Alcoa Corp. (NYSE: AA) Materials. Krause Fund Research Fall November 13, Recommendation: BUY. Current Price $43.33

Transcription

1 Krause Fund Research Fall 2017 Materials Recommendation: BUY Analysts Tyler Kromkowski Dan Fisher Company Overview Alcoa Corp. (AA) is a vertically-integrated aluminum company with a strong market presence in the aluminum industry. Alcoa is the world s largest bauxite miner, leader in alumina refining, and 6th in the world in aluminum production. Alcoa s sells both raw products: bauxite, alumina, and raw aluminum and value-added products: cast and rolled products. Some major end-use markets for aluminum include transportation equipment, packaging materials, construction, electrical appliances, industrial manufacturing and consumer durables. In addition to these business segments, Alcoa has significant investments in energy production to help manage production costs. For the fiscal year ending 12/31/16, total revenues fell 17% to $9.318 billion. Stock Performance Highlights 52 week High $ week Low $28.01 Beta Value 1.20 Average Daily Volume 3.64 m Share Highlights Market Capitalization $7.75 b Shares Outstanding m Book Value per share $32.30 EPS $2.21 P/E Ratio Dividend Yield NA Dividend Payout Ratio NA Alcoa Corp. (NYSE: AA) Key Investment Highlights November 13, 2017 Current Price $43.33 Target Price $ $58.00 Increasing Aluminum Prices: Aluminum prices have increased 29.5% in The profitability of Alcoa s operations are highly dependent upon global aluminum prices, and the increase in prices suggest that Alcoa will have strong financial performance in the near future. Chinese Supply Curtailments: The majority of global aluminum production occurs in China. Recent regulations in China will reduce global aluminum supply and aluminum supply in China. The decrease in supply will support higher global aluminum prices. Increasing Demand for Aluminum Products: Demand for aluminum products is projected to increase, particularly in the automotive industry as manufacturers are increasing the amount of aluminum used in their vehicles. Management s Focus on Efficiency: Management has emphasized efficiency in operating facilities by reopening, curtailing, and closing facilities based on cost-efficiency measures. Company Performance Highlights ROA 3.27% ROE 3.26% Sales $10.38 b Financial Ratios Current Ratio 1.37 Debt to Equity 17.53% Figure 1 Source Yahoo Finance Page 1

2 ECONOMIC ANALYSIS GROSS DOMESTIC PRODUCT Real gross domestic product is an inflation-adjusted measure that reflects the value of all finished goods and services produced by an economy in a quarter or year. Real GDP provides an indication of the overall economic health by representing production and growth. Measured through the expenditure approach, GDP is equal to the sum of personal consumption, private investment, government expenditures, and net exports. Economic growth often results in increased stock performance through strong corporate earnings, particularly for the materials sector because the end-markets for materials are highly correlated to the overall economy. The economy has steadily rebounded and grown since the financial crisis although real GDP has slowed since From real GDP grew at an average annual rate of 3.0%, but after the recession the real GDP has grown slower at an average annual rate of 2.0% despite expansive Federal Reserve policies such as lower interest rates and quantitative easing. 1 For the past two quarters of 2017, real GDP has grown by at least 3.0% primarily because of increased consumer spending and an unemployment rate of 4.1%, the lowest since ,3 We expect real GDP growth to continue growing around 3.0% for the next 6 months and around 2.75% over the next 2-3 years. We expect this growth to be a result of increased government spending on infrastructure, steady unemployment, increased household spending, and President Trump s policies to support US businesses. Furthermore, the global real GDP has grown around 3.5% since the financial crisis and we expect it to continue to grow annually at roughly 3.0% for the next 2-3 years. 4 As a result of our economic expectations, we expect an increase in both aluminum demand and prices, resulting in an increase in Alcoa s profitability. Considering economic health is an important factor in S&P and aluminum performance, we looked at historical performance from the past 5 years and saw a strong correlation between the S&P 500 (orange) and S&P Aluminum Index (blue). Interestingly, the S&P Aluminum Index far outperformed the S&P Metals & Mining Index meaning it s performance may be semi-independent of the industry. INTEREST RATES The materials sector is highly capital intensive and requires substantial cash flows to purchase, develop, and maintain large assets such as mines, smelters, and refining facilities. As a result, many materials companies are highly leveraged, requiring debt financing for these assets. In addition, the cyclical nature of the materials sector and their large vertically-integrated operations force some companies to borrow regardless of economic health. Since interest rates represent the cost of borrowing money, lower interest rates result in a lower cost of debt and WACC. Lower interest rates encourage companies to invest in projects and increase capital spending to strengthen their operations. Interest rates play a critical role in the ability of materials companies to take on and pay down debt, including interest expense. Considering such large assets require a relatively lengthy time to develop, taking on too much debt with high interest rates can effect a materials company s profitability. Therefore, Alcoa s management has made managing financial policies a priority to provide appropriate leverage, ample liquidity, and efficient use of capital to maintain appropriate capital structure and financial flexibility. While there have been two rate hikes this year, rates are still near record lows at 1.25%. President Trump has recently designated a new Fed chairman, Jerome Powell, but we expect the Fed to continue gradual monetary policy normalization, as long as the U.S. economy evolves roughly as expected. 5 We expect a gradual increase in the Fed Funds rate to around % within the next 1-2 years as the economy continues to steadily grow. The Fed Funds rate can influence Treasury bond yields, a more relevant indicator of corporate borrowing costs. While the 30 year U.S. treasury yield has decreased since the recession, we expect interest rate hikes and Trump s signaling to normalize interest rates to signal a treasury yield increase in the nearfuture of 50 basis points to around 3.25%. While we expect this to slightly increase the cost of debt, we do not see this impacting Alcoa too much because the rate is still relatively low and Alcoa s capital structure is centered on low debt with substantial liquidity. Figure 3 Source - CNBC Figure 2 Source Financial Times Page 2

