of accounting change
Net income
Diluted:
Dividends paid per common share
3
Condensed Statement of Consolidated Cash Flows (unaudited)
CASH FROM OPERATIONS
Adjustments to reconcile net income to cash from operations:
Depreciation, depletion, and amortization
Change in deferred income taxes
Equity income, net of dividends
Noncash restructuring and other charges (F)
Net gain on early retirement of debt and interest rate swap settlements (B)
Gains from investing activities - sale of assets
Provision for doubtful accounts
Accounting change (M)
Minority interests
Other
Changes in assets and liabilities, excluding effects of acquisitions and divestitures:
Increase in receivables
(Increase) reduction in inventories
(Increase) reduction in prepaid expenses and other current assets
Increase (reduction) in accounts payable and accrued expenses
Increase (reduction) in taxes, including taxes on income
Cash paid on early retirement of debt and interest rate swap settlements (B)
Cash received on long-term aluminum supply contract
Net change in noncurrent assets and liabilities
Net change in net assets held for sale
CASH PROVIDED FROM CONTINUING OPERATIONS
CASH USED FOR DISCONTINUED OPERATIONS
CASH PROVIDED FROM OPERATIONS
FINANCING ACTIVITIES
Net changes to short-term borrowings
Common stock issued for stock compensation plans
Repurchase of common stock
Dividends paid to shareholders
Dividends paid to minority interests
Net change in commercial paper (B)
Additions to long-term debt
Payments on long-term debt (B)
CASH USED FOR FINANCING ACTIVITIES
INVESTING ACTIVITIES
Capital expenditures
Capital expenditures of discontinued operations
Proceeds from the sale of assets (E)
Additions to investments
Changes in short-term investments
CASH USED FOR INVESTING ACTIVITIES
EFFECT OF EXCHANGE RATE CHANGES ON CASH
Net change in cash and cash equivalents
Cash and cash equivalents at beginning of year
CASH AND CASH EQUIVALENTS AT END OF PERIOD
4
Notes to the Condensed Consolidated Financial Statements (unaudited)
(dollars in millions, except per-share amounts)
A. Basis of Presentation - The Condensed Consolidated Financial Statements are unaudited. These statements include all adjustments, consisting of only normal recurring adjustments, considered necessary by management to fairly present the results of operations, financial position, and cash flows. The results reported in these Condensed Consolidated Financial Statements are not necessarily indicative of the results that may be expected for the entire year.
This Form 10-Q report should be read in conjunction with Alcoa’s annual report on Form 10-K for the year ended December 31, 2003, which includes all disclosures required by accounting principles generally accepted in the United States of America.
B. Debt – In June 2004, Alcoa recognized a net gain of $58 in other income on the early retirement of long-term debt and the associated settlement of interest rate swaps. Alcoa retired $1,200 of debt securities, consisting of the following: $200 of 6.125% Bonds due in 2005, $500 of 7.25% Notes due in 2005, and $500 of 5.875% Notes due in 2006. These debt securities were retired primarily with proceeds from commercial paper borrowings. The net gain of $58 is comprised of the following:
Alcoa previously used interest rate swaps to establish fixed interest rates on anticipated borrowings between June 2005 and June 2006. Due to a change in forecasted borrowing requirements, resulting from the early retirement of debt in June 2004 and a forecasted increase in future operating cash flows resulting from improved market conditions, the anticipated borrowings are no longer probable of occurring in 2005 and 2006. Therefore, Alcoa recognized $33 of gains that had been deferred on previously settled swaps and $44 of cash proceeds which was recorded as a gain to unwind the remaining interest rate swaps.
In connection with this transaction, Alcoa terminated $1,000 notional value of interest rate swaps that resulted in a cash payment by Alcoa of $32. These interest rate swaps were hedging debt maturing in 2007 and 2011. The $32 is reflected as a reduction in the carrying value of debt and it will be recognized as an increase in interest expense over the remaining maturity of the related hedged debt.
C. Stock-Based Compensation – Stock options under the company’s stock incentive plans have been granted at not less than market prices on the dates of grant. Stock option features based on date of original grant are as follows:
Date of original grant
Vesting
Reload feature
2002 and prior
One year
One reload over option term
3 years (1/3 each year)
One reload in 2004 for 1/3 vesting in 2004
None
Alcoa accounts for stock-based compensation in accordance with the provisions of Accounting Principles Board Opinion No. 25, “Accounting for Stock Issued to Employees,” and related interpretations using the intrinsic value method, which resulted in no compensation cost for options granted.
Alcoa’s net income and earnings per share would have been reduced to the pro forma amounts shown below if compensation cost had been determined based on the fair value at the grant dates in accordance with Statement of Financial Accounting Standards (SFAS) Nos. 123 and 148, “Accounting for Stock-Based Compensation.”
5
Net income, as reported
Less: compensation cost determined under the fair value method, net of tax
Pro forma net income
Basic earnings per share:
As reported
Pro forma
Diluted earnings per share:
In addition to stock option awards described above, beginning in 2004 the company granted stock awards and performance share awards that vest in three years from the date of grant. Compensation expense of $14 (pre-tax) was recognized on these awards in the first nine months of 2004.
D. Pension Plans and Other Postretirement Benefits – Effective December 31, 2003, Alcoa adopted SFAS No. 132 (revised 2003), “Employers’ Disclosures about Pensions and Other Postretirement Benefits.” This standard requires the disclosure of the components of net periodic benefit cost recognized during interim periods.
Pension benefits
Service cost
Interest cost
Expected return on plan assets
Amortization of prior service cost
Recognized actuarial loss
Net periodic benefit cost
Postretirement benefits
Amortization of prior service cost (benefit)
The net periodic benefit cost for postretirement benefits for the three-month and nine-month periods ended September 30, 2004 reflects a reduction of approximately $6 and $18, respectively, related to the recognition of the federal subsidy under Medicare Part D. For further details on the Medicare Part D subsidy, see Note V to the audited financial statements contained in the Annual Report on Form 10-K for the year ended December 31, 2003.
E. Discontinued Operations and Assets Held for Sale– In September of 2004, Alcoa reclassified the protective packaging business of Ivex Packaging Corporation (Ivex) to discontinued operations based on the decision to sell the business. Therefore, the financial statements for all periods presented have been reclassified to reflect this business in discontinued operations. The Packaging and Consumer segment results do not include the results of operations of the protective packaging business. In September of 2004, a $16 after-tax charge was recorded to reflect the current fair market value of the business. The sale is expected to be completed by the end of 2004.
