Investment Thesis: Recommendation: BUY. Table of Contents. Table of Contents

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1 Stock Analyst: Theo Constantinou Fisher College of Business The Ohio State University Columbus, OH Contact: Fund: OSU SIM Class Fund Manager: Chris Henneforth, CFA Recommendation: BUY Sector: Materials Industry: Aluminum Stock Data: Ticker: AA (NYSE) Current Price: $10.21 Target Price: $ Wk Range: $4.97 $44.77 Avg Volume (3m): 44,769,000 Market Capitalization: 9.91B Shares Outstanding: 974,276,000 Beta: 1.97 YTD Return: -8.91% Dividend Yield: 1.20% EPS: Trailing PE: 41.7 Forward PE (median): 13.2 Annual EPS Est (Dec 09): Price to Sales: 0.4 Price to Book: 0.7 Investment Thesis: Alcoa produces 24% of the world s aluminum. The company is refocusing on their upstream bauxite mining and refinery business and phasing out their downstream production business. Since the economics behind mining and alumina refining operations is more cost-effective this will keep the company on track to improve their overall profitability in the future and allow for further long term growth opportunities. Aluminum prices have had steady if not large increases since 2004 mainly because of demand from China. This is reflected in Alcoa s 52 week high of $44.77 (May 2008). The greatest catalyst for Alcoa s stock price is their correlation with the overall condition of the economy. Because of such high uncertainty and a projected compound annual sales growth rate of negative 4% from 2008 to 2014, share price appreciation remains apathetic. Since the release of Alcoa s 10Q the stock has risen nearly 25% and I personally see tremendous upside to the stock as the economy stabilizes and eventual growth. Price Performance Table of Contents Table of Contents 1

2 Company Overview...5 Business Segments Alumina....6 Primary Metals.8 Flat Rolled Products Engineered Products and Solutions..10 Packaging and Consumer..10 Economic Conditions Gross Domestic Product (GDP) Price of Aluminum (LME) 13 Currency Translation 14 Legal Proceedings..15 Regulatory Framework.16 Industry Analysis...17 Materials Sector Valuation Company Advantages / Disadvantages Portfolio Reshuffling.20 Infrastructure Development...20 Auto Industry.21 Rising Energy Costs / Leverage Financial Analysis

3 DuPont Analysis..24 Valuation Analysis Absolute and Relative Valuation...26 Discounted Cash Flow Modeling Assumptions...28 Conclusion..30 Risks and Concerns..32 Appendix I. See Table of Figures Appendix II Income Statement...36 Balance Sheet.37 Cash Flow Statement.38 DCF Model 39 Sensitivity Analysis References

4 Table of Figures Graphs Graph 1 Aluminum Price YOY and Over 10 Year Horizon...7 Graph 2 Alcoa s Revenue by Segment / Geographic Region Graph 3 Real GDP Projection Graph 4 Primary Aluminum Inventories vs. Days Inventory.13 Graph 5 10 Year London Metal Exchange Prices (Aluminum).14 Graph 6 Materials Sector vs. S&P Graph 7 Metal Prices of Steel, Aluminum, Copper and Nickel Graph 8 EPS and Future Growth Graph 9 China GDP Graph 10 Chinese Aluminum Consumption Graph 11 OECD Leading Economic Indicators Graph 12 Future LT Growth of BRIC Countries Graph 13 Escalation in Long Run Marginal Cost Graph 14 LME Future Projection Graph 15 Credit Suisse Future Financial Valuations. 35 Figures Figure 1 World Primary Aluminum Production Figure 2 Merrill Lynch Investment Clock Tables Table 1 Materials Sector vs. Aluminum (US Cents/Pound) Regression Analysis.19 Table 2 Materials Sector vs. S&P 500 Regression Analysis Table 3 Profitability / Liquidity Ratios Table 4 Asset Management / Leverage Ratios Table 5 DuPont Analysis Table 6 Alcoa Absolute Valuation Table 7 Comparable Analysis of AA, CENX and KALU Table 8 Long-Term Aluminum Demand Growth

5 Company Overview 1 In 1886, Charles Hall discovered the process of smelting aluminum. Concomitantly, halfway around the world in France, Paul Héroult discovered the same process. The process consists of passing an electrical current through a bath of cryolite and aluminum oxide, resulting in the metal aluminum. This procedure is called the Hall- Héroult process and is still the only process used to make aluminum today. Alcoa, which gets its name from the Aluminum Company of America, was founded in 1888 and is the world s third largest aluminum producer behind Rio Tinto Alcan and Rusal. Alcoa are the world leader in the production and management of primary aluminum, fabricated aluminum and alumina. Alcoa serves numerous markets, including aerospace, automotive, packaging, building and construction, commercial transportation, and industry. Additionally, Alcoa produces flat-rolled products, hard alloy extrusions, and forgings. Alcoa conducts operations in 44 countries on 5 continents. As of December 31, 2008 they have 107,000 employees. In May 2008, Klaus Kleinfeld was appointed as Alcoa s President and Chief Executive Officer. A proven leader with outstanding international credentials and an existing board member of Alcoa, Kleinfeld was the ideal leader to guide Alcoa through the current economic crisis and shape its bright future. During spring, 2007, Alcoa conducted a hostile takeover for $27 billion to acquire Alcan. A successful takeover would have undoubtedly formed the world s largest aluminum producer. The takeover bid, however, was withdrawn after Alcoa s major competitor Rio Tinto announced a friendly takeover in summer, 2007, forming what is now currently Rio Tinto Alcan. For the 1Q of 2009, Alcoa reported a loss of $497 million, or $0.61 per share. This was due to weak aluminum prices and volume. Revenue fell 13% from the previous quarter. The company raised $1.3 billion in common equity and convertible bonds to address liquidity issues. This stock sale has been extremely dilutive to existing shareholders. Aluminum inventory approached historically high levels that created trouble for a rebound in aluminum prices. Cost-cutting and liquidity preservation should and will be the main priority for Alcoa in

