Asset Kickers, LLP – Auditor’s Report on Alcoa, Inc. – 14 April 2013 Alcoa Prospective Client Risk Assessment Asset Kickers, LLP Page 1 Asset Kickers, LLP – Auditor’s Report on Alcoa, Inc. – 14 April 2013 Memorandum To: Mark Dirsmith, Director of Auditing From: Asset Kickers, LLP Subject: Alcoa, Inc.’s Prospective Client Risk Assessment Date: April 12, 2013 Alcoa, Inc. is an aluminum production company based in Pittsburgh, PA. They are the largest producer of aluminum in the United States and operate in 6 continents around the world. Alcoa is the only aluminum corporation included in the S&P 500 Materials Index, and they have been an industry leader since its inception in 1888 as the Aluminum Company of America. In 2011, Alcoa’s outstanding financial performance cannot be stressed enough. Alcoa’s financials, including their revenue, net income and gross profit, have been increasing since 2009. Income from continuing operations in 2011 was $614 million. Their revenue was up 19% from 2010 to $25 billion. Asset Kickers, LLP has completed a prospective risk assessment on Alcoa, Inc. in order to decide whether or not to accept them as an audit client. The attached documents contain all necessary and relevant information needed to make this decision. In order to create the prospective client risk assessment, we have thoroughly examined Alcoa, Inc.’s, and their major competitors’ financial statements, 2011 Annual Report, and SEC 10-K Filing. Using the financial information from these documents, we have constructed a Z-Score analysis and strategic profit model. In addition to these models, we have used a 5-year analysis of Alcoa’s financial ratios and an industry ratio comparison to help us make our decision. We are proposing the acceptance of Alcoa, Inc. as an audit client after careful consideration and evaluation of their financial position. They have been steadily increasing their sales, net income, and gross profit; in addition, they have been significantly investing in research and development showing their continuation of innovation amongst their products. Since Alcoa is in the maturity stage of their financial lifecycle, we consider them to be a low risk client. Furthermore, based on previous audit reports done for the company, their internal controls are effective. Based on these positive reflections of Alcoa we believe they would be an excellent client. Asset Kickers, LLP Page 2 Asset Kickers, LLP – Auditor’s Report on Alcoa, Inc. – 14 April 2013 Contents Memorandum……………………………………………………………………...………...2 Company Overview………………………………………………………………………...6 Industry…………………………………………………………………………………...6 Primary Products……………………………………………………………………...…7 Common Raw Materials…………………………………………………………………9 Size of the Company…………………………………………………………………....15 Locations…………………………………………………………………………….…..15 Other Closely Related Companies……………………………………………………..16 Annual Report…………………………………………………………………………..17 Industry Overview……………………………………………………………………...…19 Key Economic Factors………………………………………………………………….19 Life Cycle…………………………………………………………………….………….21 Factors for Success……………………………………………………………………...22 Notable Accounting Considerations………………………………………………..….25 Legal and Regulatory Concerns…………………………………………………….…26 Social Matters…………………………………………………………………………...28 Primary Competitors………………………………………………………………..….29 Ease of entry into the Industry………………………………………………………...31 Michael Porter’s “Five Forces Model”…………………………………………..……32 Government Structure………………………………………………………………….35 Asset Kickers, LLP Page 3 Asset Kickers, LLP – Auditor’s Report on Alcoa, Inc. – 14 April 2013 Financial Health……………………………………………………………….. Ratio Analysis…………………………. Profitability Ratios………………………… Efficiency Ratios………………………… Cash Flow Ratios………………………………. Investment Ratios…………………………….. Industry Comparison……………………………… Liquidity Ratios…………………………………….. Financial Leverage………………………………….. Profitability………………………………… Company’s Health………………………………………… Z-Score Analysis……………………………………………….. Strategic Profit Model……………………………………… Which Way the Company is Moving…………………………………. Sources and Value of Capital…………………………………….. Capital Market Place Response………………………………… Quality of Earnings…………………………………………………. Stock Compared to the Industry…………………………………. Auditor………………………………………………………….. Financial Statement Perception………………………………………………. Specific Consideration………………………………………………….. Transaction Types……………………………………………. Asset Kickers, LLP Page 4 Asset Kickers, LLP – Auditor’s Report on Alcoa, Inc. – 14 April 2013 High-risk Areas……………………………………………………. Low-risk Areas……………………………………………………… Integrity Issues……………………………………………………………. Client Selection Decision……………………………………….. Allocated Audit Effort……………………………………………. Problems with External Control………………………………….. Internal Audit……………………………………………………. Form of Report………………………………………………………. Implications of SOX (Sec 404)………………………………………… Initial Assessment………………………………………………………….. Z-Score Analysis…………………………………………………………. Appendix………………………………………………………………….. Budget…………………………………………………………… Leadership…………………………………………………… Coordination…………………………………………………… Norms……………………………………………………………… Conflict…………………………………………………………. Team Coordination…………………………………………….. Instructions………………………………………………………… Other Qualitative Information……………………………………. “The Oral”…………………………………………………………. Asset Kickers, LLP Page 5 Asset Kickers, LLP – Auditor’s Report on Alcoa, Inc. – 14 April 2013 Company Overview Industry Alcoa is classified under the industry of Basic Materials and the subsector of Aluminum. Basic Materials – Aluminum has a market capitalization of $884 billion industry, which makes up only 0.39% of Basic Materials. The aluminum subsector has the lowest profit margin of the industry of only 2.2%, significantly lower than the industry average of 9.85% (Alcoa 10-K). The following companies are the leaders in the subsector according to production worldwide: 1. United Co. RUSAL (Russia) 2. Rio Tinto (UK-Australia) 3. Alcoa (USA) 4. Aluminum Corporation of China 5. Norsk Hydro ASA (Norway) This makes Alcoa the largest American aluminum producing corporation. Alcoa has a market share of 14.7% (S&P). The industry is seeing the largest growth in both consumption and production in China, where Alcoa has little exposure. The United States has remained relatively constant in terms of production and consumption over the past ten years, where Alcoa earns 49% of its revenue (Alcoa 10-K). The following charts show the worldwide production of aluminum by country (Chart 1), followed by the worldwide consumption of aluminum by country (Chart 2). Doing manual comparisons, one can see where the largest markets for aluminum are in relation to those countries producing Asset Kickers, LLP Page 6 Asset Kickers, LLP – Auditor’s Report on Alcoa, Inc. – 14 April 2013 aluminum. Most of Alcoa’s revenue comes domestically, although most of its aluminum/alumina is produced abroad. (Aluminum Statistics) Primary Products Aluminum and alumina products account for 80% of Alcoa’s revenue. Aluminum is the third most abundant element in the Earth’s crust, and is the most abundant metal. Aluminum has many Asset Kickers, LLP Page 7 Asset Kickers, LLP – Auditor’s Report on Alcoa, Inc. – 14 April 2013 properties that are very desirable for human use. Aluminum is very lightweight, stainless, nontoxic, and malleable. Although it is not the strongest of metals, many aluminum alloys are produced which are drastically stronger but keep the same desirable properties of pure aluminum. Alcoa’s aluminum/alumina product lines are divided into (1) Flat rolled products and (2) Engineered products. Flat rolled products are considered “upstream” since they are essentially raw aluminum/alumina products that are either pressed or rolled into different shapes for use. The following are the primary flat rolled products that Alcoa manufactures and sells: 1. Rigid container sheet for consumers (including aluminum cans) 2. Aerospace 3. Automotive 4. Commercial transportation 5. Construction building material Alcoa sold its interest in consumer aluminum foil in 2009 (Alcoa 10-K). Engineered products are considered “downstream” because they are more complex than basic aluminum/alumina products. In most cases, Alcoa’s engineered products are for aerospace and vehicle engineering and construction. Here are the primary engineered products that Alcoa engineers and sells: 1. Super alloy investment casings 2. Forgings and fasteners 3. Wheels 4. Structural systems 5. Architectural extrusions Asset Kickers, LLP Page 8 Asset Kickers, LLP – Auditor’s Report on Alcoa, Inc. – 14 April 2013 6. Hard alloy extrusion Alcoa generates 20% of its revenues from non-aluminum/alumina products. Once again, these products are mostly accessories for industrial and aerospace engineering. These products include: 1. Precision castings 2. Aerospace fasteners 3. Industrial fasteners Common Raw Materials Amongst the raw materials listed above, there are many common items used in the process of producing aluminum. The materials that are the most important and have a significant effect on Alcoa’s operations and profit margin are bauxite, electricity, and natural gas. Bauxite Bauxite is a type of rock that has a high concentration of aluminum ore. Bauxite is the primary source of aluminum for all alumina/aluminum producers in the world. Alcoa has bauxite interests in Australia, Brazil, Guinea (which controls 50% of the world’s reserves with 8.4 billion metric tons), Jamaica, and Suriname. According to the firm’s management, they have enough proven reserves under their control to meet forecasted demand requirements for the foreseeable future (Alcoa 10-K). Over 85% of Alcoa’s current bauxite consumption is from company controlled mining operations in the countries listed above. The firm and its subsidiaries successfully mined 50.5 million metric Asset Kickers, LLP Page 9 Asset Kickers, LLP – Auditor’s Report on Alcoa, Inc. – 14 April 2013 tons of bauxite in 2011 alone. The other 15% is obtained from third parties, such as through the collection of scrap metal or through aluminum recycling efforts. (World Bauxite Reserves) After it is mined, bauxite is converted to pure aluminum ore (alumina) through the Bayer Process. This is a chemical process where unwanted minerals are “washed” from the bauxite, leaving alumina. The raw materials used in the process of extracting alumina as listed above are used in the Bayer Process as extraction agents. An unwanted, potentially dangerous byproduct called red mud is produced through the Bayer process. Red mud is essentially the leftover dirt from Bauxite that has a very basic pH of 10-13, and it can be fatal to all life that it comes into contact with. Two to three times more red mud is produced through the Bayer process than alumina, and it cannot be Asset Kickers, LLP Page 10 Asset Kickers, LLP – Auditor’s Report on Alcoa, Inc. – 14 April 2013 farmed on or used for construction purposes. Alcoa must be wary of its red mud storage as it potentially presents a major environmental liability (Alcoa 10-K). The following graphic details the Bayer Process of converting raw bauxite into alumina. Notice the red mud byproduct at the bottom. (Bayer Process) The next graphic shows a red mud lake in Jamaica (a major producer of alumina). The lake is dangerous for all forms of life, and continuing the production of red mud could have harsh consequences for the firm in the form of litigation, legislation, or lawsuits. Asset Kickers, LLP Page 11 Asset Kickers, LLP – Auditor’s Report on Alcoa, Inc. – 14 April 2013 (Red Mud Lake) Alcoa has alumina refining operations in Australia, Brazil, Jamaica, Spain, Suriname, and the United States. Although most of the bauxite used is mined in Guinea, it must be shipped to a more developed nation because the industrial processes and resources that are needed to produce alumina aren’t available or feasible in a third-world country. Once alumina is extracted, it is either used for alumina-only products, or most of the time, it is then converted to aluminum in what is called the Hall-Heroult Process, or better known as smelting. The next graphic documents the Hall-Heroult Process in more detail, showing the different raw materials and industrial equipment needed to convert the alumina to aluminum. Asset Kickers, LLP Page 12 Asset Kickers, LLP – Auditor’s Report on Alcoa, Inc. – 14 April 2013 (Hall-Heroult Process) Alcoa’s smelting operations exist in Australia, Brazil, Canada, Iceland, Italy, Norway, Spain, and the United States, which are all first world countries with the exception of Brazil. Smelting is even more difficult to achieve at an industrial capacity than alumina, which requires more machinery, skilled laborers, and stable power to achieve. After all the industrial processes are said and done, it takes about 4-6 metric tons of bauxite to yield 1 metric ton of raw aluminum (Alcoa 10-K). Electricity Electricity is undoubtedly one of the most important materials in the process of converting raw bauxite into aluminum or other related products. Electricity accounts for 25% of alumina refining costs and for 26% of smelting costs. 