Integrated aluminum powerhouse Alcoa has (AA) benefited from a rebound in the price of the metal, the key profitability driver. While aluminum prices are impossible to predict, global demand for aluminum should continue to increase as population growth and economic development lead to more use in end-markets such as transportation, construction and packaging.
The extent to which Alcoa benefits is likely driven by how cost-competitive it stays relative to lower-cost capacity entering the market (click to enlarge images):
ALCOA - SELECTED INDUSTRY AND BUSINESS METRICS
Alcoa is the leading global producer of primary and fabricated aluminum, as well as the largest miner of bauxite (the key raw material) and refiner of alumina. (Aluminum is produced from bauxite, an ore containing aluminum in the form of aluminum oxide, commonly referred to as alumina.) The company is a cost-competitive and vertically-integrated producer, with a top 30th percentile rank on the refining cost curve, and ~50th on the aluminum curve. The company owns long-life bauxite ore rights in Brazil, Australia, Jamaica, Guinea and Suriname. Roughly 80% of the needed ore for the company's 2009 production came from Alcoa-controlled sources. The company also generates 20+% of the electric power used at its smelters.
Alcoa’s existing capacity appears undervalued based on an $11 billion integrated aluminum complex being built in Saudi Arabia. The cost of the project, a joint venture between local miner Ma’aden (75%) and Alcoa (25%), is about $15,000 per metric ton of integrated smelting capacity versus Alcoa’s $7,000 per ton, as implied by the company's recent enterprise value.
ALCOA’S MA’ADEN SAUDI ARABIA JV – IMPLIED VALUATION
The following table shows how one might think about the fair value of Alcoa. The valuation analysis is based on a range of assumptions regarding the fair value discount to the newbuilding cost of integrated aluminum smelting capacity, plus the estimated value of the engineered products business. The analysis suggests a fair value range of $17-$30 per share for Alcoa.
ALCOA – OUR ESTIMATE OF THE EQUITY FAIR VALUE RANGE
Alcoa management expects demand for aluminum to double by 2020 (it was up 50+% from 2000-2010), implying the need for three million tons of new annual supply (4-5 Ma’aden JV-like smelters). Aluminum is durable and lightweight and is used in aerospace (~50% of engineered segment revenue), cans (~40% of rolled segment revenue), auto, construction, and electronics markets.
2011 PROJECTED PRIMARY ALUMINUM CONSUMPTION, BY REGION
(in millions of metric tons – mmt)
We see the following key risks to an investment in Alcoa:
- Commodity-driven business: While Alcoa may have an edge due to scale and vertical integration, profitability remains largely driven by the aluminum price, which Alcoa cannot control. According to Alcoa, a $100/ton decline in aluminum prices (~5%) would reduce net income by $200 million.
- The China factor: China’s aluminum demand/supply dynamics may have adverse effects. China, which is a modest net importer, is to account for ~45% of the ~44 million tons of world aluminum demand in 2011.
- Financial leverage: Alcoa has $8 billion of net debt (~2.8x 2010 adj. EBITDA) and ~$5 billion of unfunded pension liabilities. The company is contributing ~37 million new shares and $300 million of cash to the pension plan in 2011.
- Inventory overhang of three months’ consumption due to ~11 million tons of excess aluminum (incl. ~5 million unreported tons), as estimated by Norsk Hydro). Rising supply may delay an adjustment.
Despite the aforementioned risks, Alcoa may be a worthwhile investment candidate for investors interested in exposure to global growth generally or the aluminum industry in particular. Based on a recent stock price of $15 per share and consensus analyst EPS estimates of $1.34 in 2011 and $1.54 in 2012, Alcoa shares are not dirt cheap. However, as the above valuation analysis suggests, the shares may be modestly undervalued under the assumptions shown in the table.