In the fourth quarter of 2002, Alcoa performed a portfolio review of its businesses and the markets they serve. As a result of this review, Alcoa committed to a plan to divest certain noncore businesses that
6
did not meet internal growth and return measures. A detailed discussion of Alcoa’s 2002 divestiture plan and changes to the plan in 2003 can be found in Note B to the audited financial statements contained in Alcoa’s Annual Report on Form 10-K for the year ended December 31, 2003. Information on divestiture activities that occurred during 2004 is provided below.
For the periods presented in the Condensed Consolidated Financial Statements, businesses classified as discontinued operations included the protective packaging business of Ivex, Alcoa’s commodity automotive fasteners business, a packaging business in South America, and Alcoa’s packaging equipment business. In January of 2004, Alcoa sold its packaging equipment business to American Industrial Partners for $44 in cash and recognized an after-tax gain of $10. In February of 2004, Alcoa sold its automotive fasteners business to the Kaminski Holdings group for $17 in cash and notes receivable and recognized an additional after-tax loss of $5. In July of 2004, Alcoa sold its flexible packaging business in South America and recognized no material gain or loss. The gain and loss from these transactions are recorded in discontinued operations in the income statement.
The following table details selected financial information for the businesses included within discontinued operations.
Sales
Loss from operations
Loss on sale of businesses
Total pretax loss
Provision for taxes
For the periods presented in the Condensed Consolidated Financial Statements, businesses classified as assets held for sale included Alcoa’s specialty chemicals business, an extrusion facility in Europe, certain extrusion facilities in Latin America, foil facilities in St. Louis, MO and Russellville, AR, as well as the protective packaging business of Ivex, Alcoa’s commodity automotive fasteners business, a packaging business in South America, and Alcoa’s packaging equipment business as described above. In February of 2004, the specialty chemicals business of Alcoa was sold to two private equity firms led by Rhone Capital LLC for an enterprise value of $342, which included the assumption of debt and other unfunded obligations. Alcoa received cash of $248 and recognized a pre-tax, pre-minority interest gain of approximately $53 ($61 after-tax, after-minority interest). The gain is included in Restructuring and Other Charges in the income statement. In April of 2004, Alcoa sold its St. Louis, MO and Russellville, AR foil facilities, as well as an extrusion facility in Europe. Alcoa received $37 in cash and no material gain or loss was recorded on these transactions.
In the second quarter of 2004, certain architectural products businesses in North America were reclassified from assets held for sale to assets held and used as management discontinued the plan of sale due to market conditions. The financial statements for all periods presented have been reclassified to reflect this change. The reclassification did not impact the Condensed Statement of Consolidated Income. The results of the North American architectural products businesses continue to be reflected in the Engineered Products segment.
7
The major classes of assets and liabilities of operations held for sale in the balance sheet are as follows:
Assets:
Receivables
Inventories
Properties, plants, and equipment, net
Total assets held for sale
Liabilities:
Accounts payable and accrued expenses
Other liabilities
Total liabilities of operations held for sale
The changes in assets and liabilities of operations held for sale at September 30, 2004 compared with December 31, 2003 are due to the divestitures of Alcoa’s packaging equipment, automotive fasteners, and specialty chemicals businesses, as well as the sale of the St. Louis and Russellville foil facilities, an extrusion plant in Europe, and a packaging business in South America in 2004. The divestiture program is essentially complete, with the exception of certain Latin American extrusion facilities that remain in assets held for sale and the September 2004 decision to move the protective packaging business of Ivex into discontinued operations.
F. Restructuring and Other Charges – In the first nine months of 2004, Alcoa recorded income of $22 for restructuring and other charges, consisting of income of $31 in the first quarter, and expenses of $5 and $4 in the second and third quarters, respectively. Alcoa recorded restructuring and other charges of $4 ($4 after tax and minority interests) in the third quarter, consisting of charges of $7 for employee termination and severance costs associated with 400 salaried and hourly employees (primarily in the U.S. and Mexico), and $4 for asset impairments, partially offset by adjustments of $5 to prior year employee termination and severance cost reserves, and $2 net gains on divested businesses. As of September 30, 2004, approximately 150 of the 400 employees had been terminated.
In the second quarter of 2004, Alcoa recorded restructuring and other charges of $5 ($4 after tax and minority interests), consisting of charges of $14 for employee termination and severance costs associated with 2,700 salaried and hourly employees (primarily in Mexico and the U.S.), as the company continued to focus on reducing costs, partially offset by income of $6 associated with net gains on divested businesses and asset sales, and income of $3 resulting from adjustments to prior year employee termination and severance cost reserves. As of September 30, 2004, 2,400 of the 2,700 employees had been terminated.
In the first quarter of 2004, Alcoa recorded income of $31 ($50 after tax and minority interests) for restructurings, consisting of a $44 gain on the sale of the specialty chemicals business and charges of $13 for employee termination and severance costs associated with 380 salaried and hourly employees (primarily in the U.S. and U.K.). As of September 30, 2004, 280 of the 380 employees had been terminated.
Approximately $17 of cash payments were made against the reserves in the first nine months of 2004. All layoffs recorded in 2004 are expected to be completed in 2004. Restructuring and other charges are not reflected in the segment results.
During 2003, Alcoa recorded income of $26 ($25 after tax and minority interests) for restructuring and other charges. The income recognized was comprised of the following components: $45 of charges for employee termination and severance costs associated with approximately 1,600 hourly and salaried employees (located primarily in Europe, the U.S., and Brazil), as the company continued to focus on cost reductions in businesses that continued to be impacted by market declines; $20 of charges related to a reduction in the estimated fair values of businesses included in assets held for sale; and $91 of income comprised of $53 primarily associated with the sale of the Latin America PET business, and $38 resulting from adjustments to prior year employee termination and severance cost reserves (in conjunction with the $38 reserve adjustment, there was a change in the number of employees to be terminated under the 2002 restructuring program from 8,500 to 6,700 employees). The 2003 restructuring program is essentially complete.
8
During 2002, Alcoa recorded charges of $425 ($280 after tax and minority interests) for restructurings associated with the curtailment of aluminum production at three smelters, as well as restructuring operations for those businesses experiencing negligible growth due to continued market declines and the decision to divest certain businesses that have failed to meet internal growth and return measures. The 2002 charges were comprised of $296 for asset write-downs, consisting of $113 of goodwill on businesses to be divested, as well as $183 for structures, machinery, and equipment; $105 for employee termination and severance costs related to approximately 6,700 hourly and salaried employees at over 70 locations, primarily in Mexico, Europe, and the U.S.; and charges of $31 for exit costs, principally for remediation and demolition costs, as well as lease termination costs. The 2002 restructuring program is essentially complete.
