Alcoa (AA) is standing strong at the top of its industry as the largest producer of alumina as well as leading manufacturer of aluminum. Since aluminum is a cyclical commodity in nature, it tends to carry's many critical short-term risks such as exposure to commodity price volatility. Historically, the price volatility surrounding aluminum has posed an immense effect on Alcoa's security market price in the short run, however, future estimates surrounding the price of aluminum and the industry as a whole eliminate the magnitude and relevance of any short-term driven volatility.
The futures market is projecting that the price of aluminum with reach approximately $2,300 within the next three years. In any market under the assumption of normality, consumers benefit from falling prices and producers do merely the opposite. Since aluminum is currently trading for $2050 in commodity markets, the futures market estimate implies an upward sloping cost curve. For producers, an upward sloping cost curve is highly beneficial and will enable aluminum producers such as Alcoa to benefit from a price increase in aluminum. In addition, Alcoa's refinery expansion in Brazil and access to financial resources has enabled them to greatly reduce input costs. Therefore, the occurrence of these factors combined will result in a large influx in Alcoa's profit margins and ultimately add firm value. I recommend buying Alcoa, with an anticipated price target of $20 in one year. This estimate is based off of the underlying assumptions used in the corporate valuation model (shown later in figure 6).
What Does Alcoa Do?
Alcoa was founded in 1888 and since has established a long history of evolving success over the past twelve decades. Alcoa's business model is dedicated towards addressing customers' evolving needs in modern markets, but at the same time, management has clearly expressed they operate in the best interest of the shareholders. Approximately 75% of all the aluminum ever produced is still actively used across the world. Today, Alcoa employs roughly 61,000 people in more than 200 different locations spread across 30 countries globally.
Alcoa's operations are broken down into four segments including:
- Alumina - refinery system, including mining of bauxite, which is then refined into alumina.
- Primary Metals - This segment consists of the smelter system that receives alumina and produces primary alumina.
- Flat-rolled products - This segment is engaged in the production and sale of aluminum plates and sheets.
- Engineering Products and Solutions - Over time Alcoa's operations have evolved dramatically and in order to maintain a competitive edge in the modern-day aluminum industry, Alcoa takes on high priority projects that involve marketing advanced engineering products and solutions to different markets. This is the most recently established segment of Alcoa's operations. This segment is responsible for producing and providing services for the following areas including titanium, aluminum, and super alloy investment castings, forgings and fasteners, aluminum wheels, combined aluminum structural systems, and architectural extrusions. Operations through this segment enable Alcoa to reach a wide customer base entering different markets such as aerospace, automotive, packaging, building and construction, commercial transportation, and consumer electronics.
Alcoa operates through seven primary subsidiaries, and within each subsidiary there is a minimum of one additional company or branch. Note the additional companies and branches have been excluded below but can be retrieved from Alcoa's 10-K.
- Alcoa Domestic LLC
- Alcoa International Holdings Company
- Alcoa Power Generating Inc.
- Alcoa World Alumina LLC
- Alumax Inc.
- Cordant Technologies Holding Company
- Reynolds Metals Company
For the past 11 years, Alcoa has been a member of the Dow Jones Sustainability Index. Alcoa's effort towards increasing the level of sustainability company-wide was first implemented in 2001. Since 2001, efforts to continue sustainability practices have become scrutinized increasingly more by management to ensure these practices continue. Sustainability has been heavily integrated into Alcoa's operating practices, specifically surrounding the engineering design process as well as production at its plants and facilities. On November 30, 2012, Alcoa was named a model company for sustainability for the fourth year in a row. One factor that contributed to winning the award was the practice of Alcoa replacing fuel oil with natural gas at one of its alumina refineries. This solution was advantageous because not only was it highly cost effective, but it resulted in an 11% reduction of CO2 emissions at the alumina refinery.
As you are starting to understand, sustainable practices are a critical part of Alcoa's business model. Alcoa's operations require the use of viable resources and protecting these resources is a top priority. Alcoa has implemented plans to ensure that all resources are utilized efficiently and to set controls that will effectively minimize waste and harmful byproducts. Figure 1 below highlights Alcoa's efficiency goals set forth by management to aid in protecting its vital resources.
