- There is a 0.8 correlation between Alcoa's gross profitability and aluminum prices.
- Aluminum prices are cyclical. Any analysis and valuation of Alcoa should be based on this cyclical performance.
- But because of the high tax rates, there is no margin of safety based on the cyclical after-tax profits. This is despite Alcoa being operationally sound.
Alcoa Corporation (NYSE:AA) is a producer of bauxite, alumina, and aluminum. Aluminum prices are cyclical. Alcoa’s earnings would be cyclical given the strong correlation between aluminum prices and Alcoa's gross profitability.
Alcoa could generate significant operating profits under various aluminum price scenarios. However, over the past 9 years, Alcoa had a very heavy tax burden. There were taxes even if it was loss-making. During profitable years, tax rates ranged from 45 % to 108%.
These tax rates will reduce the cyclical after-tax profit. A valuation of Alcoa on such a basis shows that there is no margin of safety at the current market price. I would not invest in Alcoa until they can reduce the tax burden.
Thrust of my analysis
Alcoa is a producer of bauxite, alumina and aluminum. The prices of these products are driven by different factors. But I found a close correlation between aluminum price and Alcoa’s gross profitability (gross profits / total assets).
This enabled me to create a simple financial model for an otherwise complex business. At the same time, Alcoa is in a cyclical sector. Any analysis and valuation should be based on its performance over the cycle.
Using my financial model, I looked at how the company would perform under different aluminum price scenarios. I focused on 2 price scenarios and found that the pre-tax earnings were very significant.
The problem with Alcoa was its tax rates. Over the past 9 years, it incurred taxes even when making losses. Then when it was profitable, the tax rates ranged from 45 % to 108 %.
You can imagine the impact of the taxes on the valuation. A valuation with even the lowest positive tax rate showed that there is no margin of safety.
Alcoa is a producer of bauxite, alumina, and aluminum. Its sales to third parties for these product categories in 2022 were:
- Bauxite – USD 204 million
- Alumina – USD 3,520 million
- Aluminum – USD 8,735 million
The prices for each of these products were driven by different factors. The following extracts from its 2022 Form 10k illustrate my point:
“Besides quality and geography, market fundamentals… the prices of Alumina and Aluminum, and the cost of freight – will also play a role in bauxite prices.”
“…alumina is subject to market pricing through the Alumina Price Index...”
“Pricing for primary aluminum products is typically comprised of three components: (i) the published LME aluminum price… (ii) the published regional premium… (iii) a negotiated product premium...”
Given the above, I was surprised to see a good correlation between aluminum prices, Alcoa’s revenue, and gross profitability. It was 0.66 for revenue and 0.81 for gross profitability. Chart 1 illustrates this.
With hindsight, I should not be surprised by the correlation as aluminum products accounted for 70 % of Alcoa’s total revenue in 2022.
Notes to Chart 1:
a) To plot all the 3 metrics onto the same chart, I had to convert them into indices. The index for each item was obtained by dividing the values in the year by the respective 2014 value.
b) The aluminum prices for each year was the Jun prices based on Trading Economics aluminum data.
The aluminum sector is cyclical as illustrated in Chart 2, making Alcoa a cyclical company. You should not be surprised as this is acknowledged by the company in its 2022 Form 10k.
“The aluminum industry and aluminum end-use markets are highly cyclical…”
But while cyclical, prices also have a long-term uptrend. From 1975 to 2022, prices grew at 4.5 % CAGR. But in the past 2 years, prices were extraordinarily high.
The implications for my analysis are:
- We should look at the performance and valuation through a cyclical lens. Alcoa provided financials from 2014 onwards. Using the 2014 to 2022 data would cover at least 2 price cycles.
- If we consider only the Earnings Power Value, this would be a conservative approach given the long-term price uptrend.
- We may have to ignore the past 2 years’ price data to get a more representative average aluminum price over the cycle.
Valuation of cyclical companies
According to Damodaran.
“Cyclical and commodity companies share a common feature, insofar as their value is often more dependent on the movement of a macro variable (the commodity price or the growth in the underlying economy) then it is on firm-specific characteristics…the biggest problem we face in valuing companies tied to either is that the earnings and cash flows reported in the most recent year are a function of where we are in the cycle, and extrapolating those numbers into the future can result in serious misvaluation.”
To overcome the cyclical issue, we have to normalize the performance over the cycle. Damodaran suggested 2 ways to do this.
- Take the average values over the cycle.
- Take the current revenue and determine the earnings by multiplying it with the normalized margins.
In the case of Alcoa, there was not much revenue growth. It did not matter whether I used the former or the latter. The key was to ensure that I covered several cycles.
Heavy Tax Burden
Over the past 9 years, Alcoa had a heavy tax burden. The chart below shows the taxes paid relative to the earnings (or losses) as well as the effective tax rates. The takeaways were:
- Taxes were incurred even if Alcoa was not profitable for the year.
- The tax rates ranged from 45 % to 108 % for the profitable years.
As a global company, Alcoa is subject to income taxes in the US and non-US jurisdictions.
