Investment Thesis: Alcoa produces 24% of the world’s aluminum. The company is refocusing on their upstream bauxite mining and refinery business and phasing out their downstream production business. Since the economics behind mining and alumina refining operations is more cost-effective this will keep the company on track to improve their overall profitability in the future and allow for further long term growth opportunities. Aluminum prices have had steady if not large increases since 2004 mainly because of demand from China. This is reflected in Alcoa’s 52 week high of $44.77 (May 2008). The greatest catalyst for Alcoa’s stock price is their correlation with the overall condition of the economy. Because of such high uncertainty and a projected compound annual sales growth rate of negative 4% from 2008 to 2014, share price appreciation remains apathetic. Since the release of Alcoa’s 10Q the stock has risen nearly 25% and I personally see tremendous upside to the stock as the economy stabilizes and eventual growth. Price Performance Stock Analyst: Theo Constantinou Fisher College of Business The Ohio State University Columbus, OH Contact: 330.620.9361 Email: [email protected]Fund: OSU SIM Class Fund Manager: Chris Henneforth, CFA Recommendation: BUY Sector: Materials Industry: Aluminum Stock Data: Ticker: AA (NYSE) Current Price: $10.21 Target Price: $18.25 52 Wk Range: $4.97 – $44.77 Avg Volume (3m): 44,769,000 Market Capitalization: 9.91B Shares Outstanding: 974,276,000 Beta: 1.97 YTD Return: -8.91% Dividend Yield: 1.20% EPS: -0.68 Trailing PE: 41.7 Forward PE (median): 13.2 Annual EPS Est (Dec 09): -0.98 Price to Sales: 0.4 Price to Book: 0.7
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Table of Contents
Table of Contents
Investment Thesis: Alcoa produces 24% of the world’s aluminum. The company is refocusing on their upstream bauxite mining and refinery business and phasing out their downstream production business. Since the economics behind mining and alumina refining operations is more cost-effective this will keep the company on track to improve their overall profitability in the future and allow for further long term growth opportunities.
Aluminum prices have had steady if not large increases since 2004 mainly because of demand from China. This is reflected in Alcoa’s 52 week high of $44.77 (May 2008). The greatest catalyst for Alcoa’s stock price is their correlation with the overall condition of the economy. Because of such high uncertainty and a projected compound annual sales growth rate of negative 4% from 2008 to 2014, share price appreciation remains apathetic. Since the release of Alcoa’s 10Q the stock has risen nearly 25% and I personally see tremendous upside to the stock as the economy stabilizes and eventual growth.
Price Performance
Stock Analyst: Theo Constantinou Fisher College of Business The Ohio State University Columbus, OH Contact: 330.620.9361 Email: [email protected] Fund: OSU SIM Class Fund Manager: Chris Henneforth, CFA Recommendation:
BUY Sector: Materials Industry: Aluminum Stock Data: Ticker: AA (NYSE)
Current Price: $10.21
Target Price: $18.25
52 Wk Range: $4.97 – $44.77
Avg Volume (3m): 44,769,000
Market Capitalization: 9.91B
Shares Outstanding: 974,276,000
Beta: 1.97
YTD Return: -8.91%
Dividend Yield: 1.20%
EPS: -0.68
Trailing PE: 41.7
Forward PE (median): 13.2
Annual EPS Est (Dec 09): -0.98
Price to Sales: 0.4
Price to Book: 0.7
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Company Overview…………………………………………………….........................................5
In 1886, Charles Hall discovered the process of smelting aluminum. Concomitantly, halfway around the
world in France, Paul Héroult discovered the same process. The process consists of passing an electrical
current through a bath of cryolite and aluminum oxide, resulting in the metal aluminum. This procedure
is called the Hall- Héroult process and is still the only process used to make aluminum today.
Alcoa, which gets its name from the Aluminum Company of America, was founded in 1888 and is the
world’s third largest aluminum producer behind Rio Tinto Alcan and Rusal. Alcoa are the world leader in
the production and management of primary aluminum, fabricated aluminum and alumina. Alcoa serves
numerous markets, including aerospace, automotive, packaging, building and construction, commercial
transportation, and industry. Additionally, Alcoa produces flat-rolled products, hard alloy extrusions, and
forgings. Alcoa conducts operations in 44 countries on 5 continents. As of December 31, 2008 they have
107,000 employees.