3 EXCHANGE RATES Since Alcoa is a global company with assets around the world, around half of its sales are exposed to currency exchange rate fluctuations. Alcoa sells their products in U.S. dollars, but incurs some expenses in other currencies, which also influences their level of exchange rate risk. While Alcoa uses hedging to manage foreign currency risk, the company s risk is still sensitive to external influences like international currency strength and a strengthening dollar. Due to relative economic strength, the US dollar appreciated 26.7% from , but has depreciated 8.3% since the start of According to Alcoa, a strong U.S. dollar generally has a positive impact on their short-term profitability by reducing international expenses, but over the long-term can have negative impact on their position on the global aluminum cost curve. 7 Alcoa s primary currency exchange risks stem from the valuation of the dollar compared to the Australian dollar, Brazilian real, and Canadian dollar. Breaking down Alcoa s global sales in 2016 by country: 47% United States, 28% Spain, 17% Australia, 4% Brazil, 4% Canada. 8 Over the past 5 years, the US Dollar has strengthened compared to the Australian dollar, Canadian dollar, and Brazilian Real which has made it more expensive for customers in these markets to purchase from Alcoa. INFRASTRUCTURE AND CONSTRUCTION In recent years, particularly with the election of President Trump, there has been more focus on increasing infrastructure spending to address problems and support economic growth. According to the American Society of Civil Engineers in 2013, the U.S. infrastructure received a D+ grade. Based on 2025 infrastructure goals, it is estimated $2.06 trillion of expected infrastructure spending is currently unfunded. 10 President Trump is currently attempting to address this issue and encourage infrastructure spending by improving federal investment efficiency, targeting high-priority investments, promote state and local action, and leveraging the private sector. 11 As of 2014, the U.S. public infrastructure spending as a share of GDP and infrastructure spending as a share of Federal spending were near 58 year lows at 2.4% and 2.7% respectively. 12 If the U.S. can effectively increase infrastructure spending to meet needs, we expect this to help improve economic health and support GDP growth. We believe Alcoa will capitalize on this expected increase in infrastructural spending considering construction is a large aluminum end-market, accounting for 26.0% of global aluminum demand in The graph below represent US infrastructure spending as a percentage of GDP, with 2.6% being the average over this time period. Figure 5 Source U.S. Congressional Budget Office Figure 4 Source Tradingview.com Figure 4 compares US Dollar ETF (DXY) - blue line, to Australian Dollar ETF (FXA) yellow line, Canadian Dollar ETF (FXC) green line, and Brazilian Real ETF (BZF) red line. 9 The Euro and Norwegian kroner also affect Alcoa s profitability because many significant input purchases are made in these currencies. Thus, a stronger dollar reduces some of Alcoa s international expenses and increases short-term profitability. Yet, a stronger dollar can diminish long-term profitability because of the company s U.S. smelting portfolio and a strong dollar shifting down cost curves for non-u.s. smelters, which may not be replicated by U.S. smelters. Currently, the U.S. Dollar Index (DXY) is trading at $94.39 and we expect it to begin to stabilize and trade between $91 and $97 over the next year due to a slightly stronger global economy relative to the US economy. The McKinsey Global Institute produced a new study that reveals declining infrastructure spending has been a global trend in recent years, citing ten countries where infrastructure spending fell as a share of GDP from 2008 to MGI estimates $3.3 trillion of annual infrastructure investment (3.8% of global GDP) is needed through 2030 to support current economic growth projections. 14 We expect a large portion of these infrastructure investments to be in developing countries, which could potentially increase opportunities for Alcoa to grow revenue. Contrary to this global trend, China, which accounts for 50% of global aluminum consumption, has been more active in their infrastructure spending, with average infrastructure spending of 8.6% of GDP from Currently, China has implemented curbed aluminum production capacity to meet pollution-control targets which has reduced the global surplus and balanced global supply. This control of supply should increase aluminum prices and increase global demand, particularly in the countries that have above average Page 3

4 infrastructure spending, which we expect to positively impact Alcoa. Figure 7 compares the total returns of the S&P500, S&P BSE Basic Materials index, and the S&P GSCI Aluminum index. Notice the aluminum and basic materials indices are outperforming the S&P YTD. INDUSTRY ANALYSIS ALUMINUM INDUSTRY OVERVIEW Figure 6 Source McKinsey & Company Figure 6 displays infrastructure spending on an annual average as a percentage of GDP. The U.S. bar is wide and short because it represents a big economy with low infrastructure spending. CAPITAL MARKETS OUTLOOK As discussed previously, we believe that the global and U.S. economies will be growing and this will support a likely increase in infrastructure spending, in order to meet future growth expectations. We also expect interest rates to rise slightly over the next 2 years which would increase the borrowing costs for companies. However, interest rates are still relatively low so a slight raise should not have a large effect on capital spending, particularly for Alcoa whose vertical integration, large market share, and low debt capital structure minimize interest rate effects. Additionally, rising commodity prices and better management of global supply support increased performance in the materials sector. The S&P has reached historic levels in 2017 and is currently trading near record highs. Keeping that in mind, indexes for the Basic Materials sector and Aluminum sub-industry have outperformed the market in the past year. We expect this trend to continue in 2018 based on stable economic growth, rising commodity prices, and growth in end-markets. Figure 7 Source - S&P Indices Alcoa operates in the aluminum sub-industry, which is part of the larger metals and mining industry. The aluminum industry consists of many operating segments that connect to form the value chain. Operations that that involve the manufacturing of aluminum from raw materials are part of the upstream process. In this process, bauxite is first mined and then refined into alumina. Next, alumina is smelted into aluminum to complete the upstream process. Historically, bauxite and alumina market prices fluctuations have been correlated with the price of aluminum. Bauxite and alumina are also sold to external customers and Alcoa sells roughly 14.0% of its bauxite production and 68.0% of its alumina production externally. 