22% of Alcoa’s electricity for industrial use is generated on site at plants, and the other 78% is purchased through long-term arrangements, typically with local Asset Kickers, LLP Page 13 Asset Kickers, LLP – Auditor’s Report on Alcoa, Inc. – 14 April 2013 power authorities. For example, at some smelters in Brazil, the firm has built its own hydroelectric plants nearby to satisfy its own consumption needs, with any excess power being sold to third parties (Alcoa 10-K). Natural Gas In order to offset some of the financial burden the firm must endure from the high costs of electricity, natural gas is often shipped in via pipeline to some plants to help power operations. However, this is not a constant process considering that any volatility in natural gas prices can adversely affect the firm’s reliance on one commodity over the other. Additionally, it must be economically feasible to have a pipeline be built to a particular plant with sufficient capacity. Because of the expensive processes that make up the production of aluminum from mining, to transportation, refining, smelting, further engineering, and final movement, Alcoa’s gross margin for the year ended 2011 is 17.95%. Furthermore, the firm’s profit margin is at only 2.45%, just 45 basis points higher than the industry average. Alcoa is exposed to a risky level of liability in industrial processes due to the somewhat dangerous processes that are conducted, and because of the production of the useless and dangerous mass byproduct of red mud. Due to the steep costs of producing aluminum from raw bauxite and the subsequent liability it is exposed to, the firm has an incentive to purchase recycled aluminum that is chemically cleaned and reengineered to perfectly new products. It is estimated that two-thirds (2/3) of all aluminum ever produced is still used in some capacity today (Alcoa 10-K). The next graphic is a breakdown of the inputs into aluminum as well as the aluminum market. Note that this is not Alcoa’s specific structure for procurement and sales, but it represents the aluminum industry as a whole. Asset Kickers, LLP Page 14 Asset Kickers, LLP – Auditor’s Report on Alcoa, Inc. – 14 April 2013 (Flowchart of Aluminum Production) Size of the Company Alcoa is the world’s 3rd largest producer of aluminum. Its 2011 revenue was measured at $25.0 billion, clearing $1.06 billion in operating income. Their assets total $40.1 Billion and they have 61,000 people in their employ. Alcoa is also a worldwide company, having interest in 25 smelters in 8 countries and conducting business in 30 countries. A majority of their sales actually come from outside of the U.S., by a scant 51 to 49 percent margin (Alcoa Website). Asset Kickers, LLP Page 15 Asset Kickers, LLP – Auditor’s Report on Alcoa, Inc. – 14 April 2013 Locations Alcoa was founded in and is primarily associated with the city of Pittsburgh. Alcoa moved their headquarters to Lever House in New York City in 2006, taking most of the top executives to the new locale, although they still operate out of their corporate center in Pittsburgh. The office in Pittsburgh has around 2000 employees versus only 60 stationed in New York (Boselovic). Asset Kickers, LLP Page 16 Asset Kickers, LLP – Auditor’s Report on Alcoa, Inc. – 14 April 2013 As we have discussed earlier, Alcoa is also a very globally diversified company. Alcoa operates in more than 200 locations in 30 countries. They also have interests in 25 primary aluminum smelters in 8 countries (Alcoa Website). (Chart Derived From Alcoa Website) Location Categories Alumina Primary Metals Flat-Rolled Products Packaging and Consumer Engineered Solutions Extruded and End Products Technical Center Corporate The map above shows the type of operations that Alcoa has globally. As you can see, they have large clusters of operations in the US, Eastern Europe and parts of China and Brazil. This international diversity is an important part of Alcoa’s business plan and is a big reason that they are an industry leader. They are a well differentiated company, in terms of production and sales, Asset Kickers, LLP Page 17 Asset Kickers, LLP – Auditor’s Report on Alcoa, Inc. – 14 April 2013 and that differentiation helps them greatly in keeping their company growing at a fast pace worldwide. Other Closely Related Companies Alcoa’s subsidiaries include Halco Mining, Kawneer and Howmet Castings. They co-own Halco Mining with Alcan and have outright ownership of Kawneer and Howmet. Halco Mining is an aluminum mining company based in Guinea. Halco is the primary owner of the Compagnie des Bauxites de Guinee, also known as CBG, the largest aluminum smelter and mining company in Guinea. Kawneer is a commercial producer of aluminum systems and products, catering largely to the architecture industry. Their products are used on a variety of multi-purpose residential buildings such as stadiums, sports facilities, office buildings, schools, colleges and universities, and healthcare facilities. Kawneer is headquartered in Norcross, Georgia, and much like Alcoa is a global corporation, with operations in 13 different countries. The company is part of Alcoa's global Building and Construction Systems (BCS) business unit. Howmet Casting is primarily involved in the investment casting of super alloys, aluminum, and titanium. These castings are used primarily for jet plane and gas engine components. Howmet is based in Cleveland, Ohio and is largely a domestically based company, with most of their operations based in North America with a few exceptions in France, the UK, Hungary and Japan. Alcoa Howmet also offers laboratory testing and casting-related services, from finishing operations to contract management. On July 16, 2012, Alcoa announced that it had bought full ownership and control of Evermore Recycling and folded it into Alcoa's Global Packaging group. Evermore is one of the world’s leading recyclers, buying more recycled cans per year than any other company. Asset Kickers, LLP Page 18 Asset Kickers, LLP – Auditor’s Report on Alcoa, Inc. – 14 April 2013 According to Alcoa’s annual 10K report, Alcoa buys products from and sells products to various related companies, consisting of entities in which Alcoa retains a 50% or less equity interest, at negotiated arms-length prices between the two parties. These transactions were not material to the financial position or results of operations of Alcoa for all periods presented. To us, as auditors, this means that there is little risk in Alcoa committing fraudulent related party transactions. Annual Report “Alcoa won’t wait” is the headlining mentality of Alcoa’s Annual Report, followed by the phrase, “Taking Decisive Action in a Turbulent World.” Their overall approach to their business reflects the globalization in their company, as well as their drive in setting and quickly achieving goals. They did not allow external forces that they could not control distract them from what they do best, which is making high quality products. Alcoa’s sales reached a record high of $25 billion in 2011, nearly $3 billion over the previous year. The annual report reflects the success of the company through their outstanding financial growth and their plan to continue this growth. The report is broken into 7 sections: the front cover, financial highlights, a letter from the Chairman of the Board and Chief Executive Officer, nonGAAP measures, the Form 10k, shareholder information, and the back cover. The financial information reflects growth in sales, number of employees, assets, and earnings per share. Klaus Kleinfeld, the Chairman of the Board and Chief Executive Officer of Alcoa, projects the strong liquidity and financial position, regional growth, customer value through innovation, the Company’s enduring values, and their look ahead into the future. His powerful closing statement is: “We can’t wait—we won’t wait—to find new and better ways to deliver value, consistently and responsibly, in good times and tough times, for our shareholders, our customers, our communities, Asset Kickers, LLP Page 19 Asset Kickers, LLP – Auditor’s Report on Alcoa, Inc. – 14 April 2013 and our employees.” The non-GAAP financial measures reflect the changes from GAAP with respect to adjusted income, adjusted Earnings before interest, taxes, depreciation, and amortization (EBITA), free cash flow, net debt, and EBITA of the product segments separately. The Form 10K is divided into four parts. Part one includes aspects of the business, risk factors, unresolved staff comments, properties, legal proceedings, and mine safety disclosures. Part two includes market of registrant’s common equity, related stockholder matters and issuer purchases of equity securities, selected financial data, management’s decision and analysis of financial condition and results of operations, quantitative and qualitative disclosures about market risk, the audit report done by PricewaterhouseCoopers, LLP, changes in and disagreements with accountants on accounting and financial disclosure, controls and procedures, and other information. Part three includes directors, executive officers and corporate governance, executive compensation, security ownership of certain beneficial owners and management and related stockholder matters, certain relationships and related transactions, and director independence, and principal accounting fees and service. The last part is the exhibits and financial statement schedules, followed the signatures section. The shareholder’s information gives the shareholder’s information about their annual meeting, where to stay updated on Alcoa’s news and company information, dividends, and how to contact the Company. The annual report reflects Alcoa’s main cost drivers, which include selling and general administrative, research and development, and depreciation, depletion, and amortization of assets expenses. Alcoa’s research and development sector is of high importance to the Company. It is listed as a main cost driver in the Statement of Consolidated Operations with 2011 costs of $184 million. Asset Kickers, LLP Page 20 Asset Kickers, LLP – Auditor’s Report on Alcoa, Inc. – 14 April 2013 This is a cost that continues to increase exponentially, year by year. The reflection of the positive effects of these costs is shown in their increased sales. Industry Overview Key Economic Factors Largest Markets Transportation 13.1% 23.7% 11.9% 26.5% Packaging Building and Construction Electrical (Data from “Industry Overview”) Asset Kickers, LLP Page 21 Asset Kickers, LLP – Auditor’s Report on Alcoa, Inc. – 14 April 2013 Leader in preservation of natural resources Preserving natural resources is very important in this market with the recent focus on sustainability. The aluminum supply in North America comes from domestic sources, imports, and recycling. Over two-thirds of all aluminum ever produced is still used somewhere due to recycling (“Aluminum is Sustainable”). In recent news, Alcoa has been making a huge impact in recycling. The Alcoa Foundation partnered with the Times Square Alliance and New York City to launch the largest recycling program in Times Square. These new bins will use solar energy to compact garbage and hold five times more capacity than older models. This will reduce traffic in the area as well since they will be emptied less often. Alcoa provided the $250,000 grant that is making this possible. The city believes that this will spread the message of recycling since it is such a highly populated area with people from around the world, and will also help the US and New York get ahead on recycling rates (“Alcoa Foundation and Partners”). Impacts every community in the country Aluminum is a very unique industry in the way that it touches so many different aspects of business and life. Some uses of aluminum include consumer goods consumption, heavy industry, physical plants, and recycling. Most people deal with this in at least some way (“Industry Overview). Transportation Industry Impact Asset Kickers, LLP Page 22 Asset Kickers, LLP – Auditor’s Report on Alcoa, Inc. – 14 April 2013 Among developed countries, transportation is the one of the largest end markets for aluminum. Therefore, changes in demand for automobiles can impact the aluminum industry significantly. In times of recession, people have less disposable income for consumers and less demand for cars. An automobile is comprised of 300 pounds of aluminum on average, so the reduction in production results in decreased sales for Alcoa (“Industry Overview). Government Policy The industry has voluntarily taken action towards reducing greenhouse gas emissions and has been supporting policies and programs working towards these initiatives since 1990. Early action to solve these problems is key. Energy-saving aluminum product applications are a big focus of the industry too with public and private partnerships that research this topic. The Voluntary Aluminum Industrial Partnership (VAIP) is another somewhat recent way to try to attempt to increase efficiency in the industry and reduce emissions. This is a private and public combined partnership within the Environmental Protection Agency (EPA). They work towards identifying factors causing perfluorocarbon (PFC) emissions and watching the efficiency efforts in aluminum smelting and protecting the environment for the future. This group has cut PFC emissions by 77% in 14 years (“Government Policy”). Life Cycle Alcoa is currently a mature company. At this point, aluminum is a well-known product and adapted to the market. Their stock price has remained relatively constant over the last year and