In May 2008, Klaus Kleinfeld was appointed as Alcoa’s President and Chief Executive Officer. A proven
leader with outstanding international credentials and an existing board member of Alcoa, Kleinfeld was
the ideal leader to guide Alcoa through the current economic crisis and shape its bright future.
During spring, 2007, Alcoa conducted a hostile takeover for $27 billion to acquire Alcan. A successful
takeover would have undoubtedly formed the world’s largest aluminum producer. The takeover bid,
however, was withdrawn after Alcoa’s major competitor Rio Tinto announced a friendly takeover in
summer, 2007, forming what is now currently Rio Tinto Alcan.
For the 1Q of 2009, Alcoa reported a loss of $497 million, or $0.61 per share. This was due to weak
aluminum prices and volume. Revenue fell 13% from the previous quarter. The company raised $1.3
billion in common equity and convertible bonds to address liquidity issues. This stock sale has been
extremely dilutive to existing shareholders. Aluminum inventory approached historically high levels that
created trouble for a rebound in aluminum prices. Cost-cutting and liquidity preservation should and will
be the main priority for Alcoa in 2009.
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Business Segments2 Alcoa has five primary business segments that generate revenue for the company: Alumina, Primary
Metals, Flat-Rolled Products, Engineered Products and Solutions, Packaging and Consumer.
Alumina
Aluminum is one of the most plentiful elements in the earth’s crust. Aluminum is produced primarily
from bauxite, an ore containing aluminum in the form of aluminum oxide, commonly referred to as
alumina. Aluminum is made by extracting alumina from bauxite and then removing oxygen from the
alumina. Alcoa processes most of the bauxite that it mines into alumina. Alumina is sold directly to
internal and external smelter customers worldwide or is processed into industrial chemical products.
Late in 2008, management made the decision to reduce Alcoa’s aluminum and alumina production in
response to the significant economic downturn. As a result of this decision, reductions of 750 kmt, or
18%, of annualized output from Alcoa’s global smelting system were implemented. Accordingly,
reductions in alumina output were also initiated with a plan to reduce production by 1,500 kmt-per-year
across the global refining system.
It is important to note that; sales for the 2009 first quarter decreased $2,851M, or 41%, compared with the
same period in 2008. The decline was driven mainly by three factors: (1) a drop in realized prices for
alumina (36%) and aluminum (44%), (2) decreases in volume in the downstream segments due to weak
end markets, and (3) the absence of sales from the businesses within the former Packaging and Consumer
segment ($497 in the 2008 first quarter). Alumina production decreased 11% in the 2009 first quarter
compared with the corresponding period in 2008. This illustrates the sharp decline of aluminum prices
over the past year compared to their steady growth over the past decade to show the inevitable rebound in
the global price of aluminum that directly correlates to Alcoa’s alumina production (Graph 1)3. The
downside risks associated with Alcoa should start to lighten as aluminum prices start to stabilize and
increase.
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GRAPH 1 - Aluminum Price YOY and Over 10 Year Horizon
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Alumina continued
Another important point is the dominance and sustainable growth of China. According to Morningstar
analyst Min Ye, “China's aluminum consumption growth has accounted for 60% of world consumption
growth during the last seven years.”4 This is a key driver in pointing to further growth in the aluminum
industry. The industrialization of emerging-market countries will further the long-term growth and
utilization of aluminum (Figure 1)5.
FIGURE 1 – World Primary Aluminum Production
Primary Metals
This segment consists of Alcoa’s worldwide smelter system. Primary Metals receives alumina, primarily
from the Alumina segment, and produces primary aluminum used by Alcoa’s fabricating businesses, as
well as those sold to external customers, aluminum traders, and commodity markets. Results from the sale
of aluminum powder, scrap, and excess power are also included in this segment, as well as the results of
aluminum derivative contracts. The sale of primary aluminum represents more than 90% of this
segment’s third-party sales.
Third-party sales for the Primary Metals segment declined 55% in the 2009 first quarter compared with
the same period in 2008. The decrease was largely the result of a 44% drop in realized prices driven by a
50% decline in LME prices. Refer to Graph 1. A serious problem within the smelting industry is the high
fragmentation, possibly resulting in overcapacity. In 2007, China’s share of aluminum smelting
drastically increased from 13% to 32%. Looking forward there should be lower production in the
anticipation of the further smelter cutbacks.