26 Once aluminum is manufactured, it is then formed into cast products or rolled products to be used in a wide variety of industries, in particular the automotive, construction, and beverage/packing industries. Aluminum smelting requires a large amount of electricity, so many aluminum manufacturers own energy assets to help control production costs and increase profits by selling surplus energy production. A detailed display of Alcoa s upstream aluminum process is shown in Figure 8 below. Figure 8 Source Alcoa 3Q 2017 Earnings Presentation KEY SUCCESS FACTORS High Aluminum Prices: Aluminum manufacturing companies can be generally classified as commodity companies. Commodity companies are, for the most part, price takers that have to sell their output near the prevailing market price. As a result, the revenue and profitability of commodity companies are heavily impacted by current commodity prices, causing these companies to be cyclical in nature. 18 Page 4

5 Upstream Vertical Integration: Companies that are vertically integrated are able to reduce input costs because they do not need to purchase raw materials externally, reducing transaction costs. It also allows for a stable and long-term supply of raw materials reducing complexity. 21 Alcoa s upstream process is vertically integrated and is discussed in more detail in the Company Analysis section below. Proximity to Key Suppliers and Markets: Aluminum and its raw materials inputs are heavy. Companies can save on transportation costs by positioning operations near suppliers and key markets. 21 As is discussed in the Company Analysis section below, Alcoa benefits from having several operations in close proximity to key markets. aluminum (5.39%), alumina (5.38%), and bauxite (5.11%). 29,30 These figures are extremely similar and suggest that global production of bauxite and alumina are correlated with changes in the supply and demand of aluminum. Since production is a key determinate of revenue and profitability, this relationship is important in forecasting the performance of Alcoa s bauxite and alumina segments. This is discussed further in the Company Analysis and Valuation Analysis sections. INDUSTRY TRENDS Aluminum Price Influences Other Upstream Prices The price of bauxite and alumina have historically fluctuated similarly to the price of aluminum. Figure 9 displays yearly percentage changes in the price per metric ton of aluminum, alumina, and bauxite from 1995 to Alumina is more correlated to the price of aluminum than bauxite, with a 6.96% standard deviation in price change relative to aluminum compared to bauxite with 15.66% standard deviation in price change relative to aluminum. 29,30 As shown in Figure 9, the price per metric ton of each segment tend to change in a similar manner. The connection between aluminum prices and the other two upstream segments suggest that the revenue and profitability of each segment is linked to the price of aluminum. This relationship is a crucial factor in forecasting revenue and profitability figures for Alcoa s bauxite and aluminum segments, which is discussed in greater detail in the Company Analysis and Valuation Analysis sections. Figure 9 Source U.S. Geological Survey 29,30 Aluminum Production Drives Other Upstream Production The global production of aluminum, alumina, and bauxite are also correlated with each other. Displayed in Figure 10 is the yearly global production of each upstream segment from 1995 to Over the period, global production of bauxite was the highest, followed by alumina then aluminum. This is to be expected as each product represents a different stage in the upstream aluminum manufacturing process. The average yearly change in global production for each product were as follows: Figure 10 Source U.S. Geological Survey 29,30 Aluminum Outlook Supply Side The aluminum industry will benefit from increasing aluminum prices. The International Monetary Fund (IMF) projected aluminum prices to increase 17.5% in 2017 to reach $1,884 per metric ton as displayed in Figure 11. However, current aluminum prices are $2,101 per metric ton, approximately 12.0% above IMF s expectations suggesting stronger revenue growth than originally expected. Some of this price increase can be attributed to decreases in supply of aluminum from China. 31,32 The Chinese Ministry of Environmental Protection has implemented policies to reduce aluminum supply by 30.0% and alumina supply by 50.0% in four key provinces (Hebei, Henan, Shandong, and Shanxi) during the winter months of November 2017 through March Alcoa s analysis of the new regulations suggest that they could reduce alumina supply by 8.0 million metric tons and aluminum supply by 1.2 million metric tons. 16 China s aluminum operational capacity is 37.0 million metric tons, representing a 3.2% potential reduction in total aluminum output from China. 20 If China continues to cut supply as expected into 2018, the global aluminum market could be moving into a deficit in 2018 of an estimated 538,000 metric tons, which may further appreciate aluminum prices. 31 Alcoa s revenue and profitability will benefit from increasing aluminum prices and supply reforms in China. Page 5