Activity and reserve balances for restructuring charges are as follows:
Asset
write-downs
Reserve balances at December 31, 2002
2003:
Cash payments
2003 restructuring charges
Additions to 2002 restructuring charges
Reversals of 2002 restructuring charges
Noncash additions/reversals to the reserves in 2003
Reserve balances at December 31, 2003
2004:
2004 restructuring charges
Reversals of 2003 restructuring charges
Net gains on sales of assets not impacting reserve balances
Noncash charges
Reserve balances at September 30, 2004
For further details on the restructurings, see Note D to the audited financial statements contained in the Annual Report on Form 10-K for the year ended December 31, 2003.
G. Inventories
Finished goods
Work in process
Bauxite and alumina
Purchased raw materials
Operating supplies
Approximately 43% of total inventories at September 30, 2004, was valued on a LIFO basis. If valued on an average cost basis, total inventories would have been $616 and $558 higher at September 30, 2004 and December 31, 2003, respectively. The increase in inventories is a result of improved market conditions.
9
H. Commitments and Contingencies - Various lawsuits, claims and proceedings have been or may be instituted or asserted against Alcoa, including those pertaining to environmental, product liability, and safety and health matters. While the amounts claimed may be substantial, the ultimate liability cannot now be determined because of the considerable uncertainties that exist. Therefore, it is possible that results of operations or liquidity in a particular period could be materially affected by certain contingencies. However, based on facts currently available, management believes that the disposition of matters that are pending or asserted will not have a materially adverse effect on the financial position or liquidity of the company.
Alcoa Aluminio S.A. (Aluminio) is a participant in several hydroelectric power construction projects in Brazil for purposes of increasing its energy self-sufficiency and providing a long-term, low-cost source of power for its facilities.
The completed and committed hydroelectric construction projects that Aluminio participates in are outlined in the following tables.
Completed projects
Share of
output
Debt
guarantee
Machadinho
Aluminio committed to taking a share of the output of the completed Machadinho project for 30 years at cost (including cost of financing the project). In the event that other participants in this project fail to fulfill their financial responsibilities, Aluminio may be required to fund a portion of the deficiency. In accordance with the agreement, if Aluminio funds any such deficiency, its participation and share of the output from the project will increase proportionately.
Committed projects
Barra Grande
Serra do Facao
Pai-Quere
Estreito
These projects were committed to during 2001 and 2002, and the Barra Grande project commenced construction in 2002. As of the third quarter of 2004, approximately 50% of the long-term financing for the Barra Grande project was obtained, of which Aluminio guaranteed 42.20% based on its investment participation. The plans for financing the other projects have not yet been finalized. It is anticipated that a portion of the project costs will be financed with third parties. Aluminio may be required to provide guarantees of project financing or commit to additional investments as these projects progress.
During 2003, the participants in the Santa Isabel project formally requested the return of the performance bond related to the license to construct the hydroelectric project. This project has been terminated.
Aluminio accounts for the Machadinho and Barra Grande hydroelectric projects on the equity method. Its total investment in these projects was $125 and $136 at September 30, 2004 and December 31, 2003, respectively. There have been no significant investments made in any of the other projects.
In September 2003, Alcoa signed a memorandum of understanding (MOU) with the government of the Kingdom of Bahrain to acquire up to a 26 percent equity stake in Alba, a Bahrain company that owns and operates a 512,000 metric ton per year (mtpy), four-potline aluminum smelter. Alcoa and the government were unable to reach mutually acceptable terms to finalize the terms of the MOU, and it is no longer in force. Alcoa and the government are continuing to explore other ways for Alcoa to invest in Alba.
10
I. Comprehensive Income
Changes in other comprehensive income (loss), net of tax:
Unrealized gains (losses) on available-for-sale securities
Minimum pension liability
Unrealized translation adjustments
Unrecognized gains (losses) on derivatives
Net change from periodic revaluations
Net amount reclassified to income (1)
Net unrecognized gains (losses) on derivatives
Comprehensive income
J. Earnings Per Share – The information used to compute basic and diluted EPS on income from continuing operations follows: (shares in millions)
Less: preferred stock dividends
Income from continuing operations available to common shareholders
Average shares outstanding – basic
Effect of dilutive securities:
Shares issuable upon exercise of dilutive stock options
Average shares outstanding – diluted
Options to purchase 58 million and 64 million shares of common stock at average exercise prices of $38.00 and $36.00 were outstanding as of September 30, 2004 and 2003, respectively, but were not included in the computation of diluted EPS because the option exercise price was greater than the average market price of the common shares.
K. Other Income, Net
Equity income
Interest income
Foreign exchange losses
(Losses) gains on sales of assets
Other income
Other income for the third quarter and nine-month periods of 2004 included a gain of $35 for the termination of an alumina tolling arrangement. In addition, the 2004 nine-month period included a charge of $20 recognized in the first quarter of 2004 related to settlements reached in the El Campo litigation matter.
11
L. Income Taxes – The effective tax rate of 28.3% for the 2004 nine-month period differs from the statutory rate of 35% and the 2003 nine-month rate of 25.3% principally due to the sale of the specialty chemicals business in 2004 and lower taxes on foreign income.
M. Cumulative Effect of Accounting Change – Effective January 1, 2003, Alcoa adopted SFAS No. 143, “Accounting for Asset Retirement Obligations.” Under this standard, Alcoa recognized additional liabilities for asset retirement obligations (AROs), consisting primarily of costs associated with spent pot lining disposal, bauxite residue disposal, mine reclamation, and landfills. These costs reflect the legal obligations associated with the normal operation of Alcoa’s bauxite mining, alumina refining, and aluminum smelting facilities. There were no material changes to the ARO balances during the third quarter of 2004. Additionally, Alcoa capitalized asset retirement costs by increasing the carrying amount of related long-lived assets, principally machinery and equipment, and recorded associated accumulated depreciation from the time the original assets were placed into service. The cumulative effect adjustment recognized upon adoption of this standard was $47, consisting principally of costs to establish assets and liabilities related to spent pot lining for pots currently in operation.
N. Segment Information - The following details sales and after-tax operating income (ATOI) for each reportable segment for the three-month and nine-month periods ended September 30, 2004 and 2003. For more information on segments, see Note P to the audited financial statements contained in the Annual Report on Form 10-K for the year ended December 31, 2003.
September 30, 2004
Sales:
Third-party sales
Intersegment sales
Total sales
ATOI
September 30, 2003
12
The following reconciles segment information to consolidated totals.
Total ATOI
Impact of intersegment profit adjustments
Unallocated amounts (net of tax):
Corporate expense
Discontinued operations (E)
Consolidated net income
The significant changes in the reconciling items between ATOI and consolidated net income for the 2004 third quarter and nine-month period compared with the corresponding 2003 periods consisted of:
The 2004 nine-month period was also negatively impacted by a $42 increase of the environmental reserve primarily for the Grasse River project and the absence of the sale of assets (primarily office space) that occurred in the first half of 2003. These were partially offset by the $58 gain recognized on the debt restructuring in the second quarter of 2004. See Note B for additional details surrounding the restructuring of debt.