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Even though this is a downstream business for Alcoa it is interesting to note two things about their
smelting business: secured long-term power contracts for almost half of the global smelting system and
the successful start-up of the first ‘greenfield’ smelter in two decades.
According to United States Patent and Trademark Office Application #200600011996
New investments (called "greenfield plants" in engineering lingo) are rare (one per year to one every two years in average worldwide) due to the growing difficulty in concentrating on one site an energy source allowing for sufficiently low cost per kWh procured, for a period allowing depreciation of the huge capital costs (typically $4,500 to 5,000 per tonne/year capacity in 2000-2004). It is generally recognized that between 2000 and 2004 the world aluminum industry spent on average 2 US cents per kWh or roughly $280 per tonne of aluminum produced.
In 2008, Alcoa produced roughly 4 million tonnes. Since producing aluminum costs nearly $280 per
tonne, the developments of this ‘greenfield’ plant is detrimental for reduced cost in this segment and
future growth.
Flat-Rolled Products
The principal business of the company’s Flat-Rolled Products segment is the production and sale of
aluminum plate, sheet, foil and hard alloy extrusions. These products serve the packaging and consumer,
transportation, building and construction, distribution, aerospace and automotive markets. This segment
includes rigid container sheet (RCS), which is sold directly to customers in the packaging and consumer
market and is used to produce aluminum beverage cans. Third-party sales for the Flat-Rolled Products
segment decreased 35% in the 2009 first quarter compared with the corresponding period in 2008. This is
largely the result of a reduction in volumes across all businesses, due to weak end markets in Europe and
North America, and a decline in realized prices.
When the Euro is strong, this segment is somewhat offset due to the positive foreign currency movement.
The gradual downstream shift in Flat-Rolled Products and Primary Metals will help Alcoa focus on their
bauxite mining and refinery business.
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Engineered Products and Solutions This segment includes titanium, aluminum, and super alloy investment castings; forgings and fasteners;
aluminum wheels; integrated aluminum structural systems; and architectural extrusions used in the
aerospace, automotive, building and construction, commercial transportation, and power generation
markets. A major problem with this segment is that it is heavily tied to the auto and construction
industries. Since these two industries are materially weak and the pending bankruptcy of General
Motors*, overall optimism is not warranted.
Some positive outlook comes from productivity in the aerospace and industrial gas turbine markets.
According to the US Department of Energy7,
Domestic and global potential markets for advanced turbines are large. At least half of all new power generating capacity added between now and 2010 is likely to use gas turbines. In addition, mid-sized turbines have tremendous potential for use as base-load, peaking, and standby/backup power in commercial and industrial settings.
The above statement from the US Department of Energy generates sanguinity for engineered products and
solutions with increased productivity and strong future demand for gas turbines.
Packaging and Consumer
On February 29, 2008, Alcoa completed the sale of its Packaging and Consumer businesses to Rank
Group Limited. The Packaging and Consumer segment no longer contains any operations. The principal products in this segment included aluminum foil; plastic wraps and bags; plastic beverage
and food closures; flexible packaging products; thermoformed plastic containers; and extruded plastic
sheet and film. Consumer products were marketed under brands including Reynolds Wrap®, Diamond®,
Baco®, and Cut-Rite®.
*General Motors, as of June 1, 2009, have filed for bankruptcy.
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GRAPH 2 – Alcoa’s 2008 Revenue by Segment / Geographic Region
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Macroeconomic Conditions8 Important macroeconomic factors significant to Alcoa’s performance include: industrial production in
important emerging market countries, economic growth domestically (GDP) and overall prices of
aluminum on the LME (London Mercantile Exchange). Alcoa’s primary business is cyclical in direct
correlation to economic growth and current economic conditions. When there is economic uncertainty
and a continuing recession, aluminum inventories will be high, thereby driving prices down directly and
affecting Alcoa’s ability to generate higher revenue. Another important factor for Alcoa as a multi-
national firm is fluctuation in currencies and the result this has on amount of P/L reported in their
financial statements.