6 aluminum s fastest growing sector with a study by Ducker Worldwide forecasting aluminum content in cars to increase by 30% over the next 10 years. 22 Figure 11 Source International Monetary Fund 32 Demand Side The expected growth in demand for aluminum from primary end markets could further support rising aluminum prices in the future. Transportation equipment, packaging and containers, and construction together make up 62.8% of the aluminum markets revenue and will have significant impacts on the aluminum industry s future revenues. 19 Figure 12 shows the major end markets of aluminum and the percentage contributed to the aluminum industry s revenue based on segment. The largest aluminum revenue contributors are transportation equipment, exports, packaging, and construction, which is where we expect Alcoa s cast and rolled product revenue growth to stem from. The second largest purchaser of aluminum is the packaging and containers industry because of aluminum s low density, high thermal conductivity, and durability. The metal can and container manufacturing industry is the largest market for rolled aluminum. This industry is expected to have modest growth as a result of market saturation and a decrease in per capita soft drink consumption. The market is also beginning to use substitutes for aluminum like plastic and paper, which may limit demand from the aluminum industry. While Alcoa has over 90% of market share in the North American aluminum food can segment and is 2 nd in North American beverage can sheet segment, rolled products only accounted for 0.6% of their EBITDA in Thus, the reduction in aluminum used in the packaging and container industry will limit sales in Alcoa s rolled products segment, but will have little effect on the company s overall profitability due to the segments relatively small contribution to Alcoa s profits. COMPETITIVE ANALYSIS Figure 13 displays key operating and financial metrics for some of Alcoa s largest competitors. Alcoa has the lowest market share of the group and the second lowest level of revenue, indicating that Alcoa is a smaller company than several of its competitors. Alcoa s gross profit margin of 15.3% is also relatively low compared to some of the company s competitors. However, Aluminum Corporation of China, the industry leader by market capitalization, has a considerably lower level of profitability than Alcoa. 36 Overall, while some marginal differences between the companies exist, no company maintains a significant operational advantage over Alcoa. Below is a more detailed explanation of each of Alcoa s competitors. Revenue Gross Profit Company Market Cap Alcoa $ $9, % Figure 12 Source IBISWorld 19 The transportation sector is the largest purchaser of aluminum and includes the automotive industry, the largest market for aluminum. Supported by economic factors of increased consumer spending and new car sales, this segment has experienced steady revenue growth for the past 5 years. With rising fuel efficiency requirements for vehicles and aluminums high strength to weight ratio, more automotive companies are substituting steel parts with lightweight aluminum. Growing consumer preference for fuel-efficient vehicles and lightweight trends at the manufacturing level also contribute to the industry s growing trend of using aluminum. This is has boosted demand of aluminum over the past five years and is expected to continue driving aluminum demand from 200 million pounds in 2012 to almost 4.0 billion pounds in 2025, an annualized growth of 6.4% over 13 years. 19 Due to these trends, the automotive market is Aluminum Corp. China Hindalco Industries Ltd United Company Rusal Plc $16,286.3 $21, % $9,082.5 $15, % $10,631 $7, % Norsk Hydro $15,359 $10, % Figure 13 Source S&P Capital IQ 36 Aluminum Corporation of China Aluminum Corporation of China (Chalco) was established as a joint stock limited company with the People s Republic of China in The company is involved in every step of the aluminum manufacturing value chain and also sells several types of aluminum related products. In addition, the company generates Page 6

7 and sells electricity though its energy segment. 35 Chalco has not been dramatically affected by the capacity curtailments implemented in the Shanxi and Henan Province and only saw an increase in alumina unit cost of 1.4% in 3Q This is because the company has 800 mt of bauxite resources globally. Like Alcoa, the company has begun to increase alumina smelting capacity in order to capitalize on favorable aluminum prices. This suggests that the two companies have a similar view of the global aluminum market and their corporate strategies are closely aligned. Hindalco Industries Ltd. Hindalco Inc. is engaged in the production of aluminum and aluminum products, and copper and copper products. The company has operations across the globe, but is primarily based in India. Hindalco has reported robust earnings growth with EBITDA increasing 21.3% over the past year due to volume growth in the aluminum segment and strong commodity prices. 35 Unlike Alcoa, the company produces copper. This may give Hindalco an advantage over Alcoa because the average EBITDA margin for the copper industry is 9.1% compared to an average of 5.6% in the aluminum industry. 36 Hindalco also has the advantage of being diversified across two commodity industries, reducing risk associated with commodity price fluctuations. On the other hand, Hindalco does not have any energy resource like Alcoa, which exposes the company to production cost increases if electricity prices rise. United Company Rusal Plc United Company Rusal is a Hong Kong-based aluminum manufacturing company and is the world s largest aluminum producer. The company has four business segments: aluminum, alumina, bauxite, and energy. United Rusal also sells semifinished aluminum products to the transportation, packaging, and consumer goods industries. 35 An advantage United Rusal has over Alcoa increased diversification of revenue streams with no particular country accounting for more than 21.0% of revenues. This is compared to Alcoa, which generates 47.0% if revenues from the U.S. 35 However, Alcoa is able to save on costs by concentrating resources in the U.S. and reducing transportation costs. Norsk Hydro ASA Norsk Hydro operates through six segments, which are practically identical to Alcoa s business segments. The company generates a majority of sales through its metal markets segment (48.0% of revenues in 2016), which is similar to Alcoa s cast product segment (28.0% of revenues in 2016). In contrast to Alcoa, only 25.0% of revenues are derived from the upstream aluminum manufacturing business, while the remainder of the company s revenues are obtained through the metals markets segment and rolled products segment. 