The following table represents segment assets.
Alumina and Chemicals
Primary Metals
Flat-Rolled Products
Engineered Products
Packaging and Consumer
Total segment assets
The increase in segment assets across all segments is due to higher customer receivables and increased inventories from stronger volumes and prices in 2004.
O. Reclassifications - Certain amounts have been reclassified to conform to current period presentation.
P. Subsequent Event - On October 26, 2004, Alcoa agreed to acquire approximately a 20% interest in a consortium formed to acquire the Dampier to Bunbury Natural Gas Pipeline in exchange for an initial cash investment of $17 million and a future funding commitment of an additional $72 million which will be paid as expansions of the pipeline occur through 2008. Alcoa’s investment was made to secure a supply of natural gas to its refineries in Western Australia. In addition to its ownership interest, Alcoa maintains an on-going natural gas supply contract with the joint venture which provides for the purchase of approximately 40% of the pipeline’s production. Alcoa will account for its investment in accordance with the equity method of accounting for investments in common stock.
13
Report of Independent Registered Public Accounting Firm *
To the Shareholders and Board of Directors of
Alcoa Inc.
We have reviewed the accompanying unaudited condensed consolidated balance sheet of Alcoa Inc. and its subsidiaries (Alcoa) as of September 30, 2004, and the related unaudited condensed statements of consolidated income for each of the three-month and nine-month periods ended September 30, 2004 and 2003 and the unaudited condensed statement of consolidated cash flows for the nine-month periods ended September 30, 2004 and 2003. These interim financial statements are the responsibility of Alcoa’s management.
We conducted our review in accordance with the standards of the Public Company Accounting Oversight Board (United States). A review of interim financial information consists principally of applying analytical procedures and making inquiries of persons responsible for financial and accounting matters. It is substantially less in scope than an audit conducted in accordance with the standards of the Public Company Accounting Oversight Board, the objective of which is the expression of an opinion regarding the financial statements taken as a whole. Accordingly, we do not express such an opinion.
Based on our review, we are not aware of any material modifications that should be made to the accompanying unaudited condensed consolidated interim financial statements for them to be in conformity with accounting principles generally accepted in the United States of America.
We previously audited in accordance with the standards of the Public Company Accounting Oversight Board (United States), the consolidated balance sheet as of December 31, 2003, and the related statements of consolidated income, shareholders’ equity and of cash flows for the year then ended (not presented herein), and in our report dated January 8, 2004 we expressed an unqualified opinion on those consolidated financial statements. In our opinion, the information set forth in the accompanying condensed consolidated balance sheet as of December 31, 2003, is fairly stated in all material respects in relation to the consolidated balance sheet from which it has been derived.
As discussed in Note M to the unaudited condensed consolidated financial statements, Alcoa changed its method of accounting for asset retirement obligations effective January 1, 2003.
/s/ PricewaterhouseCoopers LLP
Pittsburgh, Pennsylvania
October 7, 2004, except for Note P,
as to which the date is October 26, 2004
14
Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations.
(dollars in millions, except per share amounts and ingot prices; shipments in thousands of metric tons [mt])
Certain statements in this report under this caption and elsewhere relate to future events and expectations and, as such, constitute forward-looking statements. Forward-looking statements include those containing such words as “anticipates,” “believes,” “estimates,” “expects,” “hopes,” “targets,” “should,” “will,” “will likely result,” “forecast,” “outlook,” “projects” or similar expressions. Such forward-looking statements involve known and unknown risks, uncertainties and other factors that may cause actual results, performance or achievements of Alcoa to be different from those expressed or implied in the forward-looking statements. For a discussion of some of the specific factors that may cause such a difference, see Note H to the Condensed Consolidated Financial Statements; the disclosures included below under Segment Information, Environmental Matters, and Quantitative and Qualitative Disclosures about Market Risks; and Alcoa’s Form 10-K, Part I, Item 1, for the year ended December 31, 2003.
Results of Operations
Selected Financial Data:
Earnings per common share:
Diluted – Income from continuing operations
Diluted – Net income
Shipments of aluminum products (mt)
Shipments of alumina (mt)
Alcoa’s average realized ingot price
Average 3-month LME price
Alcoa’s income from continuing operations for the 2004 third quarter and nine-month period was $298, or 34 cents per diluted share, and $1,053, or $1.20 per share, respectively. Income from continuing operations increased 5% in the 2004 third quarter and 52% in the nine-month period, as compared to the corresponding 2003 periods. Results in 2004 were favorably impacted by higher realized prices, as alumina prices rose 23% and 26% and aluminum prices climbed 20% in the 2004 third quarter and nine-month period, respectively, compared with the corresponding 2003 periods. Volume increases in the Engineered Products, Packaging and Consumer, and Flat-Rolled Products segments and the termination of an alumina tolling arrangement favorably contributed to 2004 results. The 2004 nine-month period was also favorably impacted by the gain on the specialty chemicals business that was sold in the first quarter of 2004 and the debt restructuring that occurred in the second quarter of 2004. However, the impact of a weaker U.S. dollar against other currencies, increased raw material and energy costs, the strike at the Becancour, Quebec smelter, and the effects of Hurricane Ivan in Jamaica partially offset the increase in income during 2004. The 2004 nine-month period was unfavorably impacted by litigation settlements in the first quarter of 2004.
Net income for the 2004 third quarter and nine-month period was $283, or 32 cents per share, and $1,042, or $1.19 per share, respectively, as compared to $280, or 33 cents per share, and $647, or 76 cents per share, for corresponding periods in 2003. In September of 2004, a $16 after-tax charge was recorded to reflect the current fair market value of the protective packaging business, which was reclassified into discontinued operations. The 2003 results included a cumulative effect charge of $47, or 6 cents per share, for the accounting change for asset retirement obligations under Statement of Financial Accounting Standards (SFAS) No. 143, “Accounting for Asset Retirement Obligations.”
Sales for the 2004 third quarter and nine-month period increased $665, or 13%, and $1,818, or 11%, respectively compared with corresponding 2003 periods. The increase in realized prices for alumina and aluminum as well as higher volumes in businesses serving the commercial transportation, distribution, aerospace, telecommunications, packaging, and residential building and construction markets drove the
15
increase in sales. The favorable impact of foreign currency exchange movements and the consolidation of KAAL Australia (Alcoa acquired the remaining 50% interest from Kobe Steel Ltd. in October 2003.) also contributed to the sales increase. Partially offsetting these increases were the impact of divestitures, principally the specialty chemicals and Latin American PET businesses, and lower volumes in the Primary Metals segment due to the strike at the Becancour smelter as well as lower volumes in the automotive business.