a half, which is common of a well-known and developed company. They have not experienced any rapid growth or decline among their financial performance since 2009. In comparison to their Asset Kickers, LLP Page 23 Asset Kickers, LLP – Auditor’s Report on Alcoa, Inc. – 14 April 2013 competitors, Alcoa has a strong presence and is ranked in the top three producers of aluminum, reflecting their well-established reputation. Based on these facts, we would place them in the maturity stage of their financial life cycle (“Product Life Cycle”). (Graph adapted from “Product Life Cycle”) Factors for Success Trade International trade is very important to the aluminum industry. The US is ranked 5th in the world in annual primary aluminum producing capacity and in 2009 with 1.73 million metric tons of primary aluminum were produced in the US. The Aluminum Association is a supporter of the World Trade Organization and the free flow of aluminum products on a global scale. The aluminum industry is global with multinational companies and locations around the world. Here in the United States, aluminum is both imported and exported frequently. Asset Kickers, LLP Page 24 Asset Kickers, LLP – Auditor’s Report on Alcoa, Inc. – 14 April 2013 Alcoa is a worldwide company located in more than 200 locations across 30 countries. As a member of the Aluminum Association as well, Alcoa works towards reaching a fair and open world market for aluminum. Alcoa, along with other members, is working towards a plan to eliminate tariffs within 10 years, and is supportive of the World Trade Organization (“Industry Overview”). Lifecycle Considerations Sustainability during the smelting of alumina to aluminum is important in addition to the recycling of end products. Perflurocarbon emissions in the US have been reduced over 70% since 1999 (“Reducing PFC Emissions”). Alcoa is one of the Aluminum Association member companies that is leading the Voluntary Aluminum Industry Partnership (VAIP) along with the Environmental Protection Agency. They work to change emissions through management and technological changes (“Reducing PFC Emissions”). Product Life The way a product is used can contribute to reducing emissions and energy consumption. For example, aluminum is very lightweight and durable, which leads to fuel and emission savings in the automotive and transportation business. Alcoa is right up to standards with light weight, fuel saving aluminum for transportation. There is a 5-7% fuel savings for every 10% reduction in vehicle weight. Aluminum gives an added benefit to hybrid vehicles as well by improving fuel economy by 13.5% compared to steel. This much lighter metal leads to large savings in fuel costs (“Industry Overview”). Asset Kickers, LLP Page 25 Asset Kickers, LLP – Auditor’s Report on Alcoa, Inc. – 14 April 2013 Energy Use In the past century, energy consumption per ton of aluminum has fallen up to 70% worldwide. It use to take 28,000 kWh to produce a metric ton and now it is down to 13,000 kWh with new smelters. Recycled aluminum can be reprocessed with about 5% of the original energy needed in ore production. Energy represents about a third of the total production cost of primary aluminum, so cutting the amount used is great for both the environment and the cost of goods sold for aluminum companies. Alcoa leads a market-based plan to deliver the correct supply of low to no carbon emitting energy sources. 50% of their purchased electricity and 2.3 of electricity used globally by smelters comes from renewable sources. Incentive compensation is available for achieving carbon dioxide emission reductions to a certain standard (“A Leader in Energy Efficiency”). (Graph from “A Leader in Energy Efficiency”) Technology Asset Kickers, LLP Page 26 Asset Kickers, LLP – Auditor’s Report on Alcoa, Inc. – 14 April 2013 Overall, the improvements in basic technology and smelters will help with many aspects of the business including lifecycle considerations, energy use, and production costs. The Aluminum Association has partnered with the Department of Energy to work towards technology projects under the “Industries of the Future” Program. Technology Roadmap diagrams are being designed as well to identify barriers and places to improve. Alcoa works hard on their technology to create better products and therefore compete well. Factors to look for include improved safety and reliability, processes to save time, lighter weight materials, and reduced fuel and drilling costs. Some products require development to become fire, heat, moisture and impact resistant. Alcoa must look at their customer base to determine where to focus their efforts (“Industry Overview”). Notable Accounting Considerations As a publicly-traded company, the basis of Alcoa’s presentation of their financial statements is a key accounting consideration. The Consolidated Financial Statements of Alcoa Inc. and its subsidiaries are prepared in conformity with generally accepted accounting principles. The Consolidated Financial Statements include the accounts of Alcoa and companies in which Alcoa has a controlling interest of 50% or greater. The company employs the equity method of accounting for investments over which they have a significant influence (20% to 50%). Lastly, investments that are less than 20% controlled by Alcoa use the cost method of accounting. With regard to properties, plants, and equipment, inventories are recorded at cost. Depreciation of assets is recorded by the straight-line method at rates based on the estimated useful lives of the Asset Kickers, LLP Page 27 Asset Kickers, LLP – Auditor’s Report on Alcoa, Inc. – 14 April 2013 assets, and is recorded in that manner until that asset no longer has any future benefit to the company. For companies in the aluminum production industry, some accounting policies are more relevant than others. Specifically, companies in the aluminum industry engage in long-term supply contacts with aluminum and alumina customers and receive advanced payments for these contracts. This places a notable amount of importance on revenue recognition. Alcoa records their advanced payments as deferred revenue, and the revenue is not recognized until the shipment has been made and the title has been transferred to the customer. Legal and Regulatory Concerns Alcoa is liable to be exposed to significant legal proceedings, investigations, or changes in U.S. federal, state, or foreign law, regulation, or policy. The company may experience a change in effective tax rates or be subject to rising costs associated with changes in laws, regulations, or policies. They are susceptible to a number of legal compliance risks. The main risks include potential claims relating to product liability, health, and safety, environmental matters, intellectual property rights, government contracts, taxes, and compliance with U.S. and foreign export laws, anti-bribery laws, competition laws and sales and trading practices. Due to Alcoa’s worldwide operations, they are subject to a broader scope of complex and increasingly strict health, safety, and environmental laws and regulations. For example, in 2010, there was a break in a red mud lake levee in Hungary. The resulting spill destroyed all life into the river it flowed into, and it killed 10 citizens. An additional 90 were treated with chemical burns. As a result, the alumina producer was nationalized by the Hungarian government, and tens of millions of dollars in cleanup Asset Kickers, LLP Page 28 Asset Kickers, LLP – Auditor’s Report on Alcoa, Inc. – 14 April 2013 costs were incurred (Red Mud Lake). Alcoa must be very weary of risks such as these. The costs associated with compliance of these laws are significant and will continue to be this way. Climate Change Legislation As the laws and regulations surrounding energy consumption evolve, this will affect Alcoa’s legal liability because of the significance of energy input in their operations. A number of governmental bodies have introduced or are considering legislative and regulatory change in response to the recognition that consumption of energy derived from fossil fuel is a contributor to global warming. The changes in regulatory mechanisms for greenhouse gas-intensive and energy-intensive assets may directly or indirectly impact Alcoa’s operations. The impacts of these potential regulatory changes may differ in the several countries in which Alcoa operates, requiring extra awareness and higher costs of complying. Asbestos Proceedings Alcoa and its subsidiaries are the defendants of several hundred active lawsuits due to previous asbestos exposure in their factories. In the period of time between World War II and 1970, during some of Alcoa’s busiest times, they made copious use of toxic asbestos inside their plants. This significant use of asbestos occurred before the Occupational Safety and Health Administration (OSHA) guidelines governing work practices made employees safer in their work environments. Factory workers operating furnaces, ovens, mills, and boilers that were lined with asbestos insulation were most likely exposed to the asbestos on a daily basis. Additionally, Alcoa required the workers to wear protective asbestos-containing clothing to protect them from burns, causing additional exposure. This toxic exposure was unavoidable at the time if you were directly involved Asset Kickers, LLP Page 29 Asset Kickers, LLP – Auditor’s Report on Alcoa, Inc. – 14 April 2013 in production. When the truth and effects of asbestos came into the public eye in the 1970s, many individuals tried to sue Alcoa for compensation for their injuries. More recently, families of former Alcoa workers continue to file lawsuits seeking compensation for deaths caused by the asbestos exposure decades ago. With regard to the effects of these previous and active lawsuits, Alcoa has numerous insurance policies that provide coverage for asbestos-based claims. The legal costs of defense and settlement have not been and are not expected to be material to the result of operations, cash flows, and financial position of the company. Employee Retirement Income Security Act and Labor-Management Relations Act Violations A class action suit was filed by plaintiffs representing 13,000 retired former employees of Alcoa and spouses and dependents of such retirees alleging violation of the Employee Retirement Income Security Act (ERISA) and the Labor-Management Relations Act by requiring plaintiffs, beginning January 1, 2007, to pay health insurance premiums and increased co-payments and co-insurance for certain medical procedures and prescription drugs (Alcoa 10-K). This suit was filed in November 2006, in Curtis v. Alcoa Inc. The plaintiffs alleged these changes to their retirement health care plans violated their rights and that Alcoa had violated ERISA standards by misrepresenting to them that their health care benefits would never change. The plaintiffs sought compensation for injunctive and declaratory relief, back payments, and attorneys’ fees. More recently, on March 23, 2011, plaintiffs filed a motion an amendment of the judgment order to prevent Alcoa from modifying the vested retirement plans or changing the premiums and deductibles that plaintiff’s must pay, as well as a motion for awards of attorney’s fees and Asset Kickers, LLP Page 30 Asset Kickers, LLP – Auditor’s Report on Alcoa, Inc. – 14 April 2013 expenses. Alcoa filed pleadings opposing to both motions on April 11, 2011. The result of this litigation could have a significant impact on the company’s health insurance costs. Social Matters Sustainability Increased interest in sustainability will have a positive impact on the aluminum industry because aluminum is sustainable. Twenty years ago, the term sustainability was seldom heard, but now more often than not a company’s website will have a section devoted to sustainability. The chart below shows how the usage of the word sustainability has increased from roughly .05 to .45 articles per newspaper issue. This increase has resulted in an increased emphasis on recycling and social responsibility. Aluminum cans are already the most prevalent type of beverage container, but with the increased trend of sustainability the demand for aluminum cans with continue to grow. The amount of Asset Kickers, LLP Page 31 Asset Kickers, LLP – Auditor’s Report on Alcoa, Inc. – 14 April 2013 energy required to recycle aluminum is merely 5% of the energy used to create the original products, in contrast to plastic and glass recycling which require 30% and 70%, respectively. Aluminum cans are recycled and back on the shelf as new cans in as few as 60 days, making aluminum the most cost-effective and efficient material to recycle. Primary Competitors The aluminum industry is one that is dominated by a few major players, Alcoa being one of them. In recent years, various aluminum producers have arose around the world, from places like Russia, China, India and the Middle East. These worldwide companies have been able to gain global strongholds and instead of resting on their domestic dominance, Alcoa has responded with aggressive expansion. The organized and ambitious plan that Alcoa has been carrying out is one thing that has been separating them from their competition. One major company that has become threatening to Alcoa is Rio Tinto Alcan, formerly