35 Norsk Hydro had a superior gross profit margin in 2016 of 30.5% relative to Alcoa s gross profit margin of 15.3% in the same year. 35 While Norsk Hydro s higher level of profitability represents an advantage over Alcoa, the companies are focused on different parts of the aluminum value chain mitigating the effects of profitability differences. Figure 13 Source Yahoo Finance 34 Figure 13 displays the one-year stock performance of each of Alcoa s competitors previously discusses. As indicated in the chart, all of the companies have seen an increase in share price over the past year. The one-year stock price increase for Hindalco (58.0%), Aluminum Corp. of China (66.0%), Norsk Hydro (65.0%), and UC Rusal (69.0%) are all greater than Alcoa (44.0%). 34 This suggests that while Alcoa s stock has performed very well over the year, it competitors stock has performed even better. We think this indicates that Alcoa s stock can continue to increase, as Alcoa s competitors have demonstrated that a 44.0% share price increase over the year is not abnormal and may be low relative to the aluminum manufacturing industry. COMPANY ANALYSIS GENERAL INFORMATION Company Overview Alcoa Corporation produces and sells bauxite, alumina, and aluminum products. The company also offers cast products, rolled products, and energy assets. Alcoa is one of the leading companies in the metals and mining industry with revenues exceeding $13 billion. 9 Primarily known for aluminum production, the company is also the world s largest bauxite miner and alumina refiner. The company s bauxite segment represents its global portfolio of bauxite mining assets. Alcoa s alumina segment represents its refining system across the world, and processes bauxite into alumina, which it then sells directly to internal or external aluminum smelters. Alcoa s cast products and rolled aluminum sheets are primarily sold to customers in the automotive, construction, and beverage industries. The energy segment represents Alcoa s energy portfolio, with power production capacity of 1,685 megawatts. 35 Alcoa Corporation also owns 60% of the unincorporated global joint venture Alcoa World Alumina and Chemicals (AWAC). 9 Restructuring On September 28, 2015, Alcoa Inc. announced its intention to separate into two standalone, publicly traded companies. The separation transaction created Alcoa Corporation and Arconic Inc. The purpose of the transaction was to allow Alcoa Corporation to focus on its upstream aluminum production business, while Arconic Inc. concentrates on developing Page 7

8 specialized metals for the automotive and aerospace industries. 9 Arconic Inc. assumed virtually all $9 billion of the parent company s debt as a result of the restructuring, easing Alcoa s financial burden. Financial Summary Alcoa Corporation is currently priced at $43.33 per share, which is close to the high of its 52-week range of $ $ The stock reached its 52 week high in early October, but has pulled back since the company reported Q3 EPS of $0.72 below analysts EPS estimate of $0.77. Year to date, the stock is up roughly 44.0%, suggesting that the company has benefited from the restructuring. The company has also seen increased earnings and profitability. Alcoa s adjusted EBITDA on a quarterly comparable basis has increased 56.0% in 2Q and 98.0% in 3Q from 2016 to 2017 as illustrated in Figure ,26 Net income has also increased $267 million between 3Q 2016 and 3Q ,26 The significant increases in EBITDA and net income are largely due to increasing aluminum prices, decreasing supply, and increasing demand. As will be discussed further in the Valuation Analysis section, we predict strong revenue growth for Alcoa across all of its segments, but particularly the bauxite, alumina, and aluminum segments. We believe that the recent increases in revenue growth offer strong support for our positive revenue outlook. In addition, the company has improved its cash position by $266 million over the last twelve months to a total of $1.1 billion, as of 3Q ,26 For fiscal year 2017, management is predicting adjusted EBITDA to be roughly $2.4 billion. 26 PRODUCTS AND MARKETS Alcoa s revenue generating product lines are segmented into 6 segments: Bauxite Alumina Aluminum Cast Products Rolled Products Energy The graph below displays an EBITDA percentage breakdown of Alcoa s six segments. Notice that upstream bauxite, alumina, and aluminum account for 68.0% of the company s overall EBITDA value. This suggests that the upstream production process is the company s main focus and the main driver of Alcoa s profits. Figure 15 Source - Alcoa, BMO Capital Markets Global Metals & Mining Conference 20 Upstream Segments Figure 14 Source Alcoa 3Q and 1Q 2017 Earnings Presentation 24,26 Corporate Strategy Due to the nature of Alcoa s business, the company is highly exposed to fluctuations in the price of aluminum. As previously discussed, Alcoa is likely to see increases in revenue and margins over the next few years if aluminum prices increase as expected. Alcoa s management has expressed a desire to capitalize on improved market conditions by increasing capacity at some of the company s facilities. In addition, management has continued to review its operating facilities and implement capacity cuts at cost in-efficient facilities to improve its position on global cost curves. Overall, the company s strategy is simple: increase production to take advantage of favorable market conditions, while controlling costs to maintain profitability. Bauxite Alcoa obtains bauxite from its own resources, located in Australia, Brazil, and Suriname. Through the joint venture with AWAC, the company also has equity interests in facilities located in Brazil, Guinea, and Saudi Arabia. In 2016, Alcoa produced a total of 45.0 mbdmt of bauxite from all of its resources. 9 Of that total, 32.4 mbdmt were produced at the Darling Range Mines in Western Australia. 9 Alcoa benefits from having it Australian bauxite mines in close proximity to China, which is the largest external bauxite customer base. As of 3Q 2017, 14.0% of bauxite sales have been to external customers while 86.0% are internal sales. 26 The company is in the 28 th percentile of the bauxite cost curve and adjusted EBITDA over the last twelve months has totaled $423 million with an average margin of 35.0%, representing Alcoa s highest margin segment. 24,26 The adjusted EBITDA margin for bauxite exceeds that of alumina (21.0%) and aluminum (11.0%). For this reason, management has placed an emphasis on increasing sales of bauxite as it is the company s most profitable upstream product. The company is on pace to increase bauxite shipments in 2017 to mbdmt. 26 Alcoa has conducted an expansion project Page 8

