Stock Analysis Report
ALCOA Inc.
Analyst: Sok Gun Song ()
March 5, 2004
Summary
This report is to estimate intrinsic value of Alcoa. First of all, to understand what makes this business tick and to know how Alcoa gets in its present shape, I tried to analyze the industry using Porter's Model. Then, as an attempt to gauge the company's operational efficiency and ability to generate profits, company financial statements were analyzed. Based on industry and company analysis, forecast and valuation were made through ReOI model and Monte Carlo simulation.
Valuation result is 22 dollars for normal case and 36 dollars for alumina shortage case. My recommendation based on the company's intrinsic value is WAIT until the middle of April because uncertainty related to alumina is too big right now.
Table of Contents
Page1 / Company Profile / 3
2 / Basic Market Data / 3
3 / Industry Analysis / 4
4 / Company Analysis / 11
5 / Forecast / 16
6 / Valuation / 20
7 / Recommendation / 21
8 / Accounting Quality / 21
Appendices / 1 ~ 17
1. Company Profile
Alcoa, since founded in 1888, has long been the world's leading producer of aluminum, fabricated aluminum and alumina. It controls more than 70 % of US primary production and produces about 17% of world primary aluminum production. Its 2003 revenue of 21,504 million is 58.5% of total combined revenue of other aluminum companies in North American continent including Alcan and secondary production companies.
The company is fully integrated through the whole value chain in the industry. Operating 41 countries, it is active in bauxite mining, refining, smelting, fabrication and recycling with significant investment in Brazil, Australia and China.
In 2002 US market and Europe market accounted for 63% and 21% of its revenue respectively. By industry sector, major markets are packaging and consumer (24.7%), automotive (13.3%), building and construction (10.8%) and aerospace (7.4%). By product segment, revenue from engineered products and flat-rolled products accounted for about 47% of total revenue.
Figure 1[1]
2. Basic Market Data
▪ Share Price / 37.39 (Feb.27,2004) / ▪ Trailing PE / 30.93▪ Shares Outstanding / 868.49 Million / ▪ Forward PE / 14.90
▪ Market Capitalization / 32.47 Billion / ▪ PEG Ratio (5yr exp) / 1.59
▪ 52 week high/low / 39.44 / 18.45 / ▪ Price to Sales / 1.5
▪ Beta / 0.878 / ▪ Price to Book / 2.69
▪ Average Volume (3 M) / 5.35 Million / ▪ % Held by insiders / 1%
▪ Ticker / AA (NYSE) / ▪ % Held by Institution / 80.21%
3. Industry Analysis
3-1 Supplier Power
Supplier power in aluminum industry is potentially huge. A recent dramatic example of supplier power was witnessed when US aluminum industry's output dropped by 28.1% in 2001 because of a hike in electricity price.
Electricity: Since electricity cost is the largest element of aluminum manufacturing production (above 20%), securing sources of low cost electricity is critical to aluminum producers. For example, Alcan has been known as the lowest cost producer because of its high level of electricity self sufficiency (about 62%), which is far higher than the industry average of 28%.[2]
Bauxite: Even though bauxite could be found almost everywhere, large scale commercial production is highly concentrated in a handful of mines in a few countries. In 2001, Australia, Jamaica, Brazil and Guinea produced 70% of total world production.
Alumina: Alumina refineries are built close to bauxite mines because refineries have to be tailored to particular ore characteristics of the mine and bauxite transportation is very costly ($22/ton). For that reason, alumina production is geographically concentrated as well. In addition, alumina from each refinery is different in particle characteristics and smelters prefer to use alumina from a single refinery. Possible shortage of alumina in 2004 and 2005 causes a lot of confusion for future aluminum prices. It will turn out that this report's final recommendation is up to future alumina supply demand balance.
To address potentially high supplier power, Alcoa is highly vertically integrated. Alcoa is the world largest raw material producer as well as the largest aluminum manufacturer, operating 2 stand alone bauxite mines, 9 refineries and 28 smelters and various sources of electricity worldwide.