Alcan. Alcoa placed a $27 billion hostile takeover bid of Alcan in 2007, which was turned down in favor of a mutual agreement between Alcan and Rio Tinto, who later merged into Rio Tinto Alcan. Rio Tinto Alcan is also a major global player, with either ownership or an interest in 22 smelters in 11 countries and regions. One reason that Rio Tinto Alcan is a threat to Alcoa is their position on the aluminum production cost curve, utilizing their technological advances and relying on cheaper energy sources to keep their costs down. In recent years, Alcan stocks have outperformed Alcoa’s due mainly to their international diversity and ability to better absorb changes in the price of aluminum (The Economist). Asset Kickers, LLP Page 32 Asset Kickers, LLP – Auditor’s Report on Alcoa, Inc. – 14 April 2013 Other major international players include RUSAL, a Moscow based aluminum Production Company, consolidated in 2007, which holds interests in 10 separate countries and Aluminum Corporation of China, a Beijing based Metals Company that has been a huge beneficiary of China’s rapidly expanding economic growth. Personnel Turnover The Personal Turnover ratio measures how many employees an employer gains or losses during a year. It is unrealistic to retain every employee, and new employees will bring new perspectives and ideas. Turnover can be both voluntary and involuntary depending on the nature of the employee leaving. Voluntary turnovers are when the employee decides to leave on their own. Management wants to overall make people want to stay and work at Alcoa. Managing a company well is important to avoid involuntary turnover so fewer layoffs are necessary. A higher turnover ratio means overall shorter term employments, while a smaller ratio mean the number of employees each year stays more constant. A lower turnover is better since it means employees are satisfied with their work and staying (Reh, John). Alcoa experienced a really high personal turnover ratio in 2009 when many employees were let go because of the recession. The past few years this ratio has been much more consistent. Year Number of Employees Personnel Turnover Rate 2009 59,000 38.36% 2010 59,000 0.00% Asset Kickers, LLP Page 33 Asset Kickers, LLP – Auditor’s Report on Alcoa, Inc. – 14 April 2013 2011 61,000 -3.33% Ease of Entry into the Industry The ease of entry of new competitors into the aluminum industry, or any industry for that matter, is influenced by the market power and share of the existing leaders in the industry. A major barrier to entry in the aluminum industry is the high cost of start-up and continuation. As a technology leader in the aluminum industry, Alcoa engages in research and development programs that include process and product development, and basic and applied research. Expenditures (as seen below) for research and development have consistently increased for Alcoa throughout the past three years, making entry into the aluminum market increasingly more costly and challenging. R&D Costs (millions) $185 $180 $175 R&D Costs (millions) $170 $165 $160 2009 2010 2011 The research and development costs come with the costs of protecting intellectual property. Alcoa’s rights to their products are protected by patents, which are very costly to perfect. At the end of 2011, the company’s worldwide patent portfolio included 870 pending patent applications Asset Kickers, LLP Page 34 Asset Kickers, LLP – Auditor’s Report on Alcoa, Inc. – 14 April 2013 and 1,895 granted patents. Intellectual property in the aluminum industry does not stop at patents; the company also has a number of trade secrets regarding their manufacturing processes and domestic and international trademarks. Alcoa’s 10-K report stresses the highly competitive conditions of the industry. Costs to compete in the United States are one obstacle, but competitors also come from non-U.S. companies, adding to the difficult entry into the industry. In addition to high entry costs and extreme competitiveness, the segments in which Alcoa operates are highly influenced by brand names, brand recognition, and brand loyalty. Becoming established among developed and specialized companies with millions of loyal customers is not a simple task. Michael Porter’s “Five Forces Model” Asset Kickers, LLP Page 35 Asset Kickers, LLP – Auditor’s Report on Alcoa, Inc. – 14 April 2013 Power of Buyers Threat of new entrants Competitive Rivalry Power of Suppliers Threat of substitutes Rivalry It’s difficult to differentiate a product like aluminum, so the differences focus on quality and price. Developing new technology to do the process more efficiently may be a good place to set you apart from the other industry competitors. Some of Alcoa’s biggest rivals in the industry include United Co. Rusal, Rio Tinto Group, Aluminum Corp. of China and Norsk Hydro ASA. Asset Kickers, LLP Page 36 Asset Kickers, LLP – Auditor’s Report on Alcoa, Inc. – 14 April 2013 Threat of Substitutes Steel is often cheaper, making it a substitute, but it also doesn’t have some of the advantages of aluminum. In the power sector, copper is also becoming a substitute because of its higher conductivity. Aluminum properties like lower cost, higher strength to weight ratio, and durability still make it a good choice. Aluminum use should continue to increase in the long term. Alcoa can have problems with this because aluminum is one product and it is so hard to set it apart, so customers could easily start getting aluminum from another spot after a bad experience with Alcoa, making every interaction important. Bargaining Power of Customers Since aluminum is a commodity, prices are determined by supply and demand so customers have fairly high say in this. This force deals with how much customers can get businesses to provide better service, lower prices, and higher quality products. Alcoa does have major competitors, such as Rio Tinto and Rusal, so they have to be careful to keep products priced well or else they will lose their business to others with more attractive prices. Since aluminum varies little from place to place, staying competitive is important to keep customers and have them coming back. Asset Kickers, LLP Page 37 Asset Kickers, LLP – Auditor’s Report on Alcoa, Inc. – 14 April 2013 Bargaining Power of Suppliers Often in the industry, companies own their own mines and smelters so have little need for suppliers. If a company does need upstream producers though, they often have to deal with the government and have little power with the purchase of power. Alcoa does still deal with some suppliers. They set standards though that must be followed in regards to sustainability. Alcoa owns many smelters around the world allowing them to depend less on others. Threat of New Entrants There is some chance of new entrants but medium barriers to entry exist. A huge capital investment is needed to start a new plant. The development period also takes some time, and government policies make it a difficult process. Alcoa is a very long standing developed company so it has an advantage here. (Information from “Aluminum: Through the Eyes of Michael Porter and Alcoa Website”) Government Structure The management of Alcoa has been lauded in recent years for a smart, focused, and aggressive approach to their business. Given the ever-changing nature of aluminum prices and market changes, they have managed to keep their company in good standing financially and in terms of market share. Alcoa is a value driven company, seemingly at every level of their operation, holding all directors, officers and employees to conduct business in compliance with their Business Conduct Policies. Compliance with these policies is surveyed on an annual basis. Alcoa endorses The Business Asset Kickers, LLP Page 38 Asset Kickers, LLP – Auditor’s Report on Alcoa, Inc. – 14 April 2013 Roundtable Principles of Corporate Governance dated April 2010, which is a comprehensive statement of responsible corporate governance principles. According to the 2011 Covalence Ethical Ranking, Alcoa is listed as #1 in the basic resources sector and the only basic resources company among the top-ranked companies. This displays a strong ethical backbone that guides the day to day and long term activities of the company (Alcoa Website). Alcoa has had trouble in the past with their very large environmental impact; they were ranked by The Political Economy Research Institute as 15th among corporations emitting airborne pollutants in the United States. This ranking includes both quantity and toxicity of the pollutants. They also have a track record of operating unlawfully in many different environmental aspects of their business. At the turn of the century, management of Alcoa appeared to take a serious interest in their environmental impact by joining the Dow Jones Sustainability Indexes for North America and the World in 2001. They are currently ranked #1 out of all aluminum companies on that listing (Dow Jones). Financial Health Alcoa Inc. 5-Year Financial Ratio Summary 2011 2010 2009 2008 2007 Gross Profit Margin 17.92% 18.27% 8.34% 17.57% 22.12% Operating Profit Margin 4.26% 2.61% -8.12% 2.94% 16.40% Effective Tax Rate 23.99% 27.01% 38.32% 43.18% 33.80% Asset Kickers, LLP Page 39 Asset Kickers, LLP – Auditor’s Report on Alcoa, Inc. – 14 April 2013 Return on Assets 2.65% 1.00% -2.83% 0.39% 7.55% Return on Equity 5.86% 3.01% -9.03% 1.06% 19.11% Working Capital Turnover 14.68 12.60 11.47 30.89 31.83 Current Ratio 1.28 1.32 1.30 1.12 1.13 Inventory Turnover 7.47 6.99 6.07 6.76 6.80 Revenue per Employee $ 409,033 $ 356,153 $ 312,525 $ 309,207 N/A Operating Cash Flow 0.10 0.10 0.06 0.05 0.15 Free Cash Flow 656 1,005 761 -409 N/A Price/Book Value 1.29 1.07 0.6 1.96 1.89 Dividend Yield 1.43% 0.71% 1.53% 5.67% 1.94% EPS 0.57 0.25 -1.23 -0.1 2.95 Ratio Analysis The table above reflects Alcoa’s most important financial ratios to help determine the current financial health of the company. Asset Kickers, LLP would like to point out that these ratios may not be the same as the ones calculated by other financial databases, but we’ve calculated them based on constant values found in the 10k Report of Alcoa. The industry ratios listed in the section below have also been calculated in accordance with the financial statements provided by the 10k Reports of Rio Tinto and RUSAL. It is apparent that Alcoa took a financial downturn in 2009 as Asset Kickers, LLP Page 40 Asset Kickers, LLP – Auditor’s Report on Alcoa, Inc. – 14 April 2013 a result of the economic recession. The aluminum industry tends to fluctuate with the state of the economy due to the elasticity of their products. Regardless of the downturn, Alcoa was never in any immediate danger of bankruptcy and since 2009 they have recovered and improved their ratios. Overall, Alcoa has demonstrated its resiliency through its improved financials and is considered to be a strong, consistent company. Profitability Ratios Through analyzing the profitability ratios, it is visible that Alcoa maintains consistent growth and profits. The first thing that stands out when computing and evaluating the financial ratios is the significant profitability decrease in 2009. The gross profit margin, operating profit margin, return on assets, and return on equity all resulted in negative numbers. However, the return on assets and return on equity has increased since the 2009 recessionary period. The effective tax rate has decreased substantially in the last 4 years for Alcoa. Efficiency Ratios The analysis of the efficiency ratios demonstrates a strong working capital turnover that has increased to almost 15 times in a year. Although this number is substantially less than the prerecession level of 30 times, it has been strongly increasing since 2009. The inventory turnover rate seems to be one of the only ratios that didn’t suffer drastically as a result of the recession; it has remained consistently between 6 and 8 times. The sales revenue per employee has impressively increased from $309,207 M in 2008 to $409,033 M in 2011. In 2009, Alcoa’s amount of employees decreased from 87,000 to 59,000 due to recessionary constraints. The fact that Alcoa maintained their revenue per employee demonstrates their employment efficiency and their ability to react to crisis. Asset Kickers, LLP Page 41 Asset Kickers, LLP – Auditor’s Report on Alcoa, Inc. – 14 April 2013 Cash Flow Ratios Alcoa’s cash flow ratios reflect a great amount of stability in the company. Their operating cash flow ratio has remained between .15 and .05 over the past five years. Alike most of the ratios, 2009 shows the effects of the economic downturn, but the ratio has been increasing since that period. Although it is not as strong as it had been in 2007, there is hope that it will return to that high or higher levels in the near future. Alcoa’s free cash flow, which is a measure of financial performance calculated as operating cash flow minus capital expenditures, represents the company’s ability to generate profits after laying out money required to maintain and acquire assets. Their free cash flow took a dive in 2008, most likely as a result of the recession, but quickly recovered. However, similar to their operating cash flows, there is much room for improvement. Investment Ratios Based on their investment ratios, Alcoa appears to be a smart, long-term