9 at the Juruti mine that is expected to increase production an estimated 0.5 Mmt. The Western Australia state government also recently granted Alcoa approval to export to 2.5 Mmt of bauxite to external customers. 20 Increasing bauxite sales will increase revenue growth and the company s overall profitability, especially since bauxite is Alcoa s most profitable segment. Alumina Alcoa refines alumina at eight different locations across Austrailia, Brazil, and the U.S. 9 The company is currently in the 12 th percentile of its alumina cost curve and saves on transportation costs by positioning a majority of its alumina refineries near bauxite mines. 26 For example, three refineries are an average distance of 101 miles from the Darling Range Mines, which produce the vast majority of Alcoa s bauxite. As of 3Q 2017, 68.0% of alumina sales were to external customers and 32.0% were sold internally. 26 Adjusted EBITDA attributable to alumina sales totaled $898 million over the last twelve months. 24,26 The company has made an effort to increase alumina profitability by closing the Suralco refinery in Suriname in an effort to improve its position on the alumina cost curve. 9 The refinery had a capacity of 1,330 kmt-per-year and its closure will reduce Alcoa s alumina refining capacity. 9 Recent management forecasts estimate alumina shipments to be Mmt in fiscal year Aluminum Alcoa operates fifteen aluminum smelters across seven different countries in Australia, Europe, and North America. 9 Over the last twelve months, adjusted EBITDA for alumina sales has totaled $882 million. 24,26 Alcoa s aluminum segment will benefit from increasing aluminum prices over the next several years. In order to capitalize on favorable aluminum prices, management decided to partially restart the Warrick, Indiana smelting facility. The restart is expected to be completed in 2Q 2018 and will increase aluminum smelting capacity by 161 kmt. 27 The facility will be able to self-generate all power requirements, which will help improve profitability because aluminum smelting is an extremely energy intensive process. On average, Alcoa uses 12,000 kwh 17,000 kwh (kilowatts per hour) to smelt one metric ton of aluminum and electric power accounts for approximately 24.0% of aluminum production costs. 9 Management expects to ship Mmt of aluminum in fiscal year Figure 16 Source- Alcoa, BMO Capital Markets Global Metals & Mining Conference 20 Other Segments Cast Products Alcoa s cast products segment offers differentiated, value-added aluminum products that are cast into specific shapes to meet customer demand. 9 Specifically, these products include aluminum billet, foundry ingot, rolling slab, rod, powder and high purity P The majority of this segments sales are to external customers (94.0%), while the remainder are sold internally to the rolled products business at prevailing market prices. External sales are primarily to customers in the automotive, building and construction, electrical, industrial, and transportation markets. External sales for cast products declined 16.0% in 2016 compared to The decline was primarily related to an 11.0 % decrease in the average realized price per metric ton of aluminum as based on quoted price from the London Metal Exchange. 9 However, the price of aluminum has increased in 2017, which will likely increase Alcoa s adjusted EBITDA in 2017 from $284 million in Rolled Products Alcoa s rolled products segments operates two mills, one in the U.S. and the other in Saudi Arabia. The segment provides flatrolled aluminum sheets for the production of aluminum can manufacturing in the North American market. The rolled products segment represents Alcoa s least profitable segment with an adjusted EBITDA of $6 million and a 0.6% margin in The Warrick smelter previously discussed has an efficient source of molten metal for rolling mill products, which may help improve margins and will allow Alcoa meet future rolling mill volume requirements. 27 Energy Alcoa operates seven energy facilities with a combined production capacity of 1,685 megawatts. 9 This power is used internally for use in the aluminum manufacturing process and is also sold to external customers. In 2016, Alcoa generated approximately 14.0% of the power used at its smelters. Unlike Alcoa s other segments, electricity markets are very regional and competitors include integrated electric utilities companies, independent power producers, and energy brokers and traders. In Page 9

10 2016, energy sales decreased by 34.0% primarily driven by lower electricity prices in Brazil. Electricity prices vary globally and are predominately driven by regional characteristics as well as supply and demand considerations, making energy prices difficult to forecast. S.W.O.T ANALYSIS Strengths Alcoa is a global company with 43 operating locations across 10 countries. The company s size enables easy access to key markets in the Atlantic and Pacific basis as well as China. 9 Alcoa s will be able to capitalize on increasing prices in several of its segments by continuing to expand into these markets. Alcoa also benefits from having relatively low production costs due to vertical integration and efficient operating facilities. 20 Weaknesses Further facility restarts are unlikely due to cost concerns. Alcoa currently has 2.3 mtpa of alumina refining capacity at a facility in Point Comfort, Texas. However, given the high cost and estimated yearlong start-up time, it is unlikely Alcoa will restart this facility. 35 Another potential weakness is Alcoa s over dependence on the U.S. market. In 2016, 47.0% of revenues were generated in the U.S, which disproportionately exposes the company to political and economic risks in the U.S. 35 Opportunities As discussed in detail throughout this report, Alcoa will benefit from rising aluminum prices and recent supply curtailments in China. These developments will increase performance in several of the company s business segments. In addition, Alcoa s cast products segment will benefit from increased use of aluminum in the automotive industry and expected growth in the automotive industry. Threats Alcoa is vulnerable to manipulations in foreign currency exchanges rates that can increases expenses. In 3Q 2017, Alcoa suffered a $49 million expense as a result of unfavorable currency exchange rate changes. 