Cost of goods sold (COGS) as a percentage of sales was 80.1% for the 2004 third quarter and 79.0% for the 2004 nine-month period, compared with 79.2% and 79.5% in the 2003 corresponding periods. In the 2004 third quarter, higher realized prices were more than offset by unfavorable foreign currency exchange movements and higher costs associated with energy and raw materials, the Becancour strike, the impact of Hurricane Ivan in Jamaica, and throughput issues in Australia. The decrease in the 2004 nine-month period is attributed to higher realized prices and cost savings, which more than offset the unfavorable items noted previously as well as an increase of $42 in environmental reserves that occurred in the second quarter of 2004.
Selling, general administrative, and other expenses (SG&A) for the 2004 third quarter and 2004 nine-month period increased $12, or 4%, and $32 or 3%, compared with the corresponding periods in 2003. These increases resulted from expenses associated with stock awards granted in 2004 and unfavorable foreign currency movements, which were partially offset by a reduction in deferred compensation costs. The 2004 nine-month period was also negatively impacted by the bankruptcy of an alumina customer.
The provision for depreciation, depletion, and amortization increased by 3% in both the 2004 third quarter and 2004 nine-month period, as compared to the corresponding periods of 2003. The increase is primarily due to unfavorable foreign currency exchange movements.
Restructuring and other charges resulted in expense of $4 in the 2004 third quarter and income of $22 in the 2004 nine-month period. In the third quarter of 2004, Alcoa recorded restructuring and other charges of $4 ($4 after taxes and minority interests) in the third quarter, consisting of charges of $7 for employee termination and severance costs associated with 400 salaried and hourly employees (primarily in the U.S. and Mexico), and $4 for asset impairments, partially offset by adjustments of $5 to prior year employee termination and severance cost reserves, and $2 net gains on divested businesses. As of September 30, 2004, approximately 150 of the 400 employees had been terminated. In the second quarter of 2004, a charge of $14 was recorded for employee termination and severance costs associated with 2,700 salaried and hourly employees (primarily in Mexico and the U.S.). Partially offsetting this charge were income of $6 associated with net gains on divested businesses and asset sales, and income of $3 resulting from adjustments to prior year employee termination and severance cost reserves. As of September 30, 2004, 2,400 of the 2,700 employees had been terminated. In the first quarter of 2004, income of $31 was recorded for restructuring and other charges, consisting of a gain of $44 on the sale of the specialty chemicals business, which was somewhat offset by charges of $13 for employee termination and severance costs associated with 380 salaried and hourly employees (primarily in the U.S. and U.K.). As of September 30, 2004, 280 of the 380 employees had been terminated. Approximately $17 of cash payments were made against the reserves in the first nine months of 2004. All layoffs recorded in 2004 are expected to be completed in 2004. Restructuring and other charges are not included in the segment results.
16
The pre-tax income (expense) of allocating these amounts to the segment results would have been as follows:
Segment total
Corporate
Total restructuring and other charges
Interest expense for the 2004 third quarter and nine-month period decreased $8, or 11%, and $43, or 18%, from the corresponding 2003 periods, primarily due to lower average debt levels. The decrease in the 2004 nine-month period was also caused by lower average effective interest rates.
Other income for the 2004 third quarter and nine-month period increased $11, or 26%, and $65, or 48%, over the corresponding 2003 periods. The increase in the 2004 third quarter is due to the gain of $35 related to the termination of an alumina tolling arrangement and $11 of higher equity income. These were largely offset by $10 unfavorable foreign currency exchange movements, a $6 impairment of a cost basis investment, a $5 increase in expenses related to employee life insurance, as well as declines in dividend and interest income. The 2004 nine-month increase resulted from the $58 gain recognized on the restructuring of debt, the $35 gain on the termination of an alumina tolling arrangement, and $25 favorable foreign currency exchange movements, partially offset by $20 associated with litigation settlements in 2004, $15 of higher net gains on asset sales (principally office space) recognized in 2003, and an $11 increase in expenses related to employee life insurance.
The effective tax rate of 28.3% for the 2004 nine-month period differs from the statutory rate of 35% and the 2003 nine-month rate of 25.3% principally due to the sale of the specialty chemicals business in 2004 and lower taxes on foreign income.
Minority interests’ share of income from operations increased $17, or 31%, and $6, or 3%, in the 2004 third quarter and nine-month period, respectively, as compared to the same periods in 2003. The increases were partly due to higher earnings at Alcoa World Alumina and Chemicals due to higher realized prices and the gain associated with the termination of an alumina tolling arrangement. This was partially offset by Alcoa’s acquisition of the minority interest in Alcoa Aluminio in August 2003. The increase in the 2004 nine-month period was also favorably impacted by the sale of the specialty chemicals business.
Segment Information
I. Alumina and Chemicals
Alumina production (mt)
Third-party alumina shipments (mt)
After-tax operating income (ATOI)
Third-party sales for the Alumina and Chemicals segment decreased 7% and 2% in the 2004 third quarter and nine-month period, compared with the corresponding 2003 periods. An increase in realized
17
prices of 23% in the 2004 third quarter and 26% in the 2004 nine-month period, as compared to corresponding 2003 periods, was more than offset by lower third-party volumes due to higher internal demand. The increase in realized prices was also offset by the loss of revenue resulting from the sale of the specialty chemicals business in February of 2004.
Intersegment sales increased 32% in the 2004 third quarter and 38% in the 2004 nine-month period, as compared to corresponding periods in 2003, as a result of higher realized prices and increased internal demand as a result of the expiration of contracts on required third-party purchases. In the 2004 nine-month period, production increased principally at the Point Comfort, TX refinery, after startup of additional capacity during 2003.
ATOI for this segment rose 50% in the 2004 third quarter and 55% in the 2004 nine-month period, as compared to corresponding 2003 periods, due primarily to higher realized prices and the termination of an alumina tolling arrangement. Results were negatively impacted by reduced volumes, unfavorable foreign currency exchange movements, clean-up costs and lost production in Jamaica resulting from Hurricane Ivan, and throughput issues in Australia. The loss of profit associated with the sale of the chemicals business produced a negative impact on both the 2004 third quarter and nine-month periods.
Alumina prices in the fourth quarter of 2004 are expected to be flat with third quarter realizations. The third quarter benefit associated with the termination of an alumina tolling agreement will not recur in the fourth quarter.