investment. Their price to book value ratio is currently at 1.29, which has been consistently increasing since 2009. The dividend yield ratio is slowing recovering from the recessionary period that brought the ratio down to 0.71% in 2010; it is currently up to 1.43%. Their price to earnings ratio, as reflected below in the industry comparison, is also a valid ratio to drag into the investment decision. This ratio of 47.39 is extremely impressive when compared to their competitors, Rio Tinto and RUSAL. Industry Comparison-2011 Alcoa Current Ratio Rio Tinto 1.28 1.46 RUSAL 1.91 Asset Kickers, LLP Page 42 Asset Kickers, LLP – Auditor’s Report on Alcoa, Inc. – 14 April 2013 Quick Ratio 0.54 0.69 0.27 Inventory Turnover 7.47 6.56 1.62 Receivables Turnover 15.78 8.23 11.76 Debt to Equity 1.66 1.28 1.40 Profit Margin 2.45% 9.62% 14.23% Return on Assets 2.65% 4.87% 0.91% Return on Equity 5.86% 11.09% 2.16% Price/Earnings Ratio 47.39 -28.99 -15.08 Earnings per Share $ 0.57 $ 3.01 $ 0.02 Liquidity Ratios The liquidity ratios are used to measure a firm’s ability to repay short-term debts. This is extremely important to consider when evaluating the financial health of a company because it reflects the likelihood that the company will not default on their obligations. It also demonstrates their ability to continue as a going concern. Generally a higher ratio indicates a larger margin of safety over short-term debts. Current Ratio Asset Kickers, LLP Page 43 Asset Kickers, LLP – Auditor’s Report on Alcoa, Inc. – 14 April 2013 This ratio gives the viewer of the financials and indication of the company’s ability to pay back its short-term liabilities with its short-term assets. A ratio under 1 suggests that the company is unable to pay off their debts if they came due at that point. Although Alcoa’s ratio is not under 1, their ability to repay short-term debts is worse than that of their competitors, Rio Tinto and RUSAL. The possibility of Alcoa defaulting on their shortterm payments is higher than it is for their competitors; however, the ratio of 1.28 reflects that they do have the ability to quickly repay their short-term debts. Quick Ratio The quick ratio differs from the current ratio in that it measures the company’s ability to use its near cash, which is its current assets less inventory and accounts receivable, to repay its current liabilities. A ratio less than 1 reflects that the company is unable to currently pay back its current liabilities. Alcoa and its competitors all have a ratio of less than 1. Alcoa is in the middle of Rio Tinto and RUSAL in terms of its ability to currently repay its current liabilities with a ratio of .54. The current ratio and the quick ratio are equally as important when evaluating the company’s ability to repay short-term debts. If you only looked at the current ratio you would be misled to think that RUSAL has the best ability to repay its short-term debts, when in reality they have the lowest quick ratio. This may seem to be contradicting, but it simply reflects RUSAL’s lack of liquid assets (cash, cash equivalents, and marketable securities). Inventory Turnover The inventory turnover ratio shows how many times a company’s inventory is sold and replaced over a period of time, which in this case is a year. A low turnover rate is usually a bad sign because products tend to depreciate as they sit in a warehouse. The average Asset Kickers, LLP Page 44 Asset Kickers, LLP – Auditor’s Report on Alcoa, Inc. – 14 April 2013 turnover rate varies greatly by industry. For example, companies selling perishable items have a very high turnover. Alcoa has the highest turnover rate of its competitors of 7.47, which shows that they move their inventory in and out of their warehouse faster than their competitors. Receivables Turnover This ratio is a measurement of the company’s effectiveness in collecting debts. A low ratio implies the company should re-assess its credit policies in order to ensure a more timely collection of accounts receivable. A higher ratio implies that company either operates on a cash basis or their credit policies are efficient in collecting from their customers. Alcoa, again, demonstrates a higher ratio than its competitors, with an impressive 15.78 collections per year. Financial Leverage Debt to equity This measure of a company’s financial leverage indicates what portion of equity and debt the company is using to finance its assets. A higher ratio means that a company has been aggressive in financing its growth with debt, which can result in unstable earnings as a result of the additional interest expense that comes along with this method of financing. The averages for the debt to equity ratio differ among industries. Alcoa has the highest debt to equity ratio of its competitors; although it is higher than Rio Tinto and RUSAL, 1.66 is still not considered to be a high ratio. Profitability Profit Margin Asset Kickers, LLP Page 45 Asset Kickers, LLP – Auditor’s Report on Alcoa, Inc. – 14 April 2013 The profit margin is not generally used to compare company-to-company, but for internal reasons. It has little meaning when comparing companies, but you can judge a firm profitability by and increase or decrease in their profit margin level. Alcoa’s profit margin is considerably less than that of their competitors; however, this should not portray a poor reflection of profitability on the company. Return on Assets Also known as the “return on investment,” the return on assets is an indicator of how profitable a company is in terms of its total assets. This demonstrates the efficiency of the company’s managements of using its assets to generate earnings. A higher percentage indicates a better ability to convert investments into profits. Alcoa’s return on assets is 2.03%, which proves that their ability to use their investments to generate profit puts them right in between Rio Tinto and RUSAL. RUSAL has an impressive 4.87% return on assets. Return on Equity Return on equity is a measure of the amount of net income returned as a percentage of shareholder’s equity. This measures the company’s profitability by showing how much profit has been generated with the money shareholders have invested. Return on equity over a span of 5 to ten years can specifically give you a better idea of the historical growth of the company. The higher the returns on equity, the higher the growth of the company should be expected to be. RUSAL has the highest return on equity, putting Alcoa in between its competitors yet again. Earnings per Share Earnings per share are the portion of a company’s net income allocated to each outstanding share of common stock. This measure is arguably the most important variable in Asset Kickers, LLP Page 46 Asset Kickers, LLP – Auditor’s Report on Alcoa, Inc. – 14 April 2013 determining a share’s price. Rio Tinto had the highest earnings per share of the three, with $3.01. While RUSAL had the lowest of $0.02, putting Alcoa in the middle of the two with $0.57. Alcoa had a weaker EPS than Rio Tinto, but this is not a poor reflection on the company. Intrinsic Stock Value Alcoa’s stock can be valued at a market rate and an intrinsic rate. The intrinsic rate is based on calculations that are made to reflect tangible and intangible factors of the company. This calculated rate is an underlying perception of the true value of the stock at hand. Alcoa’s intrinsic value, as calculated by Stock Analysis on Net, is $5.26. The current market of stock per share is $8.39. Generally, having a higher market value than intrinsic value is a negative sign to investors. This means that the stock is actually worth less than it appears to be, when you look at other factors contributing to your return on the stock. However, this is only an approximation and other aspects of the company should be evaluated before an investor would make their decision of whether or not to invest. Beta Beta is a measure of a stock or portfolio describing the correlated volatility of an asset in relation to the volatility of the benchmark that said asset is being compared to, which is generally the market of that stock. Alcoa has a beta of 1.89, meaning that it is 89% more volatile than the market. A beta that is greater than one will have a higher rate of return for their investment, but with a higher return comes a higher rate of risk. Therefore, Alcoa’s stock has a higher risk and return than the rest of the aluminum production market. Company’s Health Asset Kickers, LLP Page 47 Asset Kickers, LLP – Auditor’s Report on Alcoa, Inc. – 14 April 2013 Alcoa is in very good financial health and not in any risk of bankruptcy or possible doubt of going concern in the near future. There are a few important indicators of the strong financial health. Although Alcoa was affected by the economic recession of 2009, they survived the tough times and have been improving their profitability since that time. In terms of their position among their competitors, they are not the weakest link in the Aluminum Production industry. Their impressive earnings per share ratio of $0.57 says a lot about their place among their competitors. Z-score analysis The Z-Score analysis is used by investors to keep an eye on their investments. It’s a way to stay daily updates on the financial state of a company. The score does not predict financial health, but rather gauges it at a current point. The z-score combines the use of financial ratios and a rating scale. If the company’s score is above 3.00, then the company is believed to be economically sound and not in danger of bankruptcy. The scale draws the line at insolvency if a score is anywhere below 1.80. The calculated scores for Alcoa Inc. are listed below for the years 2009, 2010, and 2011. Alcoa Inc. Z-Score Analysis For the year ended December 31, 2011 Working Capital Total Assets x 12 = 1700 40120 x 12 = 0.51 Retained Earnings Total Assets x 14 = 11629 40120 x 14 = 4.06 EBIT x 3.3 = 1063 x 3.3 = 0.09 Asset Kickers, LLP Page 48 Asset Kickers, LLP – Auditor’s Report on Alcoa, Inc. – 14 April 2013 Total Assets 40120 MV of Equity BV of Liabilities x .6 = 13844 22925 x 0.6 = 0.36 Sales Total Assets x 0.999 = 24951 40120 x 0.999 = 0.62 Z-Score = 5.64 Alcoa Inc. Z-Score Analysis For the year ended December 31, 2010 Working Capital Total Assets x 12 = 1668 39293 x 12 = 0.51 Retained Earnings Total Assets x 14 = 11149 39293 x 14 = 3.97 EBIT Total Assets x 3.3 = 548 39293 x 3.3 = 0.05 MV of Equity BV of Liabilities x .6 = 13611 22207 x 0.6 = 0.37 Sales Total Assets x 0.999 = 21013 39293 x 0.999 = 0.53 Asset Kickers, LLP Page 49 Asset Kickers, LLP – Auditor’s Report on Alcoa, Inc. – 14 April 2013 Z-Score =5.43 Alcoa Inc. Z-Score Analysis For the year ended December 31, 2009 Working Capital Total Assets x 12 = 1608 38472 x 12 = 0.50 Retained Earnings Total Assets x 14 = 11020 38472 x 14 = 4.01 EBIT Total Assets x 3.3 = -1498 38472 x 3.3 = -0.13 MV of Equity BV of Liabilities x .6 = 12420 22912 x 0.6 = 0.33 Sales Total Assets x 0.999 = 18439 38472 x 0.999 = 0.48 Z-Score = 5.19 Alcoa had a z-score of 5.64 in 2011, 5.43 in 2010, and 5.19 in 2009. This reflects the financial health of the company since their z-scores are all above the 3.00 level for all three years. Furthermore, their z-scores have been constantly increasing over these three years, which lessens their risk of bankruptcy even further. In creating a z-score analysis for one of Alcoa’s prime competitors, Rio Tinto, Alcoa has been found to currently have a higher z-score than Rio Tinto. Rio Tinto score was 5.29 in 2011, 6.38 Asset Kickers, LLP Page 50 Asset Kickers, LLP – Auditor’s Report on Alcoa, Inc. – 14 April 2013 in 2010, and 4.81 in 2009. This shows a lack of consistency among Rio Tinto’s financials. The following three tables reflect the calculations for the scores. Rio Tinto Z-Score Analysis For the year ended December 31, 2011 Working Capital Total Assets x 12 = 6,932 119,545 x 12 = 0.70 Retained Earnings Total Assets x 14 = 27,784 119,545 x 14 = 3.25 EBIT Total Assets x 3.3 = 13,214 119,545 x 3.3 = 0.36 MV of Equity BV of Liabilities x .6 = 52,539 67,006 x 0.6 = 0.47 Sales Total Assets x 0.999 = 60,537 119,545 x 0.999 = 0.51 Z-Score = 5.29 Rio Tinto Z-Score Analysis For the year ended December 31, 2010 Working Capital Total Assets x 12 = 9,661 112,402 x 12 = 1.03 Retained Earnings Total Assets x 14 = 32,499 112,402 x 14 = 4.05 Asset Kickers, LLP Page 51 Asset Kickers, LLP – Auditor’s Report on Alcoa, Inc. – 14 April 2013 EBIT Total Assets x 3.3 = 20,577 112,402 x 3.3 = 0.60 MV of Equity BV of Liabilities x .6 = 58,333 54,069 x 0.6 = 0.65 Sales Total Assets x 0.999 = 56,576 112402 x 0.999 = 0.50 Z-Score = 6.83 Rio Tinto Z-Score Analysis For the year ended December 31, 2009 Working Capital Total Assets x 12 = 5403 97,236 x 12 = 0.67 Retained Earnings Total Assets x 14 = 20,477 97,236 x 14 = 2.95 EBIT Total Assets x 3.3 = 7,860 97,236 x 3.3 = 0.27 MV of Equity BV of Liabilities x .6 = 43,831 53,405 x 0.6 = 0.49 Sales Total Assets x 0.999 = 41,825 97,236 x 0.999 = 0.43 Z-Score = 4.81 Asset Kickers, LLP Page 52 Asset Kickers, LLP – Auditor’s Report on Alcoa, Inc. – 14 April 2013 Strategic Profit Model The Strategic Profit Model is simply an expanded version of the DuPont Model. It gives you a visual version of the breakdown of the company’s financial performance, ultimately calculating the return on