Gross Domestic Product (GDP)
The overall growth of a country is determined by their GDP growth. Developing GDP shows signs of a
strong economy that would allow for development in building and construction. Currently the average
GDP growth rate is decreasing at an annual rate of -6.1% in the first quarter of 2009. This does not favor
well for Alcoa since Real GDP is decreasing; however, GDP cannot stay negative forever and when this
number becomes positive, Alcoa will again start to grow relative to GDP. As projected by the OECD, by
2010 GDP should have positive growth and the price of aluminum should rise with GDP growth (Graph
3). 9 Appendix I – Graph 11 displays a graphical representation that if the OECD economic indicators
have bottomed the line will now start to trend upward.
GRAPH 3- Real GDP Projection
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Price of Aluminum traded on LME
Since overall domestic growth is negative and international industrial production is at record lows it is
within reason to see much cheaper prices for aluminum. Prolonged sustainable lows will not hold long
term and with the eventual decrease in aluminum inventories which are at record high-levels, the price of
aluminum will eventually rebound. Graph 1, where the 10 year price levels of aluminum are shown, in
July 2006 aluminum was selling at a record highs of $1.50 (USD/lb) when inventories were low.
Currently there is 5 times the amount of aluminum in the market that is not being turned over and is
selling for $0.59 in comparison to the highs of 2006. As more aluminum is sold the inventory will start to
decrease and as this graph starts to trend downward the price of aluminum will rise, allowing for better
profit margins for Alcoa (Graph 4)10. A graphical depiction of rate of change (ROC) in which aluminum
is trading with eventual price reversion occurring and trending upward toward the mean (Graph 5)11.
GRAPH 4 – Primary Aluminum Inventories vs. Days Inventory
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GRAPH 5 – 10 Year London Metal Exchange Prices (Aluminum)
*200 day exponential average in red. 200 day rate of change (ROC) green above.
Currency Translation
Alcoa generates 41% of its revenue overseas (Europe and Asia). With the US dollar trending downward
relative to the Euro, income repatriation will return positive profits back to Alcoa. Due to the downturn in
economic growth, the dollar has traded at historic lows over the past year $1.20/Euro and foreseeable
increases are not in the near future. Another positive note for Alcoa’s future is that commodity prices
trade relatively higher in relation to a weak dollar.
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Legal Proceedings12 As previously reported, in November 2006, in Curtis v. Alcoa Inc., Civil Action No. 3:06cv448 (E.D.
Tenn.), a class action was filed by plaintiffs representing approximately 13,000 retired former employees
of Alcoa or Reynolds and spouses and dependents of such retirees alleging violation of the Employee
Retirement Income Security Act (ERISA) and the Labor-Management Relations Act by requiring
plaintiffs, beginning January 1, 2007, to pay health insurance premiums and increased co-payments and
co-insurance for certain medical procedures and prescription drugs. Plaintiffs allege these changes to
their retiree health care plans violate their rights to vested health care benefits. Plaintiffs additionally
allege that Alcoa has breached its fiduciary duty to plaintiffs under ERISA by misrepresenting to them
that their health benefits would never change. Plaintiffs seek injunctive and declaratory relief, back
payment of benefits and attorneys’ fees.
In August 2008, the court set a new trial date of March 24, 2009 and in January 2009 moved it to
September 22, 2009. Alcoa estimates that, in the event of an unfavorable outcome, the maximum
exposure would be an additional post-retirement benefit liability of approximately $300 million and
approximately $40 million of expense (includes an interest cost component) annually, on average, for the
next 11 years. Alcoa believes that it has valid defenses and intends to defend this matter vigorously.
However, at this stage of the proceeding, the company is unable predict the outcome.
This could cause issues for Alcoa moving forward. They are already facing liquidity issues; if they are
found guilty and forced to pay $300 million, this would further impact Alcoa’s liquidity.
(Refer to Risks and Concerns to Investment Thesis for further explanation).
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Regulatory Framework13
Energy prices are a significant input in a number of Alcoa’s operations. There is growing recognition that
energy consumption is a contributor to global warming, greenhouse effects and potential climate change.
A number of governments have recognized the needs for regulatory change in response to the potential
impacts of climate change. There is current and emerging regulation, such as the mandatory renewable
energy target in Australia, or potential carbon trading regimes that will affect energy prices. This impacts
Alcoa because they have two smelters in Australia, so that alterations in energy prices could affect their
profitability. Alcoa will likely see changes in the margins of greenhouse gas-intensive assets and energy-
intensive assets as a result of regulatory impacts in those countries in which the company operates.
Assessments of the potential impact of future climate change regulation are uncertain, given the wide
scope of potential regulatory change in countries in which Alcoa operates.