II. Primary Metals
Aluminum production (mt)
Third-party aluminum shipments (mt)
Alcoa’s average realized price per pound for aluminum ingot
Third-party sales for the Primary Metals segment increased 14% in the third quarter of 2004 and 18% in the 2004 nine-month period, compared with the corresponding periods of 2003. The increases are due to 20% higher realized prices in both the third quarter of 2004 and the 2004 nine-month periods, partially offset by lower third-party volumes resulting from the curtailment of two potlines due to the strike at the Becancour smelter. Intersegment sales increased 40% in the third quarter of 2004 and 41% in the 2004 nine-month period primarily due to the increase in realized prices as well as increased volumes due to strengthening in the downstream aluminum fabricating businesses.
ATOI for this segment increased 15% in the 2004 third quarter and 24% in the 2004 nine-month period due to higher realized prices and higher total volumes, somewhat offset by higher costs for energy, the impact of unfavorable foreign currency exchange movements, and the effects of the strike at the Becancour smelter.
Alcoa has approximately 719,000 mt per year (mtpy) of idle capacity on a base capacity of 3,977,000 mtpy. On October 7, 2004, the workers at the Wenatchee smelter voted to accept a labor agreement. Alcoa will begin the process to restart two potlines at this facility, which has been idled since July of 2001.
Aluminum prices continue to be strong in the fourth quarter of 2004. Alcoa will continue its program of metal purchases to optimize the selling of value-added products. A resolution to the strike at the Becancour smelter would not likely generate any significant benefits in the fourth quarter, nor would the restart of the Wenatchee smelter. Higher energy costs will continue to negatively impact results.
18
III. Flat-Rolled Products
Third-party sales for the Flat-Rolled Products segment increased 29% in the 2004 third quarter and 26% in the 2004 nine-month period, as compared to the same periods in 2003. The increase resulted from the acquisition of the remaining 50% interest in KAAL Australia (can sheet rolling mills) in October of 2003, higher prices, and higher volumes due to improved demand in the commercial transportation, packaging, aerospace, automotive, and industrial products markets.
ATOI for this segment increased 5% in the third quarter of 2004 and 11% for the 2004 nine-month period due to higher volumes; favorable mix; improved productivity in the sheet and plate business; and the contribution of KAAL Australia. In the 2004 nine-month period, these positive contributions were somewhat offset by a hot mill interruption at the Kitts Green facility in the U.K. and temporary throughput issues at the Tennessee can sheet facility, and these issues have been resolved.
In the fourth quarter, seasonal volume declines are expected for rigid container sheet. The commercial vehicle market, while recovering, is projected to experience seasonal softening as well. The aerospace and distribution markets are expected to continue to strengthen in the fourth quarter.
IV. Engineered Products
Third-party sales for the Engineered Products segment increased 16% the 2004 third quarter and 12% in the 2004 nine-month period, as compared to 2003 corresponding periods, principally due to higher volumes in the businesses serving the commercial transportation, aerospace, building and construction, and distribution markets.
ATOI for this segment increased 28% in the third quarter of 2004 and 64% in the 2004 nine-month period. The increase in 2004 was principally due to higher volumes as a result of improved market conditions and increased productivity, which were slightly offset by increased pricing pressures.
The aerospace and distribution markets are expected to strengthen in the fourth quarter. Anticipated seasonal weakness in the automotive, building and construction, and commercial vehicle markets will likely mitigate such strengthening.
19
V. Packaging and Consumer
Third-party sales for the Packaging and Consumer segment were relatively flat in the 2004 third quarter and nine-month period, compared with the 2003 corresponding periods. Higher volumes in the thermoformed plastics, closures, consumer products, and packaging graphics and design businesses were offset by a decline in sales due to the divestiture of the Latin America PET business in 2003.
ATOI for this segment declined 27% in the third quarter of 2004 and 20% in the 2004 nine-month period compared to 2003 corresponding periods. The higher volumes noted previously were more than offset by the negative impact of persistently higher resin costs, higher costs for metal and paper, the divestitures of the Latin America PET business and Latasa (a Latin America aluminum can business in which Alcoa had an equity interest), and the fire at the Kama packaging facility.
In the fourth quarter, seasonal weakness is expected in closures while seasonal demand for consumer products is anticipated to increase. Raw materials costs continue to increase, but pass-through opportunities may mitigate some of those increases.
VI. Other
Third-party aluminum shipments (mt) *
Third-party sales for the Other group increased 3% in the 2004 third quarter and remained relatively flat in the 2004 nine-month period compared with 2003 corresponding periods, principally due to volume increases in the residential building products and telecommunications businesses, which were offset by lower volumes at AFL automotive, as this business continued to rebalance its customer base. The 2004 nine-month period was also negatively affected by the disposition of distribution facilities in Europe.
ATOI for this group increased 50% in the 2004 third quarter and 76% in the 2004 nine-month period, compared to corresponding 2003 periods, due to increased volumes in the telecommunications business and higher equity income from Integris Metals, Inc. (a metals distribution joint venture in which Alcoa has a 50% equity interest). These positive contributions were somewhat offset by lower volumes in the automotive businesses.
In the fourth quarter, automotive will continue to be weak based on production cuts at Ford and General Motors and platform specific cutbacks to reduce field inventories on specific models. Seasonal declines are expected in the building and construction market.
20
Reconciliation of ATOI to Consolidated Net Income
Items required to reconcile ATOI to consolidated net income include: corporate adjustments to eliminate any remaining profit or loss between segments; interest income and expense; minority interests; corporate expense, comprised of the general administrative and selling expenses of operating the corporate headquarters and other global administrative facilities along with depreciation on corporate-owned assets; restructuring and other charges; discontinued operations; the accounting change for asset retirement obligations in 2003; and other, which includes the impact of LIFO, differences between estimated tax rates used in the segments and the corporate effective tax rate, and other nonoperating items such as foreign currency translation gains/losses.
Restructuring and other charges
Discontinued operations
Accounting change
The 2004 nine-month period was also negatively impacted by a $42 increase of the environmental reserve primarily for the Grasse River project and the absence of the sale of assets (primarily office space) that occurred in the first half of 2003. These are partially offset by the $58 gain recognized on the debt restructuring in the second quarter of 2004. See Note B in Part I, Item I for additional details surrounding the restructuring of debt.
Liquidity and Capital Resources
Cash from Operations
Cash from operations was $1,407 in the 2004 nine-month period compared with $1,697 in the same period of 2003. The decrease of $290 is principally due to net increases in inventories, receivables, payables, and taxes of $171, and the absence of a $440 advance payment received in 2003 against a long-term aluminum supply contract, partially offset by the increase in net income.
Financing Activities
Cash used for financing activities of $1,072 in the 2004 nine-month period was relatively flat with cash used of $1,097 in the 2003 nine-month period.
21
In June 2004, Alcoa completed the early retirement of $1,200 of debt securities, consisting of the following: $200 of 6.125% Bonds due in 2005, $500 of 7.25% Notes due in 2005, and $500 of 5.875% Notes due in 2006. These debt securities were retired primarily with proceeds from commercial paper borrowings.