investment. The visual model, Strategic Profit Model is broken into three sections: net margin, assets, turnover, and financial leverage. This visual model calculated a return on investment of 6.18% while the DuPont model calculated a 5.86% return on equity. These ratios prove Alcoa to be a profitable investment. Asset Kickers, LLP Page 53 Asset Kickers, LLP – Auditor’s Report on Alcoa, Inc. – 14 April 2013 DuPont Model ROE = Net Income Sales x Sales Total Assets x Total Assets Average Shareholder's Equity ROE = 805 24951 x 24951 40120 x 40120 13727.5 ROE = 5.86% Which Way the Company is Moving Asset Kickers, LLP Page 54 Asset Kickers, LLP – Auditor’s Report on Alcoa, Inc. – 14 April 2013 Alcoa is currently in the maturity stage, but they still have room for potential growth. The increased profitability since the 2009 recession proves that they can regain their prior levels of profitability through growing the developing their products and processes. In order to avoid moving into a recessionary stage, or a trough, Alcoa should build their image through innovation. In the maturity stage, less advertising is required due to their already well-established brand image; therefore, they should use advertising funds to promote research and development. Sources and value of capital Alcoa primarily funds their business through debt and equity. Their total debt for 2011 combined to be $22,925 M, which includes their long-term debt, short-term debt, and all other non-current liabilities. While their equity for the year totaled to be $17,195 M (Alcoa 10-K). This reflects that their main source of capital is debt, which is a financing route that many businesses are skeptical to take. However, Alcoa has sufficient cash flows to repay these debts so their method works out in their favor. In 2011, Alcoa’s debt-to-capital ratio was 35%, demonstrating their ability to repay these debts. This ratio has decreased since 2008, which only further proves their more efficient method of financing with debt. In the case of bankruptcy, Alcoa would be liable to their debtors before their shareholders, which may result in little to no repayment to these shareholders. On the other hand, financing capital expenditures through debt helps Alcoa to retain more ownership of their company. Asset Kickers, LLP Page 55 Asset Kickers, LLP – Auditor’s Report on Alcoa, Inc. – 14 April 2013 Capital Market Place Response Following the 2009 recession, the capital market place had a positive response to Alcoa, as their stock price rapidly increased until the middle of 2011. Since that period of productivity the price has not been consistent, reflecting the maturity stage of their company’s life cycle. In the future, the stock prices are expected to increase as Alcoa CEO, Klaus Kleinfield speculates that the demand for aluminum will double between 2010 and 2020 (Alcoa Annual Report, p. 6). Quality of Earnings Asset Kickers, LLP Page 56 Asset Kickers, LLP – Auditor’s Report on Alcoa, Inc. – 14 April 2013 A company’s quality of earnings is attributable to either higher sales or lower costs. In analyzing the free cash flows of Alcoa, it is apparent that they have a positive quality of earnings based on the improved free cash flow generation. From 2008 to 2011, the number has increased from ($2,204 M) to $906 M; these numbers are a result of strong profits from increased sales rather than accounting irregularities or inflation. In addition, the inventory turnover rate has increased from 6.07 times in 2009 to 7.47 times in 2011. This is of interest to the quality of earnings because having control over your inventory demonstrates less desired costs for future growth. Stock compared to the industry (Alcoa 10-K) Alcoa’s stock has both underperformed the S&P 500 Index as well as the S&P 500 Materials Index. The materials index tracks those corporations in the S&P 500 which specialize in basic materials, such as chemicals, precious metals, timber products, construction materials, and industrial metals. Of these, Alcoa is the only aluminum producer included. As made apparent from visual inspection Asset Kickers, LLP Page 57 Asset Kickers, LLP – Auditor’s Report on Alcoa, Inc. – 14 April 2013 of the above chart, Alcoa has a beta higher than both of the indices it’s paired with, checking in at 1.86. As noted in the risk factors, the aluminum industry is very cyclical. Essentially, the good times are great, and the bad times are terrible. Auditor Alcoa, Inc.’s auditor is PricewaterhouseCoopers LLP. The following chart discusses Alcoa’s past five audit reports and the opinions that were issued. Year Opinion Issued Report Form December 2010-2011 Unqualified Combined Report on Financial Statements and Internal Control over Financial Reporting December 2009-2010 Unqualified Combined Report on Financial Statements and Internal Control over Financial Reporting December 2008-2009 Unqualified Combined Report on Financial Statements and Internal Control over Financial Reporting December 2007-2008 Unqualified Combined Report on Financial Statements and Internal Control over Financial Reporting December 2006-2007 Unqualified Combined Report on Financial Statements and Internal Control over Financial Reporting Alcoa has clearly been consistent with the fair statement of their financials, as well as the effectiveness of their internal control. Financial Statement Perception Alcoa’s corporate bonds are rated BB+ by Morningstar (Alcoa Inc Debt). Their capital structure is made of 59.7% Equity, 40.1% Debt, and only 0.2% Preferred shares (Alcoa Inc Debt). Although Alcoa has paid all corporate debt off in time, its lower than stellar bond rating lends itself to the cyclicity of the aluminum industry. A downturn in the economy can prove disastrous for the industry and Alcoa. For example, Alcoa’s stock plummeted from approximately $43 a share before the 2008 financial crisis to a low of around $5 a share after (Alcoa Inc. Debt). Asset Kickers, LLP Page 58 Asset Kickers, LLP – Auditor’s Report on Alcoa, Inc. – 14 April 2013 Alcoa has not failed an external auditor’s report in its history, and third parties have no reason to believe that management lacks integrity. Amongst Alcoa’s financial statement users, the general consensus is that Alcoa represents a strong industry leader that has set the standards for decades. Their business model is relatively simple (in comparison to many other corporations that make up the Dow Jones Industrial Average and the S&P 500). The main concern for investors is the state of the economy, worldwide, demand for aluminum, and aluminum prices, all being external factors. As long as Alcoa can remain solvent during economic downturns and can keep its strong, stable form of corporate governance, the firm will survive and flourish as an industry leader (Alcoa 10-K) Auditor Concerns Transaction Cycles Financial Cycle Alcoa's financial cycle is crucial for the firm to conduct operations since it relies off of its capital financing through this cycle. Alcoa issues debt in the forms of corporate debentures, convertible bonds, and commercial paper. Additionally, the firm raises capital through the sales of common and preferred shares of equity. For the year ended 2011, Alcoa had $8.64B in outstanding, long term debt. Most debt has been secured with fixed rates in from 5.25% to 6.75%, with notes due from 2013 to 2037. Long-term debt has most recently been used to finance the construction of both smelters and power plants in Brazil and Russia. Alcoa must be weary of the Net Present Value of these projects which they are using 6% notes to fund. Additionally, the firm must be prepared to use up to $997 million in cash reserves so that they may repay notes due during 2013. Cash Asset Kickers, LLP Page 59 Asset Kickers, LLP – Auditor’s Report on Alcoa, Inc. – 14 April 2013 provided from financing activities during 2011 totaled $62 million, mostly due to an increase in long-term borrowing (Alcoa 10-K). Expenditure Cycle For the fiscal year 2011, $1.287 billion of Alcoa’s assets were used for capital expenditures (CapEx). This is lower than what is usually spent on capital expenditures in the years previous due to the continuing effects of the 2008 global economic downturn, the firm's desire to increase its ratio of net cash inflows from working capital, and to increase its liquidity during a period of trying times for the aluminum industry. The measures weren't enough as there was a 3% decline in cash from operations from 2010 to 2011, though the firm's liquidity increased during this time. $184 million was spent on research and development (R&D) during 2011, a successive increase of approximately 6% from both years prior (Alcoa 10-K). Payroll Cycle The payroll cycle is vital for Alcoa's going concern, being that the company employs large numbers of workers to maintain its huge industrial capacity. Payroll for lower level laborers and middle managers are included in the Cost of Goods Sold (COGS) account, while compensation figures for upper level managers is included in the Selling, General, and Administrative (SG&A) account. At the year ended 2011, Alcoa had employed about 61,000 employees in 31 countries where there exists some level of operation. As a result of the 2008 Financial Crisis, the firm implemented both a salaries and hiring freeze which was not lifted until December 31, 2010 (Alcoa 10-K). Conservation/Revenue Cycle Asset Kickers, LLP Page 60 Asset Kickers, LLP – Auditor’s Report on Alcoa, Inc. – 14 April 2013 Since Alcoa makes almost all if it's revenue from the conversion of raw materials to commercial and industrial products, the conversion cycle is the crux on which the firm operates and survives. Alcoa mines raw bauxite from the Earth's crust, and proceeds to convert the bauxite to aluminum in two separate industrial processes. Alcoa proceeds to sell aluminum to consumer, industrial, and construction firms for their source of revenue. Alcoa is a vertically integrated corporation through their business processes in the conversion to revenue cycles. Bauxite is mined by Alcoa, shipped by Alcoa, converted to aluminum/alumina by Alcoa, and then further fabricated by Alcoa. Through their operations, Alcoa was able to convert 43 million metric tons of mined, raw bauxite, into $24.95 billion in revenue during the year ended 2011 (Alcoa 10-K). Risk Areas The following risks have been pulled from Alcoa’s 10K report. They have been deemed potentially problematic for the firm’s success and continuing operations, and therefore they must be taken into consideration seriously. High-Risk Areas The aluminum industry generally remains highly cyclical and is influenced by a number of factors including global economic conditions. Worldwide aluminum demand fluctuates not only Asset Kickers, LLP Page 61 Asset Kickers, LLP – Auditor’s Report on Alcoa, Inc. – 14 April 2013 annually, but also in correlation with the business cycle. Alcoa can be harmed by recessionary periods and can benefit greatly from expansionary periods. Market-driven balancing of global aluminum supply and demand may be disrupted by nonmarket forces or other impediments to production closures. Alcoa’s operations span the globe in many different countries, and the firm has to take on certain risks in many of the countries in which it operates. These risks include legislative initiatives that can have detrimental effects on Alcoa’s business, nation-specific economic conditions, or in some cases, conflicts that can alter business in the area which Alcoa operates. A reduction in demand (or a lack of increased demand) for aluminum by China, Europe or a combined number of other countries may negatively impact Alcoa’s results. Approximately 50% of Alcoa’s revenue comes from non-domestic sales, namely Europe and China. The ongoing European debt crisis has had a negative impact on aluminum demand, and China’s decreasing growth rate over the past 3 years has also impacted sales in that market. Alcoa could be materially adversely affected by declines in aluminum prices. Being that the firm makes over 80% of its income off of aluminum, any changes in aluminum prices are going to affect the firm’s profitability and going concern. If there is a sharp enough drop in aluminum prices worldwide (AL) will have a very negative affect on profitability, or perhaps worse, such as the ability to stay in business. Low-Risk Areas On the 10K, there are numerous inherent risk factors that are listed, such as high competition, stability of financial markets, maintaining good credit, cyber-attacks, union disputes, completely unforeseen events occurring, etc., that are not included in this list. These are inherent risks that any firm in any industry can and will face, and are therefore not unique to Alcoa or its operations. They Asset Kickers, LLP Page 62 Asset Kickers, LLP – Auditor’s Report on Alcoa, Inc. – 14 April 2013 are not included in the list below, but like all other risks, must be taken seriously and with preparedness. Alcoa’s operations consume substantial amounts of energy; profitability may decline if energy costs rise or if energy supplies are interrupted. As noted earlier in the report, energy expenses make up a substantial portion of Alcoa’s operating expenses and Cost of Goods Sold account. With a profit margin of only 6%, any increase in electricity or fossil fuel