Stock Analysis Report
ALCOA Inc.
Analyst: Sok Gun Song (song.173@osu.edu)
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
Page
1
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
2
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 11
Sales Change by Product
Sales (in million)
25000
20000
Alumina
Other
15000
Packaging
Engineered
10000
Flat Rolled
5000
Primary Metal
0
1998
1999
2000
2001
2002
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
1
source: company annual reports
3
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.
2
Alcan 2002 Annual Report
4
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 23
US Shipment by End Users 2003
24.9%
16.2%
Construction
Transportation
Consumer Durables
Electrical
Machinery
Packaging
6.2%
6.7%
37.8%
8.2%
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
3
The Aluminum Association
5
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.
Aluminum, Copper & Nickel
3500
18000
16000
14000
2500
12000
2000
10000
1500
8000
6000
1000
4000
500
2000
0
0
Jan-01 Jul-01 Jan-02 Jul-02 Jan-03 Jul-03 Jan-04
3-4 Entry / Exit / Expansion Barrier
6
Nickel
Aluminum/Copper
3000
Aluminum
Copper
Nickel
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
7
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 14 US Primary Aluminum Producers
(Unit in Million Dollars)
Sales (2003)
Alcoa
Century Aluminum
Commonwealth
Kaiser
Net Available to
Common
21,504
1,034
782
(21)
920
(31)
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 25 World Leading Aluminum Producers
(Unit in Million Dollars)
Alcoa
Alcan (Canada)
Pechiney (France)
Sales (2003)
21,504
13,640
13,314
Net Available to Common
1,034
283
(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
4
5
source: company annual reports and websites
source: company annual reports and websites
8
World capacity, production and consumption have grown more than 200%
during 1973-2003 periods as shown Figure 1.
Figure 36
In contrast, US production and consumption increased merely 6.6% and 23%
respectively as described in Figure 4.
Figure 47
It is believed that the growth of aluminum industry is driven by GDP growth8,
implying that aluminum industry is cyclical in line with general business cycle.
6
source: London Metal Exchange, Bloomberg
source: US Bureau of Mines
8
To verify the general claim, I performed regressions between GDP and aluminum consumptions.
The result can be found in Appendix 1. In Forecast section, I used this relation whenever a
projected consumption is not clear.
7
9
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.
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.
Figure 5
Triang(-0.26636, 0.0027000, 0.40625)
6
5
4
This distribution will be used to
estimate future aluminum prices
in Forecast section.
BestFit Student Version
3
For Academic Use Only
2
1
1.2%
-0.2200
90.9%
7.9%
0.2600
0.5
0.4
0.3
0.2
0.1
0.0
-0.1
-0.2
-0.3
0
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
LME 3 Months/Metric ton
Aluminum Price (1987-2003)
2,500
2,000
1,500
1,000
1,987
1,991
1,995
1,999
4. Company Analysis
4-1 Overview
10
2,003
The overall performance of Alcoa and important market factors for the period of
1987 to 2003 are shown in Figure 79 for profitability and 8 for growth.
Figure 7
1.20
1.10
1.00
0.90
0.80
0.70
0.60
0.50
0.40
0.30
0.20
40.0%
20.0%
ROCE
LME Price
Aluminum Price vs Alcoa ROCE
0.0%
-20.0%
1987
1991
1996
2000
Aluminum Price
ROCE
Figure 7 describes that Alcoa's profitability fluctuated as aluminum prices moved
as commonly expected. Through the 17 year period, Alcoa recorded an average
of 11.3% of ROCE.10
Figure 8
Metric tone
10000
220
8000
200
180
6000
160
140
4000
120
100
2000
0
US GDP Growth
GDP, US Demand & Aloca Shipment
80
1987
1991
US Consumption
1995
1999
Alcoa Shipment
2003
US GDP
The company grew solidly during that period in spite of setbacks in early 1990s
and recent years. Its shipment increased 1.28 times from 2.2 million metric tones
to 5.05 million metric tones with average annual growth rate of 5.75%.
4-2 Financial Statement Analysis
4-2-1 Common Size Analysis / Trend Analysis / Ratio Analysis
In calculating ROCE for 1992, I did not include accounting charge related to the restructuring of retirement
benefits. Appendix 2 is to show the effect of the accounting charge of $1,162 million to Figure 1 and
regression result.