On April 23, 2004 Alcoa refinanced its $2,000 revolving-credit agreement that was to expire in April 2004 into a new $1,000 revolving-credit agreement that will expire in April 2005, with an option to extend the maturity date of any borrowings outstanding on the April 2005 expiration date for one year. Additionally, Alcoa refinanced its $1,000 revolving-credit agreement that was to expire in April 2005 into a new agreement that will expire in April 2009.
Investing Activities
Cash used for investing activities was $348 in the 2004 nine-month period compared with $563 in the same period in 2003. The change of $215 was primarily due to proceeds received from the divestitures of Alcoa’s specialty chemicals, packaging equipment, and automotive fasteners businesses, as well as foil facilities, and a European extrusion facility. This was somewhat offset by cash used to acquire 44 million additional shares of Chalco to maintain Alcoa’s 8% ownership interest.
Due to the timing of spend on growth projects, Alcoa will spend approximately $1.2 billion on capital in 2004. This amount is almost $100 million lower than original projections.
Environmental Matters
Alcoa continues to participate in environmental assessments and cleanups at a number of locations. These include approximately 30 owned or operating facilities and adjoining properties, approximately 39 previously owned or operating facilities and adjoining properties and approximately 67 Superfund and other waste sites. A liability is recorded for environmental remediation costs or damages when a cleanup program becomes probable and the costs or damages can be reasonably estimated.
As assessments and cleanups proceed, the liability is adjusted based on progress made in determining the extent of remedial actions and related costs and damages. The liability can change substantially due to factors such as the nature and extent of contamination, changes in remedial requirements, and technological changes. Therefore, it is not possible to determine the outcomes or to estimate with any degree of accuracy the potential costs for certain of these matters.
The following discussion provides additional details regarding the current status of Alcoa’s significant sites where the final outcome cannot be determined or the potential costs in the future cannot be estimated.
Massena, NY. Alcoa has been conducting investigations and studies of the Grasse River, adjacent to Alcoa’s Massena, New York plant site, under order from the U.S. Environmental Protection Agency (EPA) issued under the Comprehensive Environmental Response, Compensation and Liability Act, also known as Superfund. Sediments and fish in the river contain varying levels of polychlorinated biphenyl (PCB).
In 2002, Alcoa submitted an Analysis of Alternatives Report that detailed a variety of remedial alternatives with estimated costs ranging from $2 to $525. Because the selection of the $2 alternative (natural recovery) was considered remote, Alcoa adjusted the reserve for the Grasse River in 2002 to $30 representing the low end of the range of possible alternatives, as no single alternative could be identified as more probable than the others.
In June of 2003, based on river observations during the spring of 2003, the EPA requested that Alcoa gather additional field data to assess the potential for sediment erosion from winter river ice formation and breakup. The results of these additional studies, submitted in a report to the EPA in April of 2004, suggest that this phenomenon has the potential to occur approximately every 10 years and may impact sediments in certain portions of the river under all remedial scenarios. The EPA informed Alcoa that a final remedial decision for the river could not be made without substantially more information, including river pilot studies on the effects of ice formation and breakup on each of the remedial techniques. The EPA requested that Alcoa consider a Remedial Options Study to gather this information. The scope of this study includes sediment removal and capping, the installation of an ice control structure, and significant monitoring.
22
In May of 2004, Alcoa agreed to perform the study at an estimated cost of $35. Most of the work should be completed by the fourth quarter of 2005. The findings will be incorporated into a revised Analysis of Alternatives Report, which is expected to be submitted in 2006. This information will be used by the EPA to propose a remedy for the entire river.
Alcoa adjusted the reserves in the second quarter to include the $35 for the Remedial Options Study. This is in addition to the $30 previously reserved. Currently, none of the existing alternatives in the 2002 Analysis of Alternatives Report is more probable than the others and the results of the Remedial Options Study are necessary to revise the scope and estimated cost of many of the current alternatives.
The EPA’s ultimate selection of a remedy could result in additional liability. Alcoa may be required to record a subsequent reserve adjustment at the time the EPA’s Record of Decision is issued.
Sherwin, TX. In connection with the sale of the Sherwin alumina refinery in Texas, which was required to be divested as part of the Reynolds merger in 2000, Alcoa has agreed to retain responsibility for the remediation of then existing environmental conditions, as well as a pro rata share of the final closure of the active waste disposal areas, which remain in use. Alcoa’s share of the closure costs is proportional to the total period of operation of the active waste disposal areas. Alcoa estimated its liability for the active disposal areas by making certain assumptions about the period of operation, the amount of material placed in the area prior to closure, and the appropriate technology, engineering, and regulatory status applicable to final closure. The most probable cost for remediation has been reserved. It is reasonably possible that an additional liability, not expected to exceed $75, may be incurred if actual experience varies from the original assumptions used.
Based on the foregoing, it is possible that Alcoa’s results of operations, in a particular period, could be materially affected by matters relating to these sites. However, based on facts currently available, management believes that adequate reserves have been provided and that the disposition of these matters will not have a materially adverse effect on the financial position or liquidity of the company.
Alcoa’s remediation reserve balance at September 30, 2004 was $410 and $395 at December 31, 2003 (of which $65 was classified as a current liability in both periods), and reflects the most probable costs to remediate identified environmental conditions for which costs can be reasonably estimated. Remediation costs charged to the reserve in the 2004 nine-month period were approximately $25. They include expenditures currently mandated, as well as those not required by any regulatory authority or third party. The reserve balance was increased by $40 in the 2004 nine-month period, principally due to the additional reserve recorded for the Grasse River site in the second quarter of 2004.
Included in annual operating expenses are the recurring costs of managing hazardous substances and environmental programs. These costs are estimated to be about 2% of cost of goods sold.
Item 3. Quantitative and Qualitative Disclosures about Market Risk
In addition to the risks inherent in its operations, Alcoa is exposed to financial, market, political and economic risks. The following discussion provides additional detail regarding Alcoa’s exposure to the risks of changing commodity prices, foreign exchange rates, and interest rates.
Derivatives
Alcoa’s commodity and derivative activities are subject to the management, direction, and control of the Strategic Risk Management Committee (SRMC). The SRMC is composed of the chief executive officer, the chief financial officer, and other officers and employees that the chief executive officer selects. The SRMC reports to the Board of Directors on the scope of its derivative activities.
All of the aluminum and other commodity contracts, as well as various types of derivatives, are held for purposes other than trading. They are used principally to mitigate uncertainty and volatility, and to cover underlying exposures. The company is not involved in energy-trading activities, weather derivatives, or other nonexchange commodity trading activities.