prices will immediately impact profits in a negative fashion. Alcoa’s profitability could be adversely affected by increases in the cost of raw materials or by significant lag effects for decreases in commodity or LME-linked costs. Alcoa relies off of raw materials, such as bauxite and electricity, to make its primary products. Increases in the prices of raw materials will directly affect profitability. The LME, or London Metal Exchange, is the primary exchange for aluminum trading in the world. If the LME isn’t effectively pricing and speculating aluminum, the company’s profitability can be hurt. Alcoa may not be able to realize expected benefits from the change to index pricing of alumina. Alcoa has created its own independent index pricing of alumina based on LME prices and speculation. This is to produce a more accurate pricing and forecasting model for aluminum contract futures. However, if this initiative is not successful, Alcoa may be at the wrong end of price setting, and a loss in income. Asset Kickers, LLP Page 63 Asset Kickers, LLP – Auditor’s Report on Alcoa, Inc. – 14 April 2013 Climate change, climate change legislation or regulations and greenhouse effects may adversely impact Alcoa’s operations and markets. Alcoa has significant reliance on electricity for its operations, and in many cases, electricity is produced from fossil fuels. These fossil fuels produce large amounts of greenhouse gases as byproducts, which is the conclusion of some to be the cause of global warming and the deterioration of the atmosphere. New regulations and legislation could potentially impact Alcoa’s production and consumption of electricity, which could harm its operations and aluminum production. Management Integrity Asset Kickers, LLP Page 64 Asset Kickers, LLP – Auditor’s Report on Alcoa, Inc. – 14 April 2013 Alcoa has remained at the maturity phase of its life cycle for many years. At this point, the nature of the business hasn’t changed drastically in a while, and there are not many expectations that the business environment of the industry Alcoa is a part of will change much in the foreseeable future. PricewaterhouseCoopers completed a full audit of Alcoa for the year ended 2011, and they concluded that all financial statements were presented fairly and in accordance with GAAP for the last 3 years (Alcoa 10-K). In 2007, Alcoa attempted a hostile takeover of Alcan, which ultimately failed. Alcan was later acquired by Rio Tinto that same year to become, at the time, the world’s largest aluminum producer. The attempt of a hostile takeover can be cited as a lack of integrity by management. However, as a third party, it is difficult to say that overall, management has integrity, or a lack thereof, based on this one event. There are no other reasons to cite or to believe that Alcoa’s management lacks integrity. Auditor’s Report For the year ended 2011, Alcoa contracted PricewaterhouseCoopers (PwC) to conduct a full scale audit of the firm. PwC also reviewed the financials going back 3 years previous. In the external auditor’s professional opinion, all financial statements were presented fairly and in accordance with the United States’ Generally Accepted Accounting Principles. Additionally, the auditors found that Alcoa’s internal control is sufficient enough to provide reasonable assurance as to the integrity of its financial reporting. The following statement is PricewaterhouseCoopers audit report listed in Alcoa’s 10K: Report of Independent Registered Public Accounting Firm To the Shareholders and Board of Directors of Alcoa Inc. Asset Kickers, LLP Page 65 Asset Kickers, LLP – Auditor’s Report on Alcoa, Inc. – 14 April 2013 In our opinion, the accompanying consolidated balance sheets and the related statements of consolidated operations, changes in consolidated equity, consolidated comprehensive (loss) income, and consolidated cash flows present fairly, in all material respects, the financial position of Alcoa Inc. and its subsidiaries (the “Company”) at December 31, 2011 and 2010, and the results of their operations and their cash flows for each of the three years in the period ended December 31, 2011 in conformity with accounting principles generally accepted in the United States of America. Also in our opinion, the Company maintained, in all material respects, effective internal control over financial reporting as of December 31, 2011, based on criteria established in Internal Control—Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO). The Company’s management is responsible for these financial statements, for maintaining effective internal control over financial reporting and for its assessment of the effectiveness of internal control over financial reporting, included in the accompanying Management’s Report on Internal Control over Financial Reporting. Our responsibility is to express opinions on these financial statements and on the Company’s internal control over financial reporting based on our integrated audits. We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audits to obtain reasonable assurance about whether the financial statements are free of material misstatement and whether effective internal control over financial reporting was maintained in all material respects. Our audits of the financial statements included examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, assessing the accounting principles used and significant estimates made by management, and evaluating the overall financial statement presentation. Our audit of internal control over financial reporting included obtaining an understanding of internal control over financial reporting, assessing the risk that a material weakness exists, and testing and evaluating the design and operating effectiveness of internal control based on the assessed risk. Our audits also included performing such other procedures as we considered necessary in the circumstances. We believe that our audits provide a reasonable basis for our opinions. A company’s internal control over financial reporting is a process designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles. A company’s internal control over financial reporting includes those policies and procedures that (i) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the company; (ii) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that receipts and expenditures of the company are being made only in accordance with authorizations of management and directors of the company; and (iii) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of the company’s assets that could have a material effect on the financial statements. Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate. /s/ PricewaterhouseCoopers LLP PricewaterhouseCoopers LLP Pittsburgh, Pennsylvania February 16, 2011 Client Selection Our firm takes its responsibility to the public and to our clients very seriously. As such, we choose only to accept clients who live up to the highest professional and ethical standards. After thorough review of the ethical and internal control policies of Alcoa, we have decided that it would be Asset Kickers, LLP Page 66 Asset Kickers, LLP – Auditor’s Report on Alcoa, Inc. – 14 April 2013 appropriate to take Alcoa on as a client. The acceptable audit risk of Alcoa is well below what we have determined to be the acceptable threshold. The management at Alcoa appears committed to strong, ethical business practices and having a committed management team is one of the most important parts to starting a strong internal control. Alcoa’s decision making, however, is not beyond criticism. In 1994, during Alcoa’s expansion into Brazil, they had the Brazilian government use large quantities of Agent Orange to defoliate a large part of the Amazon Rainforest. This was in order for Alcoa to build the Tucuruí dam, a source of power for their mining operations. This defoliation took out a large part of the forest, as well as homes of the indigenous tribes and others living in the forest. Additionally, in 1998, The United States Environmental Protection Agency (EPA) issued a Superfund Unilateral Order requiring Alcoa to “excavate, treat and dispose of the contaminated wetlands sediments (on one of their York properties)”.These incidences raised an ethical red flag to us. However, since the Agent Orange incident and the EPA order, Alcoa has shown a strong commitment to social responsibility and companywide ethics. We believe that this approach is more than just a quick rejoinder to a pressure filled situation and instead reflects a long term plan to conduct their businesses in an ethical manner (Cahill). Alcoa’s financial position is also pretty well secured. Their stock has shown a little fluctuation lately but nothing more than the regular market ups and downs. This helps demonstrate the strength and stability of the company. Alcoa is a value-based company with strong morals and a well enforced code of ethics. Their internal controls are strong and look to prevent any future misdeeds, like the ones they had in the 1990s or otherwise. They are not currently involved in any legal proceeding or integrity violations. Asset Kickers, LLP Page 67 Asset Kickers, LLP – Auditor’s Report on Alcoa, Inc. – 14 April 2013 We will accept Alcoa as a client with a good amount of professional skepticism. We will continue to monitor their policies and how well they are upheld. We will keep a watchful eye on the way Alcoa does business and make sure their convictions are as strong as they have indicated. Allocated Audit Effort Alcoa is based in Pittsburgh and has over 2000 employees stationed there. Due to the resource concentration Alcoa has in Pittsburgh; we believe that it would be the best place to headquarter our audit efforts. However, since Alcoa houses most of its important top executives in New York City, we certainly want a strong auditing presence there to probe Alcoa’s top minds. A good understanding of the total operations of a company is key to a thorough audit; this means that we will also need to do extensive research into the international arms of the operation as well. Now, since Alcoa has operations in 30 countries, it would be unfeasible to visit all branches of operation. We need to subdivide based on what is important. Alcoa’s main areas of international concentration are in Eastern Europe, China and Brazil. We plan on sending a representative out to each of those areas because it will give us a developed understanding of Alcoa’s international business procedures. It is important to concentrate your audit efforts in the most effective areas, as audit firms do not have unlimited resources. We believe that our plan spans a large enough geographical area and covers a large portion of the inner workings of Alcoa and, as such, is an effective allocation of our resources and auditors. Asset Kickers, LLP Page 68 Asset Kickers, LLP – Auditor’s Report on Alcoa, Inc. – 14 April 2013 Problems with External Control Alcoa faces a lot of issues with external control. The industry that they are in is very volatile as it is largely based on the discovery and retrieval of natural resources. Natural resources have a way of running hot and cold, there can be long periods of slow discovery and there is a finite amount of the resource in the earth. One major issue was that Alcoa's affiliate in Ghana, the Volta Aluminum Company, was completely closed between May 2003 and early 2006, due to problems with its electricity supply. They are a very global company and located on many different continents so their plants can run into a lot of trouble with power supply. They employ many different methods of powering, including electricity, hydropower, hydroelectric, and formerly coal power. They have run into a lot of trouble with the supply of these powers, shutting down production for short bursts as well as closing smaller plants (Alcoa Website). Since they are a global company, they may also run into problems in dealing with other countries. Changing policies, new governments and expanding regulations are all issues they need to consider on a day to day basis. One instance of this was their movement in to Wagerup, Australia. Due to the constraints of the Financial Crisis, they had to halt their Australian expansion plans and pause their ownership of the Western Australia alumina refinery. These external control factors have a large impact on the way Alcoa runs their business and need to be taken into account as ongoing risk factors now and into the future. Use of Internal Audit Asset Kickers, LLP Page 69 Asset Kickers, LLP – Auditor’s Report on Alcoa, Inc. – 14 April 2013 The Auditor’s Consideration of the Internal Audit Function in an Audit of Financial Statements” or Auditing Standard 322, discusses the auditor’s role in relation to the internal auditor and how to evaluate and test the work of an internal auditor. The flowchart below is a useful tool to decide how reliable the company’s internal audit work is. By using this flowchart and reading the financial statements, it can be seen that Alcoa’s internal audit department is dependable and we can use their work for assistance in our audit. PricewaterhouseCoopers, the independent auditor, gives reasonable assurance that Alcoa’s internal controls for 2011 are good as well. In the auditor’s report for 2011, PwC also references the