The potential physical impacts of climate change on the company’s operations are highly uncertain, and
will be unique to the geographic circumstances. These may include changes in rainfall patterns, water
shortages, sea levels, storm patterns and intensities and temperature levels. These effects may adversely
impact the cost, production and financial performance of Alcoa’s operations.
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Industry Analysis The materials sector in the S&P 500 is highly cyclical. Alcoa operates in a very mature industry with
over 100 years of experience. There is still countless room for growth in this industry, especially with the
development of emerging market countries. Alcoa’s business moves directly with the economy in the
United States and with the S&P 500. When the economy is booming and there is tremendous growth the
price of aluminum soars producing higher profit and positive EPS for Alcoa. In the case of economic
turmoil and a bleak outlook on future growth and earnings, Alcoa is drastically hurt by negative economic
growth and Real GDP. It is my opinion that our economy is in the recovery stage where there is cyclical
growth and eventual cyclical value (Figure 2)14. The problem in writing this thesis is the profound
economic uncertainty that we are facing as a nation. With the Federal Reserve moving in the shadows of
the financial system, no one in the general public truly knows what the future holds. Based on my
personal optimism that we live in a country that will not become socialist and the conviction that our
politicians believe in the free market system; growth for the materials sector will begin in the later part of
this year and into 2010. The beta of Alcoa is 1.97, which is almost double the market beta of 1.0.
FIGURE 2 – Merrill Lynch Investment Clock
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Materials Sector Valuation
It is important to understand how the Materials sector and the S&P 500 are correlated with the metals and
mining industry (aluminum). Two of Porter’s 5 forces are important here when analyzing the sector and
specifically aluminum. The first is the customer’s / high, especially in the auto industry where Alcoa sells
aluminum alloy to car manufacturers. The second is rivalry / high where global competition exists and
there are cheap imports. These mature companies in the materials sector are constantly fighting for
market share as was seen when Alcoa tried a hostile takeover of Alcan.
With the exception of the dot-com bubble in 2000-2001, the materials sector is cyclical and grows in
direct relation to the S&P 500. As Real GDP grows in the future and there is eventual global economic
growth, especially in emerging market countries, the materials sector will increase as will the overall
growth of the S&P 500. A regression was run to show how closely related the stock price of aluminum
was related to the Materials sector (SPBMS) and the relationship of the Materials sector with the S&P
500 (SPX) (Graph 6)15.
GRAPH 6 – Materials Sector vs. S&P 500
The data from 1998 to 2002 was removed for the regression analysis because of the Dot‐Com bubble that did not affect the Materials Sector.
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TABLE 1 – Materials Sector vs. Aluminum (US Cents/Pound)
Regression StatisticsMultiple R 0.913429629R Square 0.834353688Adjusted R Square 0.832973302Standard Error 16.35796775Observations 122
1 Adapted from the 2008 Alcoa Company 10-K and Wikipedia Contributors: Alcoa 2 Adapted from the 2008 Alcoa Company 10-K 3 InfoMine: Mining Intelligence & Technology 4 Morningstar 5 World Bureau of Metal Statistics 6 Fresh Patents 7 US Department of Energy 8 Thomson Baseline 9 Thomson Baseline 10 CRU: The Independent Authority 11 Investment Tools 12 Adapted from the 2008 Alcoa Company 10-K 13 Adapted from the 2008 Alcoa Company 10-K 14 Merrill Lynch Investment Clock 15 Thomson Baseline 16 2008 Alcoa Company 10-K and 2009 Alcoa Company 10-Q 17 Relative Prices: Platts Metals Week, Purchasing, Bloomberg 18 Adapted from the 2008 Alcoa Company 10-K and Mergent Online 19 Thomson Baseline 20 Companies for comparable analysis: Yahoo Finance 21 Legg Mason Capital Management: Common Errors in DCF Models 22 Long-Term Aluminum Demand Growth: The O’Carroll Aluminum Bulletin 23 Thomson Baseline 24 China GDP: Bloomberg 25 World Bureau of Metal Statistics 26 2008 Alcoa Company 10-K 27 Organisation for Economic Co-Operation and Development 28 CRU: The Independent Authority 29 CRU: The Independent Authority 30 CRU: The Independent Authority 31 Credit Suisse Equity Research: Alcoa