10 9.1% if the accounting charge in 1992 is included.
9
11
Discussion of implications from patterns to be revealed through these analyses
will be incorporated in profitability analysis and growth analysis section.
As you can find in Appendix 3, 4 and 5, common size analysis and trend analysis
reveals apparently deteriorating patterns in almost all aspects. Most conspicuous
are the following four patterns. First, long-term debt is increasing too fast even
though the company reduced it by large amount in 2003. Second, growth rate of
share holders' equity far exceeds that of retained earnings. Third, growth rate of
PPE is deteriorating while goodwill gets to account for more portions of total
assets. Fourth, the company pays less proportion of tax out of operating income
with years. Even though a few patterns related to income items are shown but
they are not apparent.
As for the tax issue, it turns out that the company managed to lower effective
tax rates through either recognizing benefits from foreign net operating losses or
obtaining more favorable tax treatment from foreign governments. Alcoa's
effective tax rate was 33% in 1997 and it went down to 21% in 4th quarter in
2003.
Ratio Analysis in Appendix 6 provides additional issues. Besides a disturbingly
increasing debt to total assets ratios, asset turnover ratios and capital
expenditure ratios raise reasonable concerns. Asset turnover did not improve and
capital expenditure ratios aggravated in 2003 implying that these issues might
stem from some other problems in addition to cyclical downturn in aluminum
industry.
Figure 9
Selected Ratios
40.00
35.00
30.00
25.00
CAPEX Ratios 20.00
15.00
10.00
5.00
0.00
2.00
1.50
1.00 1/ATO
0.50
0.00
1996
1997
1998
1999
Total Assets to Capital Expenditure
2000
2001
2002
2003
PPE to Capital Expenditure
1/ATO
Table 3 Selected Ratios
1996
Debt to Total Assets
1/(Asset Turnover)
Total Assets to CAPEX
PPE to CAPEX
Sales to CAPEX
0.13
1.94
6.75
3.55
13.11
1997
0.11
1.00
14.52
7.53
14.59
1998
0.16
1.00
16.40
8.49
16.48
12
1999
0.16
0.95
18.83
9.96
17.80
2000
0.16
0.93
22.12
9.97
20.56
2001
0.23
0.75
25.66
10.42
19.23
2002
2003e
0.28
0.21
0.70
23.03
9.36
16.04
0.70
35.48
14.23
24.80
4-2-2 Profitability Analysis
Alcoa's financial statements from 1996 to 2003 are reformulated to facilitate
profitability analysis, growth analysis and forecast as you can see Appendix 7 and
8. Appendix 9 and 10 shows common size analysis and trend analysis from
reformulated statements. Insights from those analyses are incorporated in the
following profitability analysis and growth analysis. Table 6 summarizes
profitability analysis.
Table 6
2003
Return on Common Equity (ROCE)
Return on Net Operating Asset(RNOA)
2002
2001
2000
1999
1998
1997
15.90%
10.76%
0.79%
1.54%
5.80%
4.75%
15.49%
11.74%
13.20%
10.50%
16.49%
13.73%
13.43%
12.13%
2.32%
8.45%
0.608
2.74%
-1.21%
0.621
2.89%
1.86%
0.565
4.48%
7.26%
0.516
3.63%
6.87%
0.393
5.13%
8.60%
0.321
6.27%
5.87%
0.221
8.17%
3.44%
4.72%
0.505
2.14%
3.39%
-1.25%
0.504
3.61%
1.61%
2.00%
0.487
9.34%
4.26%
5.08%
0.494
7.70%
3.29%
4.41%
0.561
9.72%
3.57%
6.15%
0.631
8.46%
3.64%
4.82%
0.690
9.85%
7.83%
0.055
0.203
0.125
0.024
0.044
1.42%
7.42%
0.054
0.198
0.124
0.020
-0.040
4.09%
10.07%
0.073
0.220
0.120
0.028
-0.032
8.09%
13.54%
0.088
0.245
0.109
0.047
-0.007
6.81%
11.76%
0.080
0.232
0.114
0.037
-0.012
7.85%
10.78%
0.070
0.222
0.114
0.037
0.008
6.58%
11.14%
0.068
0.229
0.117
0.043
-0.003
0.915
0.128
0.115
0.574
0.300
0.084
0.150
0.146
0.178
0.921
0.130
0.119
0.583
0.295
0.078
0.164
0.120
0.155
0.861
0.127
0.113
0.542
0.258
0.076
0.156
0.091
0.144
0.689
0.107
0.095
0.485
0.162
0.068
0.131
0.079
0.119
0.648
0.117