Committee of Sponsoring Organizations of the Treadway Commission (COSO) and their Internal Control-Integrated Framework to state that the company maintained in all material respects effective internal control (“Auditing Standards). Asset Kickers, LLP Page 70 Asset Kickers, LLP – Auditor’s Report on Alcoa, Inc. – 14 April 2013 (“Involving Internal Auditor”) Use of Outside Specialists When deciding how much to relay on outside specialists, Auditing Standard 336, “Using the Work of Specialist” is valuable. A specialist has skills or knowledge other than accounting or auditing that can be of use to the firm. With being a large, global firm, it is probably that we will have any Asset Kickers, LLP Page 71 Asset Kickers, LLP – Auditor’s Report on Alcoa, Inc. – 14 April 2013 specialists internal to our firm, so specialists will not be needed for the audit. Some areas that could possibly use a specialist if we were not a firm full of such diverse people with specialized talents include environmental issues, valuation, and actuarial calculations (Auditing Standards). Planning and Supervision Auditing Standard 311, “Planning and Supervision” comes from the first field work standard that states “the work is to be adequately planned and assistants, if any, are to be properly supervised.” This step is very important to the audit and ensuring that the generally accepted auditing standards are followed. Planning begins with accessing the firm and obtaining knowledge of the business. An engagement letter is also written by the auditor to make sure both parties are clear on all terms. We then would come up with an overall strategy, and make sure that all steps are supervised properly so we stick to GAAS and have a complete audit that we can reasonably assure is accurate (Auditing Standards).. Expected Auditor’s Report After looking at the company and the reports issued for the current and past years, we believe that an unqualified opinion can be issued for Alcoa in the 2011 fiscal year. An unqualified opinion means that we are issuing our independent opinion of reasonable assurance that there are no material misstatements in the financial statements under US Generally Accepted Accounting Principles and also no scope limitations restricting our work (Mergent Online).. Asset Kickers, LLP Page 72 Asset Kickers, LLP – Auditor’s Report on Alcoa, Inc. – 14 April 2013 Financial Statements free of Material Misstatement Effectice Internal Control Unqualified Audit Opinion Sarbanes-Oxley Act Implications, Section 404 The Sarbanes-Oxley Act was passed in July 2002 by the United States Congress. Its purpose was to restore investor confidence in after many bankruptcies internal control breakdowns that were highly publicized. All companies that are publically registered must follow this act. The Public Company Accounting Oversight Board, or PCAOB was formed from this act and management is also more responsible for asserting that internal controls and financial reporting is effective. Section 404 really stands out in the act. This requires the independent auditor to give opinions on the effectiveness or internal control over financial statements and to give an auditor’s opinion on the fairness of financial statements. Section 404 has a top-down risk assessment that helps the auditor look at the company thoroughly. The PCAOB Auditing Standard Number 5 also discusses auditor steps to correctly assess internal control of public companies. As stated in the auditor’s report, there were no changes in internal control over reporting during the fourth quarter of the year that materially affected or are reasonably likely to materially affect the company’s internal control. By seeing this, we can feel more confident that internal control is continuing to be effective like we said it was in the past. Through research of the past three years, Asset Kickers, LLP Page 73 Asset Kickers, LLP – Auditor’s Report on Alcoa, Inc. – 14 April 2013 we can say with reasonable assurance that internal control is maintaining that accounts accurately and fairly reflect the assets of the company, that transactions are in accordance with generally accepted accounting principles, and there is a timely discovery of accounts unauthorized acquisitions that could have a material effect on financial statements. Sarbanes-Oxley 404 also allows us to state that because of inherent limitations, internal control might not prevent of detect misstatements, and as controls change, the evaluation might not be accurate any longer. (Information from “Sarbanes-Oxley Act”) Initial Assessment Appendix A Financial Statements Asset Kickers, LLP Page 74 Asset Kickers, LLP – Auditor’s Report on Alcoa, Inc. – 14 April 2013 Asset Kickers, LLP Page 75 Asset Kickers, LLP – Auditor’s Report on Alcoa, Inc. – 14 April 2013 Asset Kickers, LLP Page 76 Asset Kickers, LLP – Auditor’s Report on Alcoa, Inc. – 14 April 2013 Asset Kickers, LLP Page 77 Asset Kickers, LLP – Auditor’s Report on Alcoa, Inc. – 14 April 2013 Asset Kickers, LLP Page 78 Asset Kickers, LLP – Auditor’s Report on Alcoa, Inc. – 14 April 2013 Asset Kickers, LLP Page 79 Asset Kickers, LLP – Auditor’s Report on Alcoa, Inc. – 14 April 2013 Asset Kickers, LLP Page 80 Asset Kickers, LLP – Auditor’s Report on Alcoa, Inc. – 14 April 2013 Asset Kickers, LLP Page 81 Asset Kickers, LLP – Auditor’s Report on Alcoa, Inc. – 14 April 2013 Asset Kickers, LLP Page 82 Asset Kickers, LLP – Auditor’s Report on Alcoa, Inc. – 14 April 2013 Asset Kickers, LLP Page 83 Asset Kickers, LLP – Auditor’s Report on Alcoa, Inc. – 14 April 2013 Appendix B Budget We originally decided to meet for about three hours a week every Wednesday afternoon to work on the project, divide up work for next time, and combine our parts. To prepare for this meeting, we also figured that we would each put in around three hours of work on our own time. This would come out to about 15 hours a week or 150 hours during the semester. This was just a rough estimate with some parts of our Wednesday meeting devoted to looking at homework for class or reviewing as well, and there were certainly weeks that we put in many additional hours. Looking back on our entire project, we probably did spend about the amount of time we allocated working on this. Having the first deadline before Spring Break was a huge help to keep us on track. With a hard deadline, we worked on getting that part finalized and formatted correctly, so adding in the rest of our work later was much easier. It also let us see exactly how much time this was taking us and how to allocate our remaining weeks to make sure we got the entire project complete and in the form we wanted by the due date. Getting close to the due date, we met many more days than just once a week to make sure we were all keeping up on our parts and everything was coming together well. We also wanted adequate time to proofread the entire report and make sure it looked as good as possible. Leadership By initially dividing up most parts of the assignment, we were all able to lead in different ways. Each person read about different topics, so when we met to combine and discuss the parts we each looked at on our own, we could each share our new expertise. Each person put effort into Asset Kickers, LLP Page 84 Asset Kickers, LLP – Auditor’s Report on Alcoa, Inc. – 14 April 2013 their parts, making the switch between leaders very smooth because each person was very knowledgeable in their area and able to explain it to the others easily. Coordination This part came fairly easy to us. We never made a formal contract, but we had a copy of the syllabus in an excel file with each part in its own row. This almost served as in informal contract that we all obeyed by. When we met in the beginning, we divided up the first part that was due before spring break and color coordinated the document so it was very clear which person was leading each part. There were no discrepancies then as each team member had a copy of this. We also divided up questions by workload instead of just by the number of parts. Once we had sections that seemed of equal weight, we talked about if anyone had any prior knowledge on a topic or strong desire to do a section. This method left us all happy and with an equal workload. Another valuable asset to our coordination was a Group Me group text that we set up. With this, it was easy for us all to communicate with each other and let everyone know at once if we had to be late to a meeting or had a question. Norms In order to complete the project in a timely and efficient manner, we developed the norm of the work plan to assign topics, work independently on our parts, and edit and piece together the final product. This strategy helped us to determine a set plan and sequence of events. That mentality led us to our second norm of creating a checklist to ensure completion of all the parts. We created a Google Document with all the components of the project, complete with columns for the assigned team member and level of completion to date. Sequentially, our third norm was setting and meeting deadlines. Lastly, our most important norm was scheduled meetings. We met every Asset Kickers, LLP Page 85 Asset Kickers, LLP – Auditor’s Report on Alcoa, Inc. – 14 April 2013 Wednesday of the semester at 2:30PM in the library. We used our meetings to ask each other questions on our parts of the project, as well as class-related topics. We determined that by having scheduled meetings we would guarantee a block of time every week to work on the project, even if we were working independently. We did need to take any action to enforce these norms because we all felt strongly about their efficiency in completing the project. Conflict Our main source of conflict among the group has been determining deadlines that are within reason for all the group members. We all have busy schedules between classes, extracurricular activities, and social lives. Working around our prior commitments was a tough obstacle, but be had to resolve it in order to complete the project efficiently. First of all, we had to put ourselves in each other’s shoes and understand the importance of certain prior commitments. On the other hand, we had to take in account the fact that we are all extremely busy, but making time for this project needed to be established as a top priority for the semester. This difficulty resulted in letting our previously-set deadlines slip a few days, but we never allowed ourselves to miss deadlines but a substantial amount. If we had not resolved this conflict then we would have been scrambling to meet our preliminary and final deadlines set in the syllabus, which could result in a poorly constructed project. Contribution Overall, we all had a fairly equal share of the project. We collectively talked about each part and could go to each other with any questions or concerns that came up, but each had our own sections to really focus on. Below is how we divided up the specific tasks and questions. Asset Kickers, LLP Page 86 Asset Kickers, LLP – Auditor’s Report on Alcoa, Inc. – 14 April 2013 Kristin – Number 3 parts e, f, g, j, m. Number 4 financial health. Organization of our checklist that went along with the syllabus. Printed and turned in the project part one. Chris – Number 2 parts 1, b, c. Number 3 part k. Number 6 parts a, b, c, d. Proofread and corrected typos in project part one. Luke – Number 2 parts d, e, f, g. Number 3 parts h, Number 6 parts e, f, g. Sammi – Number 3 parts a, b, c, d, l. Number 6 parts h,I, j. Organization of Appendix. After assessing how much work we all put into the project, we think that we each did an equal share of the project and should each earn 100% of the total grade we receive. Team Member Grade Allocation Kristin 100% Chris 100% Luke 100% Sammi 100% Instructions We originally thought the project looked really long, both by looking at the topics to cover in the syllabus and also the example projects online. I think we all started out a little scared, but saw that just breaking it down made it work out and “baby steps” made it manageable. Our report quickly grew long before we knew it. Having the first part due before spring break was a great idea. It kept us on track and made sure we did not slack at all right before break and have to come back to a lot of work. This also helped us estimate the amount of time that the remaining parts of the Asset Kickers, LLP Page 87 Asset Kickers, LLP – Auditor’s Report on Alcoa, Inc. – 14 April 2013 project would take and allowed us to create a schedule of deadlines for after break. We noticed that some parts we split up and thought would be fair and equal actually were not, so in those cases, someone who had a little less work would step up to help the person who’s section was longer than we anticipated. Some parts of the project on topics we only briefly talked about in class were challenging, but it also taught us some good research skills, and the example projects were helpful as well. Other Other than working on the project, our team accomplished many different goals. We met to study for exams, completed in class tasks like flow charts and tables and conversed any time one member was unsure about class material. These non-report related meetings helped us cultivate a setting of open dialogue, hard work and productivity. Asset Kickers, LLP Page 88