Figure 1: Alcoa's Efficiency Goals
For the past two years, Alcoa has actively been engaged in working towards reducing its greenhouse gas (GHC) emissions. Alcoa has made this happen by significantly reducing its carbon footprint through delivering light and strong aluminum products to customers. One of Alcoa's first goals was to reduce the total CO2 in global primary products by 20%. Just during this past year, this goal was accomplished by achieving a 23.1% reduction. In addition, Alcoa also exceeded its goal in reducing the average freshwater by an excess of 10% for a total reduction of 20%. For further information regarding the progress of these goals, please visit the corresponding link above.
Alcoa has made huge alterations to its design process in order to provide customer with final products that are inherently sustainable in terms of size, strength, durability, and recyclability. It is clear that Alcoa ultimately wants to improve the sustainability of its customers' products and continue aluminum's long lasting history of existence in the market place. Figure 2 outlines the current improvements Alcoa is implementing into its design process.
Figure 2: Alcoa's Product Improvements
Among competitors, Alcoa was the first company to receive Cradle-to-Cradle certification for all its products. With regards to product improvements for customers in the transportation industry, Alcoa has made significant advancement with its new aerospace alloys and have created a solution augmenting aircraft fuel efficiency by a whopping 12%. These are just several examples that highlights Alcoa's accomplishments from its efforts to enhance sustainability. The end result produces a substantial impact on increasing efficiency in operations and in one case even leads to large cuts in operating costs, which I will discuss later.
As Alcoa continues to expand its operations, capital expenditures are being allotted to high growth regions as well as innovative products with cutting-edge technology, that will provide leverage over peers. Through a structured global approach, Alcoa's Growth & Marketing Strategy Team is focusing its efforts on four key markets including aerospace, defense, automotive, and non-automotive transportation. All of these markets are highly lucrative in nature and will play a major role in the growth of Alcoa's operations.
What Is Alcoa's Competition?
Broadly speaking, I like to think of Alcoa's intangible competitor to be the price of aluminum. Under existing market conditions where aluminum prices are stagnant and interest rate sensitivity is more prevalent, Alcoa's business enters a difficult state where profitability becomes directly associated with demand and volatile short-term fluctuations in the price of aluminum. Holding all else constant, the price of aluminum has the ability to send profit margins soaring, but the underlying questions still exist. What is needed for the price of aluminum to increase? The demand for aluminum is highly dependent on the performance of the economy at the macroeconomic level. Following the global credit crisis of 2008 extending into 2009, the macroeconomic implications were clearly revealed when the consumption level of aluminum declined significantly. Furthermore, there is a high level of uncertainty regarding the recovery speed of this recent decline and investors should be aware that large macroeconomic events have a pending effect that tends to be long in duration. Hence, aluminum prices have yet to trend up since the recession.
At the forefront of the aluminum industry, Alcoa is not the only big player. There are several other companies that have been working towards gaining further market share in the industry over the past decade. Here is a brief overview illustrating Alcoa's performance relative to several of its peers. Figure 3 represents a graph I constructed using YChart's custom graphs with the following peers including Alumina Limited (AWC), Aluminum Corporation of China Ltd (ACH), and Century Aluminum Company (CENX).
Figure 3: Alcoa's Relative Five-Year Performance
The performance of all three firms is directly on track with that I previously discussed regarding the poor performance of the aluminum industry as a whole following the recession. It is essential to note, two of the competitors shown above are in foreign markets. This was not by any means intentional; however, it helps depict a growing trend. The threat of new entrants, particularly start-up companies in foreign markets such as the Middle East, Russia, and China are now becoming more prevalent. The threat does not appear to be sustainable as the growing trend revolves around companies engaging in less capital-intensive segments of the industry, which in the long run will not permit the attainment of any substantial market share.
At the end of the Sustainability section, I discussed the critical areas Alcoa plan to allocate capital expenditures in the upcoming years. The critical drivers for future expansion into the aluminum market will be economic expansion from emerging and developing markets with a specific focus oriented towards aerospace and automotive markets. Over the course of the next two years, these two specialized fields cater to the largest upside in terms of growth. The major concerns are how much longer will Alcoa have to compete with China's excess capacity and will Alcoa be fully capable of continuing to maintain a strong position in the industry with these growing markets? China use to be the top consumer of aluminum; however, they still remain as the leading driver for demand and this is only expected to continue. China's production facilities for aluminum have increased significantly over the past five years and while China's production costs are significantly higher than those of Alcoa, the excess capacity in China still seems to be the influencing factor on the price of aluminum in commodity markets. However, it is expected that the novelty of excess capacity will wear off in the long run and the effect will diminish as China loses significant market share as Alcoa consistently undercuts China in terms of its production costs.