0.107
0.560
0.084
0.069
0.144
0.094
0.087
0.572
0.117
0.104
0.515
0.062
0.060
0.149
0.093
0.077
0.542
0.118
0.104
0.516
0.018
0.060
0.164
0.093
0.103
Financial Leverage Drivers
Net Borrowing Cost (NBC)
SPREAD
Financial Leverage (FLEV)
Operating Liability Leverage Drivers
Return on operating assets(ROOA)
Short term borrowing rate (after tax)
Operating Leverage SPREAD
Operating Liability Leverage (OLLEV)
Next Levels
Profit Margin
Core Sales PM
Sales PM
Gross Margin Ratio
Operating Expense Ratio
Operating Tax Ratio
Other Operating Income Ratio
1/Asset Turnover
Receivables Turnover
Inventory Turnover
PPE Turnover
Goodwill Turnover
Accounts Receivable Turnover
R $ PR Cost Turnover
Other noncurrent Liabilities
Other Turnovers
The analysis provides clear insights on the company's profitability. While the
company appears to have come back to impressively high level of ROCE, it was
largely due to increased financial leverage and further reduced net borrowing
cost, not due to improved operation.
13
The company's core ability to generate profits from sales as reflected in core
sales profit margin numbers have kept deteriorating over time. ATO seems to
have troubles in recent years. Individual profit margins and turnovers generally
have gotten worse except accounts receivable turnover.
Figure 10
Figure 11
18.00%
2.500
55.00%
14.00%
2.000
10.00%
1.500
6.00%
1.000
2.00%
0.500
Core Sales PM
70.00%
40.00%
25.00%
10.00%
-5.00%
1997
1998
1999
2000
2001
2002
-2.00%
2003
Net Borrowing Cost (NBC)
1997 1998 1999 2000 2001 2002 2003
Core Sales PM
0.000
Asset Turnover
Financial Leverage (FLEV)
Return on Common Equity (ROCE)
In other words, whereas ROCE has moved in line with aluminum price and other
market factors as discussed in overview section of company analysis, its profit
generating ability has decreased over time. It is worth noting that profit margin
in 2003 is a historical high of 9.85% while core sales profit margin is just 7.83%.
It was caused by abnormally high gains from unusual items such as currency
translation and available for sale securities, not from its core operations.
It is not easy to detect what might have caused it because almost all indicators
moved in one direction together. Fluctuation of aluminum prices can not fully
explain the disturbing fact because prices in recent several years were very
stable and prices in 2003 were higher than those in 1998 and 1999.
However, the pattern of deterioration gives a clue to understand this issue. Two
turning points in the pattern appear to be 1998 and 2000, in which the company
acquired Alumax and Reynolds respectively. I conjecture that troubles caused by
the acquisitions should be one part of explanation.
4-2-3 Growth Analysis
To measure of return for shareholders and a company's ability to grow, I am
going to look into the company's residual earnings during the years between
1996 and 200311.
11
Residual earnings as (ROCE-Cost of Equity Capital)*CSEt-1
14
1/ATO
Core Sales PM & ATO
ROCE, FLEV & NBC
Cost of equity capital and beta for Alcoa for the period of 1996 to 2003 are
shown in table 7.12
Table 4
Yearly Change of Risk-Free and Beta
Year
Risk-Free
Beta
1996
1997
1998
1999
2000
2001
2002
0.064
0.064
0.053
0.056
0.060
0.050
0.046
0.040
0.464
0.912
0.671
0.388
0.418
1.390
1.298
1.282
2003
In Appendix 11, I assumed three
scenarios. In the first scenario I used
changing risk free rates and betas from
Table 7. Constant beta of 0.878 was
used for the second scenario. For the
third scenario constant cost of equity
capital of 10.69% was assumed with
constant risk free rate of 5.42% and
beta of 0.878. Risk premium of 6% was
used throughout all of the three
scenarios.