26 In the future, Alcoa will continue to face the threat posed by unforeseen variations in currency prices. In addition, Alcoa is exposed to fluctuations in the price of aluminum. Due to the nature of Alcoa s business, the company s revenues are heavily impacted by the price of the commodity. As a result, Alcoa s operations are exposed to cyclical price fluctuations stemming from changes in the This relationship could reduce Alcoa s revenues if aluminum prices decrease. 18 VALUATION ANALYSIS After extensive research and analysis, we have decided to issue a BUY rating for Alcoa Corporation. After considering all of our future assumptions for Alcoa, we arrived at a target price range of $ $58.00 per share as of 11/13/2017. The target price was calculated by placing an 80.0% weight on the Discounted Cash Flow (DCF) and Economic Profit (EP) model and a 20.0% weight on the Dividend Discount Model (DDM). While our Relative P/E provided some guidance, we did not include the valuation methodology in our final conclusion. KEY ASSUMPTIONS Revenue Decomposition Alcoa s sales are comprised of six revenue streams: bauxite, alumina, aluminum, cast products, rolled products, and energy. We felt that analyzing each segment individually would provide the most accurate revenue forecasts. In each segment, we analyzed industry and company specific characteristics in order to determine a revenue growth rate for each segment. A key factor influencing revenue growth assumptions was the macroeconomic outlook for aluminum. Our research indicated that characteristics and trends in the aluminum market significantly impact the performance of each segment, with the exception of energy. Overall, we predict Alcoa s total revenue to increase 27.37% across all segments in Bauxite We are forecasting Alcoa s bauxite sales to increase by 39.0% in The segment saw a 15.0% increase in adjusted bauxite EBITDA from Q2 to Q3 in 2017 and we expect this trend to continue. 26 The segment will benefit from rising aluminum prices, which typically increases the price of bauxite. Management has also expressed a desire to expand Alcoa s external bauxite business as it has the highest profit margins of all businesses. The expansion project at the Juruti mine will increase Alcoa s production by 0.5 Mmt, which will increase revenues. Going forward, we expect revenue growth of 21.0% in 2018 before decreasing to single digits (9.0% - 3.0%) for the remainder of the projection period. We chose to slow revenues as we feel the cyclical aluminum business will eventually slow after 2-3 years of strong industry growth. Alumina Alcoa s management approved the closure of the Suralco alumina refinery in December The refinery had a capacity of 1,3330 kmt-per-year, which will reduce alumina production. However, increasing prices in aluminum suggest that alumina prices will rise mitigating the effects of the Suralco closure on Alcoa s overall revenue. Due to these changes, we predict Alcoa s alumina segment revenue growth to be 15.0% in 2017, which is less than the revenue growth forecasts of the other two upstream segments. Aluminum As mentioned previously, aluminum prices have risen roughly 30.0% over This is primarily due to decreasing supply in China. We predict aluminum sales growth to increase 41.0% in 2017 as a result of increasing prices and increased global demand. Alcoa s adjusted aluminum EBITDA increased 37.0% from Q2 to Q3 in 2017 offering justification for our high aluminum growth rate forecast. Over the projection period, we expected the aluminum growth rate to decrease to 25.0% in 2018 and 15.0% in 2019 before eventually stabilizing at 4.0%. Page 10

11 Cast Products We are forecasting a 28.0% increase in Alcoa s cast products revenue in The increase in the price of aluminum will elevate Alcoa s cast products segment revenue as the segment is essentially a value added form of raw aluminum. Strong demand from the automotive industry will also drive revenue increases. Going forward, we predict cast products sales growth to be 18.0% in 2018 and 15.0% in 2019 as the price of aluminum begins to stabilize. Rolled Products Our research suggests that rolled products are primarily sold to customers in the beverage and packaging industry, which is only expected to see modest growth and is using substitutes for aluminum, such as plastic and paper, at an increasing rate. These industry trends will limit rolled products segment revenue growth, however the segment only accounted for 0.4% of Alcoa s earnings in 2016, limiting the negative effects on Alcoa s overall revenue growth. We expect rolled products revenue growth to be 10.0% in Energy Alcoa s total energy revenues are driven by electricity prices in regional markets and the company s excess capacity available for sale to external customers. Regional electricity prices are difficult to predict as they are largely dependent on regionally specific considerations. Due to this characteristic, we decided to increase revenues at a constant rate of 5.0% over the projection period. We decided to use 5.0% as we feel it is a reasonable growth assumption that will limit the impact of the difficult to predict segment on our final value conclusion. Cost of Goods Sold We forecasted cost of goods sold as a percentage of Alcoa s overall sales. The cost of goods sold margin should improve over the projection period as a result of increasing product prices and the company s efforts to control costs. In the short-term, rising prices should improve margins as they generate increased revenues with limited expense impact. Alcoa is also currently conducting a review of its operations to curtail cos in-efficient facilities. The review should help Alcoa identify weaknesses in their cost structure and help the company improve its positions on global cost curves. We are forecasting cost of goods sold as a percentage of sales to decrease from 83.50% of sales in 2017 to 81.00% of sales in 2022 to reflect improving margins. Dividend Payout Policy Alcoa does not currently pay a dividend, however in the 3Q 2017 conference call management expressed an interest in redistributing profits to shareholders through a dividend at some point in the future. 