For FY 2012, Alcoa's historical average for its debt-to-equity ratio was 0.55 and currently is slightly slower at approximately 0.5349. In terms of capital allocation towards fixed assets and capitalized balance sheet items, Alcoa has exhibited strong financial management and made adequate decisions for its operations. Within the last few years, Alcoa expanded into Brazil in order to reduce operating costs. In Brazil, Alcoa built a new bauxite mine and as a result now save over 30% in energy costs.
Figure 4: Alcoa's Debt/Equity & Asset Utilization Ratios
What To Take Away From Alcoa's Q4 2012 Earnings Report As We Look Forward To FY 2013 & 2014
Given the prevailing market conditions caused a significant decline in commodity metal prices amounting to nearly $125 per metric ton, Alcoa was sure capable of shocking many analysts and investors. For the period ended Q4 2012, Alcoa's management reported astonishing results with a record breaking EBITDA margin of 17.7%. In terms of working capital, Alcoa continues to improve dramatically in this area. In Alcoa's Q4 2012 earnings call, management stated, "we attained an all-time low of 24 days and it's the 13th successive quarter of year-over-year improvement." Up to this point, Alcoa has proven its capability to reduce days working capital by 19 days since the beginning of 2008. Management estimated the savings from these improvements in working capital to be valued at nearly $1.2 billion.
Before we can evaluate Alcoa's firm specific value, it's important to take a further look into its historical financial data and search for historical trends in revenue and operating costs that may be useful when it comes to forecasting. Using the past five years of Alcoa's annual financial data and outside market projections for revenue, I constructed a pro-forma income statement extending to the end of FY 2014. At the bottom of the income statement in figure 5, I have provided several notes and assumptions to help aid your understanding as to how I derived my estimates. In addition, I would like to mention that my revenue projections take into account management's growth estimates for the aerospace, automotive, and commercial aircraft markets. In an effort towards providing conservative estimates, I have excluded any additional margins that would result from a strong increase in the price of aluminum in commodity markets.
Figure 5: Alcoa's Income Statement & Forecasted Items
What Is The True Value of Alcoa's Operations and Equity?
In order to place a value on Alcoa's future operations, I used the corporate valuation model. This valuation method works by modeling the firm's current free cash flows using a variation of the constant growth model to project forward future estimates. The last step involves discounting each free cash flow back by the difference between the firm's weighted average cost of capital and the growth rate. Note that the constant growth model also takes into account the firm's weighted average cost of capital and the anticipated firm-specific growth rate of operations, which must remain constant to ensure accuracy.
Figure 6: Alcoa's Two-Year Forward Price Targets
Based on Alcoa's current fundamentals including free cash flows, its weighted average cost of capital, and several additional balance sheet items, I was able to compute a current intrinsic share value of $15.40. According to fair value, this suggests Alcoa is currently undervalued by approximately 62%. Looking forward, I computed estimates for FY 2013 and 2014 of $20.05 and $25.70, respectively. Yes, these estimates may seem farfetched; however, in reality they are not. If the price of aluminum increases by merely 25% of what analysts are forecasting, you will be shocked at the effect on Alcoa's profit margins. These estimates are highly conservative if you take into account analysts' forecasts.
The weighted average cost of capital used in the model above was computed by multiplying the values of equity, preferred stock, and debt by its respective weight, which is simply its proportion of Alcoa's total capital structure. These calculations have been provided in further detail below.
Figure 7: Alcoa's Weighted Average Cost of Capital
Through the utilizing of lucrative financial resources and expansionary measures resulting in drastically cutting operating costs, Alcoa is well-positioned to benefit from the anticipated upward sloping costs curve for aluminum in the next two years. Financially speaking, Alcoa has proven its ability to efficiently allocate its capital expenditures towards projects that will yield payoffs in the short term by reducing operating costs as well as long-term payoffs from its strategic location. Alcoa's current liquidity position is the best it has been in the past four years and management is committed to continue generating this high level of free cash flow. From an investment standpoint, it is important to disregard short-term swings in Alcoa's market price per share because high upside on your initial investment will essentially derive from the projected upward sloping cost curve for aluminum. In conclusion, market participants seeking an investment with a roughly a one to two year horizon should buy Alcoa at its current valuation.
Sources: TD Ameritrade, Google Finance, The Wall Street Journal, Market Daily News, Morningstar, Mergent Online, & The Securities and Exchange Commission's Website.