Results show that the company made negative residual earnings in two scenarios
and earned negligible positive residual earnings in a scenario. In sum, the
company does not appear to have earned residual earnings over the past 7 year
period. Given the low interest rates in the period, it is quite disappointing.
Fluctuation of growth rates of residual earnings is surprisingly large and big
negative growth occurred, in all three scenarios, in 2000 and 2001. This analysis
provides evidence that whereas Alcoa achieved solid growth of CSE and other
items through the acquisitions, the acquired assets might not be properly
functioning.
4-2-4 Interpretation
My hypothesis is that the company's operating efficiency and ability to generate
profit were damaged by a series of acquisitions, idling capacity and aging
facilities. Patterns observed above indicate that the company had to borrow
hugely to finance the acquisitions affecting debt ratio and FLEV. However,
unfortunately, the acquired assets had higher cost structure resulting in lower
core sales pm. On top of it, packaging market, which Reynolds serves, was
struggling since 2001, aggravating the situation. Perhaps organizational turmoil
in Reynolds and Alumax worsened their performance, losing core customers,
suppliers, distributors or important employees.
Idling capacity, which still consumes a certain level of cost, definitely must have
driven down efficiency ratios and core sales pm. A large scale of layoffs since
12
Risk free rates are from 10 year US Treasury bond rates. Betas come from regressions with S&P as
benchmark. For how the data was used, see Appendix 10.
15
2000 might have discouraged employees, lowering productivity. Rising electricity
cost and employee benefit cost must have added some negative influence.
Alcoa wanted to start investing heavily in long term assets to maintain long term
capacity and efficiency because its assets started showing aging effects13.
However, the company had been in financial constraints due to a series of
acquisitions and therefore capital expenditure was restrained, pushing CAPEX
ratios high to the ceiling.
Fortunately, net borrowing costs had stayed low and FLEV was high and
aluminum prices started to recover from 2002 low. Furthermore, the economy
started picking up with weakening US dollar and soaring stock market. As a
result, the company could show a good ROCE and PM numbers in 2003.
My next question is whether the damage to efficiency and margin is permanent
or temporary. To answer to the question, I will need interviews with Alcoa
officials and additional information. For now, I will assume that the company will
gradually recover from the damage for the coming 5 years.
5. Forecast
As in many cases in valuation, it is inevitable to make a lot of assumptions.
Particularly I face two serious obstacles. First, I will assume that Alcoa does not
acquire other companies. This is problematic because companies in this industry
grow through acquisitions. Increasing capacity with green field projects is
extremely risky and costly in aluminum industry. However, it is more difficult to
project when and which company Alcoa will acquire. Second problem stems from
future aluminum price. Predicting a mid to long term aluminum price is as tricky
as predicting a stock price. As a result I will use industry consensus projections
for 2004 and 2005 and try random simulation for the period of 2006 to 2008
basing on historical data.
5-1. Sales Forecast
5-1-1 Price Forecast
The O'Carroll Aluminum Bulletin estimate will be used for 2004 and 2005 with a
moderate modification to incorporate substitute effect. The source is said to be
one of a few to estimate supply and demand through bottom up approach. Its
projection of supply-demand balance and prices is summarized as below.
Table 5 Price Forecast
13
Average age of Alcoa's smelters is over 25 years in my calculation including acquired assets.
16
Projection for 2004 and 2005
Changes in Smelter Capacity (Western World)
2003
2004
2005
Projected World Consumption
% Change
27,300
7.1%
29,234
7.1%
31,077
6.3%
Projected World Production
% Change
27,868
7.3%
28,948
3.9%
30,253
4.5%
Projected World Capacity
% Change
31,135
5.4%
32,073
3.0%
33,666
5.0%
Capacity Utilization %
91.9%
91.6%
92.0%
568
(286)
(824)
0.65
0.65
0.73
0.76
0.77
0.88
US
Canada
Latin America
Western Europe
Africa
Asia
Oceania
Western World
2004
0
2
55
130
117
199
35
538
2005
0
148
52
50
347
31
628
Source: The O'Carroll Aluminum Bulletin
Implied Inventory Change
Price
Price (Alumina Shortage)
Source: The O'Carroll Aluminum Bulletin
However, it appears that they did not incorporate possibility of substitute effect.
As discussed in Industry Analysis section, prices of metals such as copper, steel
and nickel have spiked while aluminum prices have relatively been stable.