26,35 As a result, we have projected Alcoa to begin paying a dividend in For guidance on dividend payout policy we analyzed the dividend that Alcoa Inc. paid shareholders prior to the restructuring in We learned that the former company paid a quarterly dividend of $0.03 per share over the past five years. Consequently, we believe that Alcoa Corp. will eventually begin paying a similar dividend once the company stabilizes after the restructuring. We forecast Alcoa to pay an annual dividend of $0.06 per share in 2018 and gradually increase the payout rate to eventually pay an annual dividend of $0.12 per share beginning in Weighted Average Cost of Capital We calculated Alcoa s weighted average cost of capital to be 7.52%. The company has a capital structure consisting of 81.94% equity and 18.06% debt. Equity value was calculated from market capitalization, and debt values were taken from the balance sheet as market values were unavailable. Cost of Equity Cost of equity was determined using the capital asset pricing model. We calculated a beta of 1.2 by adjusting the beta given for the metals and mining industry by Aswath Damodaran of After an analysis of beta values for comparable firms in the aluminum industry, we determined that a beta of 1.3 was too high for Alcoa and decreased Damodaran s beta by 0.1 to more accurately reflect the level of risk in the aluminum industry. We determined an equity risk premium of 4.65% using the historical geometric average risk premium from The risk-free rate was set at 2.86%, the yield of the 30-year Treasury bond on 11/13/ With these inputs, we calculated an 8.44% cost of equity. Cost of Debt Alcoa has no long-term bonds outstanding and we were unable to find a credit rating for the company. Consequently, we used the pre-tax cost of debt provided by Aswath Damodaran for the metals and mining industry of 5.20% in the calculation of Alcoa s WACC. 28 CV Growth Assumption We set the continuing growth value for both NOPLAT and EPS at 3.0%, which is consistent with our long-term GDP growth projections. This value is equal to our inflation rate assumption of 3.0%, suggesting limited terminal growth for Alcoa, but we wanted to avoid value inflation resulting from overly optimistic terminal growth. Discounted Cash Flow and Economic Profit Models The Discounted Cash Flow and Economic Profit models both produced an adjusted price for Alcoa of $55.12 per share as of 11/13/2017. Our DCF and EP models forecast NOPLAT to vary over the projection period with nominal continuing values of $17,167 billion and $6,455 billion, respectively. After adjustments were made to reconcile the value of operations to the value of equity, both models produced an intrinsic value of $59.15 per share. We adjusted the intrinsic value to 11/13/2017 using the stock price appreciation formula. DDM or Fundamental P/E Model The DDM model produced an intrinsic value of $42.57 per share. We then used the stock appreciation formula to bring the price forward to 11/13/2017 to reach a final adjusted price of $ We calculated a continuing value P/E multiple of Page 11

12 Relative P/E Valuation The relative price to earnings valuation resulted in a 2017 price of $ This approach does not consider future growth assumptions and emphasizes recent earnings. We are predicting strong revenue growth for Alcoa over the projection period, which negatively impacts the accuracy of the Relative P/E model. Alcoa also went through a restructuring in 2015, suggesting that recent earnings may not accurately reflect the long-term operational performance of the newly created company. For these reasons, we did not weight the Relative P/E ratio in our final value conclusion. DCF/EP Model and DDM Model Weighting As previously stated, we arrived at our final value conclusion by placing an 80.0% weight in the DCF/EP models and a 20.0% weight in the DDM model. Alcoa does not currently pay a dividend, but we included dividends in our model beginning in 2018 as management has expressed interest in paying a dividend and companies in the materials sector typically a pay dividend to shareholders. While we believe our dividend payout policy is logical, it is an assumption based on limited guidance from management. Unlike the DCF/EP models, the DDM model includes dividends in the computation of intrinsic value, subsequently placing a greater emphasis on our divided forecast assumption. Consequently, we chose to put more weight in the DCF/EP models as these approaches are not impacted by potential inaccuracies in our assumed dividend payout policy, resulting in a more reliable final value conclusion for Alcoa. We still chose to place a 20.0% weight on the DDM model to capture the potential impact of Alcoa initiating a dividend payment plan in our final value conclusion. Sensitivity Analysis We ran a sensitivity analysis on multiple key assumptions in our valuation to gain insight about the impacts these assumptions have on the price of Alcoa s stock. We choose assumptions that we believed significantly influenced Alcoa s business operations and stock price to see how these assumptions affected Alcoa s valuation. Marginal Tax Rate vs Risk-Free Rate With President Trump s push for tax reform and steady increasing interest rates, we believed it would be important to analyze the effects of these assumptions on Alcoa s value. A decreasing tax rate would increase FCF and a rising risk free rate would increase the cost of equity and WACC. Alcoa s definition of Adjusted EBITDA - Adjusted EBITDA is net margin plus an add-back for depreciation, depletion, and amortization. Management believes that this measure is meaningful to investors because Adjusted EBITDA provides additional information with respect to Alcoa Corporation s operating performance and the Company s ability to meet its financial obligations. Alcoa s definition of Adjusted EBITDA margin - Net margin is equivalent to Sales minus the following items: Cost of goods sold; Selling, general administrative, and other expenses; Research and development expenses; and Provision for depreciation, depletion, and amortization. kmt - Thousand metric tons Mdmt - Million dry metric tons Mmt - Million metric tons mt - Metric ton Appendix Glossary of Terms Mmtpa - Million metric tons per annum Mtpa metric ton per annum mdbmt million bone dry metric tons mtpy metric tons per year LTM Last Twelve Months (Q earnings ending April 24, 2017 to Q ending October 18, 2017) YTD - Year to date Beta vs Equity Risk Premium This table shows predicted values based on changes to the beta and equity risk premium. Considering we used an industryspecific beta and the historical average risk premium to estimate values, it is important to be aware of the different effects these values have on cost of equity, WACC, and the overall stock value. NOPLAT CV Growth vs CV ROIC We choose these factors because the continuing values of NOPLAT growth and ROIC are critical in computing the continuing value. Since continuing value cash flows are the largest cash flows in the EP model, we wanted to observe how changes in these factors affected Alcoa s value. Page 12