Alcoa is at the cusp of a major shift. From an integrated producer with a strong downstream presence in aerospace and automotive, a split would create two parts. The juries are still out whether the sum of the parts is greater than the whole. But apparently the value in the whole, as we shall see, makes integration a strong contender. In fact, taking cues from oil, there are almost no takers for the concept of a split in the oil fraternity. Oil has made peace with the integrated model.
There is an apparent tendency to over-emphasize the value of an aluminum producer in the price of aluminum. Weightage factors that link performance to the price of aluminum tend to miss out on the intrinsic factors that are associated with an integrated player. Alcoa is one such integrated player with presence in high margin businesses in the downstream. Alcoa also enjoys the lowest net debt to EBIDTA ratio (2.8), which is a great achievement.
The same is true for oil. We shall see the integrated producers like ExxonMobil, Chevron, BP, Shell and Total all score well even when the oil prices are so low. The concept of a natural hedge for a drop in price of oil (or aluminum) runs deep in the integrated model.
Let us compare the performance of all these oil producers, as taken from their annual reports, as upstream and downstream entities. Let us compare two periods, 2010 and 2015. We will see how the recent price rout helped them to recover better from the downstream operations.
Operating Income in $ Billions
|All Figures in $ billion||Upstream||Downstream||Overall|
To take the words from Rex Tillerson, chief executive officer of ExxonMobil, the integrated producer "captures the highest value for every molecule that flows through our facilities."
To put it very simply, it is the integrated producer who will tune its upstream in such a manner that the highest value can be obtained. This value will be obtained by serving those markets in the downstream that could be advantageous given the reach and capabilities. The competitive advantage can be better served by matching the hierarchy of products by margins to the internal hierarchy of advantages.
For aluminum, this works as follows:
1. The internal strengths include positioning of assets like in casting to benefit the downstream as in the case of aluminum. If the businesses remained separate entities, the true synergy will be lost.
2. To make a new product innovation in aluminum to work in the downstream, it is important that the technology must start from the upstream stage of the process. Much of the knowledge of casting technology lies with the upstream part of the chain.
Examples of such alignment between upstream and downstream assets in the case of oil do exist.
The split in oil assets as in the case of ConocoPhillips (NYSE:COP) and Phillips 66 (NYSE:PSX) or between Marathon Oil (NYSE:MRO) and Marathon Petroleum happened due to physical challenges in integration. The physical location of assets more than offset the advantages. However after the split, the current stock prices of these separate entities show that Phillips66 and Marathon both have suffered 41% and 61% drop after the split. The integrated players like ExxonMobil, Shell or Total have fared better in the same period.
Aluminum prices, as oil prices, have impacted valuations of primary producers. But for an integrated player, the value of the total entity gets a biased treatment when prices are low. So when prices are low the performance of aluminum producers must be seen against the cost of production. But it better not be limited to cash cost of output alone. The producers who have highly leveraged balance sheet would find it rather difficult to manage their cash flows when they stand alone.
First of all, let me start with a slightly longer-term picture of aluminum prices (last twenty-seven years), which reflect the long term robustness of aluminum as a metal of the future. One would notice that $1500/T is the floor. The prices have hit the highs above $2500/T for a period of three years and above $2000/T for more than six years. There are three things that go unnoticed in the price curve of aluminum as well as in the cost curve for the producers.
Firstly, that the curve is denominated in dollars and all the assets in Russia (mostly in Siberia), for example, while it enjoys the hydro power advantage, also benefit enormously from the devaluation of the currency. Those players who benefit from devaluation cannot do so as a competitive strategy forever.
Secondly ,the Middle East assets take advantage of the stranded energy (as in gas) and convert them into aluminum. This allows export of commodity (aluminum) instead of energy over longer distances. The Middle East advantage comes with a subsidy.
The Chinese assets are on the third and fourth quartile of the cost curve even after their energy subsidy. They are matching supply with demand through an export incentive on value added products. The overhang in assets in the upstream would mean that their net debt to EBIDTA positions would be far more inferior.
The aluminum cash cost curve on the other hand, denominated in dollars, have been steadily falling and now indicating a median of $1500/T. This is arrived at from the Alcoa 2015 Annual Report, considering Alcoa's cost position. This would indicate that even under extreme stresses in global commodity prices, 50% of world's capacity is above water. But we should not ignore the Chinese story in aluminum.
The Chinese have created a huge build-up of aluminum assets, which currently holds more than 50% of the world's assets in aluminum. China's aluminum consumption of 32 million tons is also 50% of the world's consumption. Such a huge tilt is not existent in any other commodity.
In fact the current very short term picture shows that the prices of aluminum and crude have diverged. A positive delta change in Oil price creates incentives for low cost players to restart their production. For Aluminum, it means the Chinese restarts are taking place whenever any uptick in prices is noticed for a stable period.
The answer to this puzzle lies in the oft repeated fact that Aluminum is globally under a Chinese siege. But such a siege would appear very wrong if one moves away from the cash cost analysis of aluminum to an all- absorbed cost analysis. And this is exactly where Alcoa upstream scores in a sustainable manner.
If one goes back to the 2015 Annual Report of Alcoa, it is clear that Alcoa has a very strong balance sheet position in terms of net investments in upstream. After the idling of high cost capacities, currently Alcoa upstream holds 38 th percentile in Aluminum and 21 st in Alumina, a very comfortable position to enjoy.
But more importantly Alcoa's total cost position by virtue of its net debt being low is very good. The total net debt of Alcoa stands at $4.2 Billion (taken from page 93 of the 2015 annual report). This is arrived at after deducting cash in hand and treasury from the total debt of $9 Billion. If we assume the upstream component to be $2 Billion, then the net debt per ton of output would be the lowest among all upstream players at $667 per ton (over a 3 million ton smelter output). For most of the new assets added in the upstream in the rest of the world, this would run into the high $2000 per ton.
In sum, the oil industry integration builds a case for advantages of integration over splits of upstream and downstream. The natural hedge against the drop in price as in oil is a clear winner for the integrated entity. The integrated entity can as a whole decide which markets to serve in a downturn. This is in contrast to the upstream behaving like a commodity player, simply going by the price signals of the market in deciding to position its assets.
The downstream has more information than just the price as a signal. It has information of the markets and the product-margins to which the upstream needs to realign. Through this realignment the combined entity is able to respond better in terms of quality and service. These are the two most important factors needed to improve margins in the downstream. The upstream and downstream both need to work together to improve margins.
Alcoa, in trying to split, must have bigger avenues for value creation. The value emanating from the current synergy it enjoys as an integrated entity is itself huge. The argument of 'focus on technologies' and innovation in the downstream looks weak going by what is already proved in the case of oil. In having a very low net debt to EBIDTA position (2.8), Alcoa on the contrary is in a commanding position to benefit from the synergies in the upstream and downstream businesses.
The sum of the parts after the split may not be bigger than the current whole.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.