Current difference between aluminum and other metals is at historical highest
within the scope of my study, 1987 ~ 2003. On top of it, prices of other metals
are expected to go up further in, at least, coming a few years14. I expect other
metals will be replaced with aluminum in a wide range of industries centering on
small businesses, low value product users and, especially, easy switching sectors.
Consequently I conjecture for 2004 and 2005 that approximately additional 4%
demand increase for aluminum will be generated from electric equipment market
(for wiring / replacing copper), packaging industry (for steel cans and closures /
replacing ordinary steel), automotive (for ordinary steel components) and
construction (for corrosion resistance / replacing nickel and galvanized steel),
expecting 0.77 (0.82 in case of alumina shortage) for 2004 and 0.80 (0.90 in
case of alumina shortage) for 2005.
It is very controversial if there will be an actual alumina shortage. Some market
observers claim that alumina shortage has begun in reference to alumina prices
at spot market. However, considering spot market buyers are mostly Chinese
manufacturers, who in many cases buy large amount of raw materials to stock
for future usage, others believe that the shortage, if any, will be temporal. I
attached alumina supply demand forecast prepared by The O'Carroll Aluminum
Bulletin as Appendix 14.
For prices after 2005 my projection is based on historical data. I used BestFit
program to find distribution pattern of price movements during the past 36 years
as shown in Industry Analysis section. The result is used as input data for Monte
Carlo simulation.
14
See Appendix 12 for Forecasted Supply Demand Balance for copper, nickel and zinc.
17
5-1-2 Shipment and Unit Price Forecast
Market estimate per product line is attached as Appendix 1315.
Increasing shipment is largely due to Boeing's increased orders, recovery of
autos and trucks, and electrical equipment. While it is generally estimated that
electrical industry is likely to struggle due to lack of new investment, I believe
some copper users, especially in wiring and appliance, will switch to aluminum in
2004 and 2005. Packaging market is forecast to be stagnant and modest growth
is predicted for consumer durables. From the market forecast mentioned above,
I prepared Alcoa's shipment and unit price forecast per product line as shown
Table 6. I assume that, as prices spike in 2004 and 2005, Alcoa restarts some of
its idling capacity of 595 thousand metric tones.
I considered the scheduled addition of a new smelter capacity of 322 kmt in
2007 and expansion of Quebec smelter. For unit price for packaging line,
possibility of introduction of new consumer products with higher margin was
incorporated.
5-2. Core Sales PM and Asset Turnover
My main idea was that, even though absolute numbers are likely to be very good
in 2004 and 2005 thanks to high aluminum prices, in relative measure the
company's core sales pm will be equivalent to 2003 level, improving a little in
2007 and 2008 as new low cost capacity comes on stream, high cost capacity in
US is dismantled and other troubles are dissolved.
A problem was caused by the fact that I could not obtain information about
Alcoa's variable cost structure. I used industry data from mid 1990s16. For
simplicity purpose, I assumed only two point estimations of core sales pm in
every year forecasted. However, in reality, it should be continuous, not discrete.
Electricity price, which is rising almost everywhere over the world, was assumed
constant mainly because of lack of data.
The company's asset efficiency to generate sales is expected to be a little higher
in 2004 and 2005 with return of some of idle capacity. It is likely to show
moderate improvement in 2007 and 2008 with addition of new efficient capacity
and dismantlement and divestiture of less efficient assets.
Source: The O'Carroll Aluminum Bulletin and various trade associations such as The Aluminum Association,
Wards Automotive, United Brewers Association and others.
15
16
Some professional organizations sell updated industry cost data.