Alcoa's recent distress was caused by rising electricity cost in US. Alcoa had to shut down smelters in Oregon and Texas in 2002, reduced production in North Carolina in 2002 and decided to idle some part of its facilities in the Pacific Northwest and New York State in 2003.
Alcoa's long term strategy should be to move smelter capacity to countries with low cost sources of electricity. Alcoa already dismantled Tacoma and Troutdale and decided to invest in a new smelter in Iceland and other hydroelectricity projects in Brazil. This transition process, in my opinion, will take more than a dozen years and will result in transforming the world aluminum industry as well as Alcoa and US aluminum market. Higher labor cost and increasing environmental cost will add impetus to this trend.
3-2 Customer Power
Customer power is disproportionately strong in aluminum industry. Major customers for aluminum producers are transportation (30%), packaging and containers (17%) and construction industry, which consist of relatively fewer numbers of major players.
Figure 2[3]
On the other hand, aluminum is basically a commodity and production differentiation is difficult. more significant is that some customers might choose a substitute such as plastic and steel when aluminum prices are too high.
Since customers tend to be gigantic manufacturers, they usually want to secure long term large quantity contracts. No aluminum producer can afford to lose those big customers because refineries and smelters can not even temporarily shut down without incurring huge cost. This lack of manufacturing flexibility and extreme amount of fixed cost often forces companies to operate under their cost curve.
Alcoa appears to have competitive advantage in dealing with customer power. Its size and financial stability has made itself one of favorites of big customers who need long term contracts. With increased practice of long term contracts Alcoa started using derivatives such as futures and options for hedging purpose.
Strategic motives behind Alcoa's recent acquisitions of Alumax, Reynolds, Cordant and many others can be seen from various angles. However, one possible interpretation is to see them as an attempt to balance customer power through consolidation in US aluminum industry. For example, after the company acquired Reynolds, which dominated aluminum packaging market, in 2000, it acquired Ivex Packaging Corp. in 2002, allowing it to enter plastic packaging market to, in my view, maximize its market power in packaging industry.
3-3 Substitute
Aluminum competes with other metals for various end users. Competition exists in packaging (glass, paper, plastics and steel), construction (composites, steel and wood), transportation (magnesium, titanium and steel) and electrical application (copper).
New application of aluminum or a competitor, relative price change among competing materials, technological breakthrough in usage of a material, and introduction of new material can make significant effect on competing dynamics among metals.
Alcoa has traditionally been addressing this issue by investing in R&D. Recently the company showed its unusual enthusiasm for entering substitutes market by acquiring Ivex Packaging Corp. in 2002, entering the thermoformed plastics and plastic extrusions markets. In the same year, Alcoa Fujikura Ltd became sole owner of Engineered Plastic Components, Inc., a supplier of automotive precision-molded components and assembles.
Due to various causes including weakening dollar and increasing Chinese demand, metal prices hiked in 2003 while aluminum was one of the weakest performers. Surprisingly, price difference between aluminum and competing metals are at highest level during the scope of this report, 1987~2003 as depicted in Figure 3. I expect that aluminum will substitute for other metals in some instances. Further discussion will be made in Forecast Section.
3-4 Entry / Exit / Expansion Barrier
It is very difficult for a new firm to enter aluminum industry. First, The industry is prohibitively capital intensive. Required capital to build a standard size smelter (250,000 tons) is estimated far above 1 billion dollars (Alcoa has 28 smelters). Second, existing producers preoccupy critical resources. A new producer, if it wants to be vertically integrated, needs to find, for example, commercially viable bauxite mines, almost all of which are already owned by existing producers. Third, mini-mills do not have competitive advantages in aluminum industry. In steel industry, better efficiency of mini-mills drove steel giants to a corner. Aluminum mini-mills lack the technology to make high quality can sheet, which is most lucrative market in the industry.
However, outside North America, many aluminum producers are government owned. Pechiney, recently acquired by Alcan, in France was wholly owned by its government and Norwegian government holds 51% of Norsk Hydro. In case, as it has been, a government wants to produce aluminum for as part of industrial development program or for national security purpose, entry barriers mentioned above can be abated significantly. Government intervention has contributed to a chronic problem in aluminum industry in that higher cost producers could stay with government subsidy.