I am not a tax expert so trying to figure out a nominal tax rate is a challenge. But I would say that Alcoa’s tax rate is unusual compared to those of its peers. Refer to Table 1 where I have computed the simple average tax rates from 2014 to 2022 for a number of US aluminum companies.
Note to Table 1. If there are losses, but tax is still payable, you will have a negative tax rate.
I normally take the average historical tax rates as a good representation of the tax rates. But looking at Table 1, this did not make sense as the average was negative. It meant that tax was payable even when there were losses.
I then considered 2 other tax situations:
- The periods when the pre-tax earnings were greater than USD 1 billion. These were in 2017, 2018, and 2021.
- All the periods with positive earnings. These were from 2017 to 2018 and 2020 to 2022.
Even then they were double the US nominal tax rate of 25 % as shown in Table 2.
Note to Table 2. If there are losses, but tax is still payable, you will have a negative tax rate.
Leaving aside the tax issue, Alcoa is strong operationally based on the following:
It has secured sources of power supply. Electrical power accounted for about 20 % to 25 % of the production costs. I have come across another aluminum company that had to curtail production because of the lack of power supply.
In 2019, the company announced a 5-year plan to reduce smelting and refining capacity to improve its cost position. Alcoa had reached about 75 % and 58 % of its targets. This is still ongoing.
Partly due to the capacity reduction exercise and other cost improvements, Selling, General and Admin (SGA) expenses and Depreciation & Amortization (D&A) expenditure had declined since 2014.
Finally, the company is financially sound as:
- The company had USD 1.4 billion cash as of the end of Dec 2022 representing about 9 % of the total assets.
- It had a 30% Debt to Total Equity ratio.
- Over the past 9 years, there was only one year with negative Cash Flow from Operations.
I focused on two aluminum price scenarios in my valuation:
- Scenario 1 – based on the average 2014 to 2022 period. This included the historically high price periods of 2021 to 2022.
- Scenario 1 – based on the average 2014 to 2020 period. As this excluded the past 2 years’ price hike, I consider it more a realistic representation of the cyclical price.
Table 3 summarized the EPV under the 2 Scenarios. You can see that there is no margin of safety under either Scenario.
Note to Table 3: Although I have shown the reference aluminum prices, I did not use them directly in my valuation model. Rather I used gross profitability related to the respective aluminum price.
I estimated the EPV of the operating assets based on the following equations:
EBIT(1-t) / WACC.
EBIT = Gross Profits – SGA – D&A – R&D.
Gross Profits = Total Assets X Gross Profitability.
Gross Profitability is an input variable depending on the Scenarios. I chose to derive EBIT using gross profitability because of the high correlation with aluminum prices.
Total Assets, SGA, D&A, and R&D were based on the average 2021 and 2022 values.
t = tax rates. I assumed it to be 48.9 % as per Table 2.
WACC = weighted average cost of capital determined from the first page of a Google search for the term “Alcoa WACC” and summarized in Table 4.
Value of equity = Value of operating assets + Cash – Minority Interests – Debt.
A sample calculation of the EPV is shown in Table 5.
Note that I chose the EPV because there was no growth not only in revenue but also in production volumes. If you look at Table 6, you can see that there are actually reductions in production quantities from 2014 to 2022.
Note to Table 6: The Bauxite data was for 2015.
Risks and limitations
The crux of my valuation is the assumption that aluminum prices can explain about 2/3 of the variances in gross profitability. But you have to remember that another 1/3 has not been accounted for.
At the same time, you have to consider the following when looking at the valuation.
- Higher WACC
- Ignoring growth
- Ignoring improvements
- Ignoring unusual items
The WACC was based on the current situation of high inflation and potential economic deflation. Since I am looking at the cyclical performance, I should also consider the cyclical WACC. It is likely the cyclical cost of capital would be lower. As such my EPV are on the low side.
I used the EPV to estimate the intrinsic value. In other words, I ignored growth. But over the long term, there is price growth. As such a single-stage growth valuation model may be more appropriate. This will then reduce the discount rate thereby increasing the intrinsic values. But the earnings will have to be reduced by reinvestments. As such I am not too sure whether there will be much impact on the value.
Over the past few years, the company had taken steps to reduce the excess capacity as well as improve its operating efficiencies. This will have a bottom-line impact which I have ignored.
My earnings assumed that there was no other cost. From 2014 to 2022, Alcoa incurred about an average of USD 176 million per year on unusual items. These included restructuring charges offset by gains from asset sales. If I factor these into my valuation model, it would reduce the earnings.
Looking at them, you can see that there are some plusses and minuses. But I am looking for more than double the current values to get a 30% margin of safety. As such, I don't think the conclusion would be different even if I accounted for the above limitations.
I have shown that there is a good correlation between aluminum prices and Alcoa's gross profitability. Aluminum prices are cyclical. The high correlation enabled me to extrapolate Alcoa’s operating earnings based on the aluminum prices over the cycle.
Unfortunately, Alcoa historically had high tax rates that would reduce the pre-tax profits by about half. Taking this into consideration, I found that there is no margin of safety at the current price.
This is not an investment opportunity unless Alcoa can reduce the effective tax rates by half. This is actually quite sad as in other operating areas, Alcoa is fundamentally sound.
This article was written by
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