18
Table 6 Forecast of Shipment and Unit Price per Product Line
Aluminum Price
Capacity
Idle Capacity
Add on New Capacity
Shipment
Unit Price
Unit Added Value
Sales
Primary Metal
Shipment
Unit Price
Unit Added Value
Sales
Flat Rolled
Shipment
Unit Price
Unit Added Value
Sales
Engineered Product
Shipment
Unit Price
Unit Added Value
Sales
Packaging
Shipment
Unit Price
Unit Added Value
Sales
Others
Shipment
Unit Price
Unit Added Value
Sales
Alumina
Shipment
Unit Price
Unit Added Value
Sales
World Real GDP Growth
Developed Country
Real GDP Growth
US Real GDP Growth
2003
2004
2005
2006
2007
2008
0.7
0.82
0.8
0.8072
0.8130
0.8175
3345
595
3645
295
3645
295
3645
295
3967
0
5047
1.937
1.237
21504
5194
2.073
1.253
23691
5440
2.064
1.264
24703
5546
2.031
1.224
24782
3967
150
322
5915
1.855
1.043
24146
6005
1.823
1.005
24084
1952
0.752
0.052
3229
1850
0.820
0.000
3337
1900
0.800
0.000
3344
1900
0.807
0.000
3374
2181
0.813
0.000
3901
2181
0.818
0.000
3923
1819
1.203
0.503
4815
1946
1.350
0.530
5781
2044
1.330
0.530
5980
2095
1.337
0.530
6162
2147
1.343
0.530
6344
2201
1.348
0.530
6524
879
2.890
2.190
5589
984
3.320
2.500
5415
1063
3.300
2.500
5848
1106
3.307
2.500
6082
1133
2.813
2.000
4987
1162
2.618
1.800
4601
167
8.751
8.051
3215
165
8.870
8.050
2922
165
8.850
8.050
2922
170
8.857
8.050
3011
170
10.813
10.000
3740
170
10.818
10.000
3740
230
5.245
4.545
2654
248
8.820
8.000
4820
268
8.800
8.000
5194
276
7.807
7.000
4737
284
6.813
6.000
4250
292
6.818
6.000
4372
7671
0.119
7700
0.184
7700
0.184
7700
0.184
7700
0.120
7700
0.120
2002
1416
1416
1416
924
924
2.63
2.69
2.81
2.78
2.76
1.63
1.50
1.81
1.90
2.03
2.50
2.02
2.50
2.03
2.50
5-3. Cost of Operating Capital and ReOI Growth Rate
The company's cost of operating capital in 2003 is estimated as 9.145% with risk
free rate of 4.95% (10 year Treasury bond rate), beta of 0.878, market premium
of 6%, and borrowing rate of 6.6%. Since it is very likely that risk free rates will
rise in the near future, I set 10% as default for Alcoa's cost of operating capital.
The effect from the company's repayment of debt will be offset by rising
borrowing rates. Valuation incorporates sensitivity analysis for cases with
different cost of operating capital from 9.15% to 14%.
19
Given the wild fluctuation of ReOI in the studied period, which might not be a
typical cycle for aluminum industry, it is very hard to estimate long term ReOI for
Alcoa. I assume Alcoa's long term ReOI to range from 2% to 3%.
6. Valuation (with Monte Carlo Simulation)
Input list is attached as Appendix 15. Below is Monte Carlo simulation model for
valuation.
Table 7 Valuation Model (ReOI with Monte Carlo)
2003 A
Sales
2004E
21,504
Growth in Sales
Core Sales PM
1/ATO
ReOI
Growth in ReOI
Cost of Operating Capital
Discount Rate
PV of ReOI
Total PV
Continuing Value
PV of CV
NOA 2003
Value of NOA
NFO
V 2003
Value per share
(at 868.49 million)
468
0.0915
2005E
2006E
2007E
2008E
23,691
10.2%
0.125
0.75
1,185
153.1%
24,703
4.3%
0.115
0.78
914
-22.8%
24,782
0.3%
0.115
0.75
991
8.5%
24,146
-2.6%
0.13
0.7
1,449
46.1%
24,084
-0.3%
0.13
0.65
1,565
8.1%
0.1000
0.1000
118.5
0.1000
0.8264
755.4
0.1000
0.7513
744.8
0.1000
0.6830
989.5
0.1000
0.6209
972.0
3,580
24,927
15,478
20,050
39,108
6750
32,358
Cost of Operaqting Capital after 2008
0.1000
ReOI Growth Rate
0.035
37.26
Valuation Result and Sensitivity Analysis
At 10% of cost of operating capital, valuation result is 22 dollars in normal case
and 36 dollars in alumina shortage case. For summarized result of simulations,
see Appendix 16 and 17.