Commodity Price Risks - Alcoa is the world’s leading producer of aluminum ingot and fabricated products. As a condition of sale, customers often require Alcoa to enter into forward-dated, fixed-price commitments. These commitments expose Alcoa to the risk of fluctuating aluminum prices between the time the order is committed and the time the order is shipped.
23
Alcoa’s aluminum commodity risk management policy is to manage, through the use of futures contracts, the aluminum price risk associated with a portion of its fixed-price firm commitments. At September 30, 2004, these contracts totaled approximately 740,000 mt with a fair value gain of approximately $144 (pre-tax).
Alcoa has also entered into certain derivatives to minimize its aluminum price risk. A portion of these derivatives do not qualify for hedge accounting treatment under U.S. GAAP, and are marked to market through earnings. These contracts totaled 76,000 mt at September 30, 2004. Additionally, in the second quarter of 2004, Alcoa entered into a long-term power supply contract that provides for increased pricing if the LME exceeds a certain price. The LME linked pricing feature in this contract is considered an embedded derivative and is also marked to market through earnings. The impact to earnings for these mark to market derivatives was a gain of $1 in the third quarter of 2004 and a loss of $1 in the 2004 nine-month period.
Alcoa purchases natural gas, fuel oil, and electricity to meet its production requirements. These purchases expose the company to the risk of higher prices. To hedge a portion of this risk, Alcoa enters into long positions, principally using futures contracts. Alcoa follows a stable pattern of purchasing these commodities; therefore, it is highly likely that anticipated purchases will occur. The fair value of these contracts was a gain of approximately $128 (pre-tax) at September 30, 2004.
Financial Risk
Currencies - Alcoa is subject to exposure from fluctuations in foreign currencies. Foreign currency exchange contracts may be used from time to time to hedge the variability in cash flows from the forecasted payment or receipt of currencies other than the functional currency. These contracts cover periods commensurate with known or expected exposures, generally within three years. The fair value of these contracts was a loss of approximately $11 (pre-tax) at September 30, 2004. These contracts are principally related to foreign exchange and inflation exposure in Brazil.
Interest Rates - Alcoa uses interest rate swaps to help maintain a strategic balance between fixed- and floating-rate debt and to manage overall financing costs. The company has entered into pay floating, receive fixed interest rate swaps to change the interest rate risk exposure of its outstanding debt. The fair value of these swaps was a loss of approximately $15 (pre-tax) at September 30, 2004.
Alcoa previously used interest rate swaps to establish fixed interest rates on anticipated borrowings between June 2005 and June 2006. Due to a change in forecasted borrowing requirements, resulting from the early retirement of debt in June 2004 and a forecasted increase in future operating cash flows resulting from improved market conditions, it is no longer probable that the anticipated borrowings will occur in 2005 and 2006. Therefore, Alcoa recognized $33 of gains that had been deferred on previously settled swaps and $44 of additional gains to unwind the remaining interest rate swaps. These gains were recorded in other income in the second quarter of 2004. See Note B in Part I, Item I for additional information.
Material Limitations - The disclosures with respect to commodity prices, interest rates, and foreign exchange risk do not take into account the underlying commitments or anticipated transactions. If the underlying items were included in the analysis, the gains or losses on the futures contracts may be offset. Actual results will be determined by a number of factors that are not under Alcoa’s control and could vary significantly from those factors disclosed.
Alcoa is exposed to credit loss in the event of nonperformance by counterparties on the above instruments, as well as credit or performance risk with respect to its hedged customers’ commitments. Although nonperformance is possible, Alcoa does not anticipate nonperformance by any of these parties. Futures contracts are with creditworthy counterparties and are further supported by cash, treasury bills, or irrevocable letters of credit issued by carefully chosen banks. In addition, various master netting arrangements are in place with counterparties to facilitate settlement of gains and losses on these contracts.
24
Item 4. Controls and Procedures
(a) Evaluation of Disclosure Controls and Procedures
Alcoa’s Chief Executive Officer and Chief Financial Officer have evaluated the company’s disclosure controls and procedures as of the end of the period covered by this report, and they have concluded that these controls and procedures are effective.
(b) Changes in Internal Control Over Financial Reporting
There have been no significant changes in internal control over financial reporting that occurred during the quarter ended September 30, 2004, that have materially affected, or are reasonably likely to materially affect, the registrant’s internal control over financial reporting.
25
PART II - OTHER INFORMATION
Item 1. Legal Proceedings.
Since 1990, Alcoa has undertaken investigations and evaluations concerning alleged releases of mercury from its Point Comfort, Texas facility into the adjacent Lavaca Bay pursuant to a Superfund order from the EPA. In March 1994, the EPA listed the “Alcoa (Point Comfort)/Lavaca Bay Site” on the National Priorities List, and Alcoa and Region VI of the EPA entered into an administrative order on consent, EPA docket no. 6-11-94, concerning the site. The administrative order required the company to conduct a remedial investigation and feasibility study under EPA oversight. Following submission by the company of all required information, in December 2001, the EPA issued its Record of Decision selecting the final remedial approach for the site, which is fully reserved. In addition, the company and certain federal and state natural resource trustees, who previously served Alcoa with notice of their intent to file suit to recover damages for alleged loss or injury of natural resources in Lavaca Bay, have cooperatively identified restoration alternatives and approaches for Lavaca Bay. The cost of such restoration is reserved. Alcoa does not believe that any additional liability for this site is reasonably possible. The company and the responsible federal and state government agencies have now negotiated Consent Orders to implement the remedial and restoration remedies. Following signature by the company and the agencies, entry of the Consent Orders in federal court is anticipated during the fourth quarter of 2004.
26
Item 2. Unregistered Sales of Equity Securities and Use of Proceeds.
(c) Issuer Purchases of Equity Securities:
Period
Total
Number
of SharesPurchased
(a)
AveragePrice
Paid
PerShare
Maximum Number
(or ApproximateDollar Value)
of Shares that MayYet Be PurchasedUnder the Plans orPrograms (b)
January 1 - January 31, 2004
February 1 - February 29, 2004
March 1 - March 31, 2004
Total for quarter ended March 31, 2004
April 1 - April 30, 2004
May 1 - May 31, 2004
June 1 - June 30, 2004
Total for quarter ended June 30, 2004
July 1 - July 31, 2004
August 1 - August 31, 2004
September 1 - September 30, 2004
Total for quarter ended September 30, 2004
27
Item 6. Exhibits.
(a) Exhibits
28
SIGNATURES
Pursuant to the requirements of the Securities Exchange Act of 1934, the Registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.
October 26, 2004
Date
/s/ RICHARD B. KELSON
/s/ CHARLES D. MCLANE, JR.
29
EXHIBITS
30