Incumbent producers have not found an easy way to expand and grow in the aluminum industry. Besides tremendous required capital for expansion, possibility of overcapacity has hindered companies to expand fast. As a result, Alcoa has sought to expand through acquisition of existing companies and brown field projects. In fact, Alcoa has not invested in a new smelter for the past 20 years. It, in my view, resulted in higher maintenance cost and decrease in asset efficiency. This issue will be revisited in Company Analysis section.
3-5 Competition
Competition in aluminum industry is potentially very high. It stems mainly from two factors. First, aluminum is a commodity, for which product differentiation is hard to come by. Second, aluminum producers are basically price takers as prices are set by supply-demand balance in London Metal Exchange. However, lack of flexibility in assets and output, long lead time to add new capacity and the huge required capital imply that a company can not encroach on others' market share without risking prohibitively costly punishment by prolonged overcapacity and plummeting prices.
Therefore, competition gets in the form of cost control. The question is whether a company can be profitable at a given aluminum price level.
Alcoa's cost structure aggravated in recent years due to rising smelter operating costs in US including electricity cost, aging of existing facilities and acquisition of high cost assets, each of which will be discussed again in Company Analysis section. Alcoa's endeavor to deal with this pressing issue can be summarized as reduction of US operation and an internal productivity improvement campaign called ABS(Alcoa Business System). The company claims that it saved $1 billion after 2000 through ABS and aims to cut additional $1.2 billion cost by 2006.
US aluminum producers include Century Aluminum Co., Commonwealth Industries Inc., and Kaiser Aluminum Corp. Alcoa's US competitors are small in size and financially unstable.
Table 1[4] US Primary Aluminum Producers
(Unit in Million Dollars)
Sales (2003) / Net Available to CommonAlcoa / 21,504 / 1,034
Century Aluminum / 782 / (21)
Commonwealth / 920 / (31)
Kaiser / In Court Receivership
Alcan, a Canadian aluminum producer spun off from Alcoa after World War II, can be considered a rival to Alcoa in terms of size and profitability. It is the second largest aluminum producer in the world and owns abundant low-cost electricity sources and efficient management. Particularly, Alcan became the sole owner of the third biggest aluminum producer, Pechiney of France, in February 2004.
Table 2[5] World Leading Aluminum Producers
(Unit in Million Dollars)
Sales (2003) / Net Available to CommonAlcoa / 21,504 / 1,034
Alcan (Canada) / 13,640 / 283
Pechiney (France) / 13,314 / (546)
As already mentioned either company could not influence the other's market share without investing hugely in new capacity, which would be prohibitively risky and costly attempt. Rather the two companies will focus on cost cutting to be more profitable at foreseeable market prices. Another possibility is tacit collusion between the two dominants to affect market price since the combined primary production capacity of the two is estimated to be about 35% of world primary capacity.
3-6 Market Size and Growth
World capacity, production and consumption have grown more than 200% during 1973-2003 periods as shown Figure 1.
Figure 3[6]
In contrast, US production and consumption increased merely 6.6% and 23% respectively as described in Figure 4.
Figure 4[7]
It is believed that the growth of aluminum industry is driven by GDP growth[8], implying that aluminum industry is cyclical in line with general business cycle.
Aluminum prices have relatively been stable through the last 100 years. Using US physical spot price for the period of 1900 – 2003, I found standard deviation of yearly change is mere $0.088 per pound. If we exclude years affected by supply or demand shocks such as world wars and oil shocks, then standard deviation can be as low as $0.044 per pound.
Figure 5/ Using BestFit, distribution of price changes during the last 36 years is found as a triangle distribution (-0.22, 0.0027, 0.26) with exclusion of outliers caused by oil shocks.
This distribution will be used to estimate future aluminum prices in Forecast section.
Figure 6 describes price movement from 1987 to 2003. After fluctuation of late 1980s and early 1990s that was caused by CIS producers, prices stabilized since mid 1990s
Figure 6
4. Company Analysis
4-1 Overview
The overall performance of Alcoa and important market factors for the period of 1987 to 2003 are shown in Figure 7[9] for profitability and 8 for growth.