Distribution of output and input sensitivity for the default case are depicted as
follows;
20
Regression Sensitivity for Value per share /
2003 A/J23 ...
4
Aluminum Price / 2008/G6
.817
3
Aluminum Price / 2005/D6
.144
@RISK Student Version
2
For Academic Use Only
Aluminum Price / 2006/E6
.068
1
Unit Added Value / 2004/C33
0
-1
-0.75
-0.5
.066
-0.25
0
0.25
0.5
0.75
Std b Coefficients
Valuation result varies depending on cost of operating capital as follows;
Cost of Capital
10% (Default)
9.15% (present)
11%
12%
13%
14%
Mean
30.47
35
26.37
23.22
20.71
18.68
Normal Case
22
25
19.5
17.8
15.6
14.2
Alumina Shortage
37.5
45
33
28.4
25.2
22.4
7. Recommendation17
Current price of 37.39 is appropriate if we assume alumina shortage will come to
existence in 2004 and 2005, which is quite uncertain at present. Accordingly I
recommend that you wait until alumina issue is clarified in a couple of months. I
expect that the issue will be cleared when Alcoa and Alcan issue their first
quarter result in the middle of April.
8. Accounting Quality
Since the most of information I used for this report came from the company's
financial statements, I checked accounting quality of Alcoa using Beneish 5 and 8
variables models. The result is as follows;
17
I made a lot of assumptions in estimating Alcoa's intrinsic value. Therefore, attention should be paid to
any deviation from my assumptions such as interest rate change, electricity price, major end users' trend,
other metals' price movement and many others. If any deviation happens, the intrinsic value should be reestimated.
21
1
The Full Beneish model for earnings manipulation detection (Based on Eight Variables)
2002
Year
2001
2000
1999
1998
1997
1996
INPUT VARIABLES
Net Sales
CGS
Net Receivables
Current Assets (CA)
PPE (Net)
Depreciation
Total Assets
SGA Expense
Net Income (before Ext. Items)
CFO (Cash flow from op.)
Current Liabilities
Long-term Debt
20,263
16,247
2,378
6,313
12,111
1,108
29,810
1,147
420
1,839
4,461
8,365
22,497
17,539
2,386
6,449
11,530
1,234
28,355
1,256
908
2,411
4,885
6,384
22,659
17,111
3,461
7,578
12,850
1,199
31,691
1,088
1,484
2,851
7,954
4,987
16,323
12,536
2,199
4,800
9,133
888
17,066
851
1,054
2,236
3,003
2,657
15,340
11,933
2,163
5,025
9,133
842
17,463
783
853
2,197
3,268
2,877
13,319
10,275
1,581
4,416
6,667
735
13,071
682
805
1,888
2,453
1,457
13,061
9,966
1,675
4,281
7,078
747
13,450
709
515
1,887
2,373
1,690
DERIVED VARIABLES
Other L/T Assets [TA-(CA+PPE)]
11,386
10,376
11,263
3,133
3,305
1,988
2,091
1.1065
1.1120
1.0438
0.9007
1.1534
0.9863
-0.0476
1.0826
0.6944
1.1110
1.0296
0.9929
0.8828
0.8600
-0.0530
0.9732
1.1338
0.9475
1.9359
1.3882
1.0383
1.0858
-0.0431
1.2313
0.9554
0.9573
0.9701
1.0641
0.9526
0.9791
-0.0693
0.9424
1.1879
1.0290
1.2441
1.1517
1.1764
1.0032
-0.0770
1.1766
0.9258
1.0368
0.9782
1.0198
0.9614
1.0601
-0.0829
0.9901
M = -6.065+ .823 DSRI + .906 GMI + .593 AQI + .717 SGI + .107 DEPI
M-score (5-variable model)
-2.76
-3.07
-2.02
-2.97
-2.47
-2.95
#REF!
M = -4.84 + .920 DSRI + .528 GMI + .404 AQI + .892 SGI + .115 DEPI
-.172 SGAI + 4.679 Accrual to TA - .327 Leverage
M-score (8-variable model)
-2.62
-2.93
-1.95
-2.81
-2.46
-2.92
#REF!
DSRI
GMI
AQI
SGI
DEPI
SGAI
Total Accruals/TA
LVGI
#REF!
#REF!
#REF!
#REF!
#REF!
#REF!
-0.1020
#REF!
Note: if M > -2.22, firm is likely to be a manipulator
The result indicates that the company might have manipulated earnings in 2000.
Further investigation to identify the causes is need. However, M scores for other
years are quite sound.
Ending Page
22