6 Business Segments 2 Alcoa has five primary business segments that generate revenue for the company: Alumina, Primary Metals, Flat-Rolled Products, Engineered Products and Solutions, Packaging and Consumer. Alumina Aluminum is one of the most plentiful elements in the earth s crust. Aluminum is produced primarily from bauxite, an ore containing aluminum in the form of aluminum oxide, commonly referred to as alumina. Aluminum is made by extracting alumina from bauxite and then removing oxygen from the alumina. Alcoa processes most of the bauxite that it mines into alumina. Alumina is sold directly to internal and external smelter customers worldwide or is processed into industrial chemical products. Late in 2008, management made the decision to reduce Alcoa s aluminum and alumina production in response to the significant economic downturn. As a result of this decision, reductions of 750 kmt, or 18%, of annualized output from Alcoa s global smelting system were implemented. Accordingly, reductions in alumina output were also initiated with a plan to reduce production by 1,500 kmt-per-year across the global refining system. It is important to note that; sales for the 2009 first quarter decreased $2,851M, or 41%, compared with the same period in The decline was driven mainly by three factors: (1) a drop in realized prices for alumina (36%) and aluminum (44%), (2) decreases in volume in the downstream segments due to weak end markets, and (3) the absence of sales from the businesses within the former Packaging and Consumer segment ($497 in the 2008 first quarter). Alumina production decreased 11% in the 2009 first quarter compared with the corresponding period in This illustrates the sharp decline of aluminum prices over the past year compared to their steady growth over the past decade to show the inevitable rebound in the global price of aluminum that directly correlates to Alcoa s alumina production (Graph 1) 3. The downside risks associated with Alcoa should start to lighten as aluminum prices start to stabilize and increase. 6

7 GRAPH 1 - Aluminum Price YOY and Over 10 Year Horizon 7

8 Alumina continued Another important point is the dominance and sustainable growth of China. According to Morningstar analyst Min Ye, China's aluminum consumption growth has accounted for 60% of world consumption growth during the last seven years. 4 This is a key driver in pointing to further growth in the aluminum industry. The industrialization of emerging-market countries will further the long-term growth and utilization of aluminum (Figure 1) 5. FIGURE 1 World Primary Aluminum Production Primary Metals This segment consists of Alcoa s worldwide smelter system. Primary Metals receives alumina, primarily from the Alumina segment, and produces primary aluminum used by Alcoa s fabricating businesses, as well as those sold to external customers, aluminum traders, and commodity markets. Results from the sale of aluminum powder, scrap, and excess power are also included in this segment, as well as the results of aluminum derivative contracts. The sale of primary aluminum represents more than 90% of this segment s third-party sales. Third-party sales for the Primary Metals segment declined 55% in the 2009 first quarter compared with the same period in The decrease was largely the result of a 44% drop in realized prices driven by a 50% decline in LME prices. Refer to Graph 1. A serious problem within the smelting industry is the high fragmentation, possibly resulting in overcapacity. In 2007, China s share of aluminum smelting drastically increased from 13% to 32%. Looking forward there should be lower production in the anticipation of the further smelter cutbacks. 8

9 Even though this is a downstream business for Alcoa it is interesting to note two things about their smelting business: secured long-term power contracts for almost half of the global smelting system and the successful start-up of the first greenfield smelter in two decades. According to United States Patent and Trademark Office Application # New investments (called "greenfield plants" in engineering lingo) are rare (one per year to one every two years in average worldwide) due to the growing difficulty in concentrating on one site an energy source allowing for sufficiently low cost per kwh procured, for a period allowing depreciation of the huge capital costs (typically $4,500 to 5,000 per tonne/year capacity in ). It is generally recognized that between 2000 and 2004 the world aluminum industry spent on average 2 US cents per kwh or roughly $280 per tonne of aluminum produced. In 2008, Alcoa produced roughly 4 million tonnes. Since producing aluminum costs nearly $280 per tonne, the developments of this greenfield plant is detrimental for reduced cost in this segment and future growth. Flat-Rolled Products The principal business of the company s Flat-Rolled Products segment is the production and sale of aluminum plate, sheet, foil and hard alloy extrusions. These products serve the packaging and consumer, transportation, building and construction, distribution, aerospace and automotive markets. This segment includes rigid container sheet (RCS), which is sold directly to customers in the packaging and consumer market and is used to produce aluminum beverage cans. Third-party sales for the Flat-Rolled Products segment decreased 35% in the 2009 first quarter compared with the corresponding period in This is largely the result of a reduction in volumes across all businesses, due to weak end markets in Europe and North America, and a decline in realized prices. When the Euro is strong, this segment is somewhat offset due to the positive foreign currency movement. The gradual downstream shift in Flat-Rolled Products and Primary Metals will help Alcoa focus on their bauxite mining and refinery business. 9

10 Engineered Products and Solutions This segment includes titanium, aluminum, and super alloy investment castings; forgings and fasteners; aluminum wheels; integrated aluminum structural systems; and architectural extrusions used in the aerospace, automotive, building and construction, commercial transportation, and power generation markets. A major problem with this segment is that it is heavily tied to the auto and construction industries. Since these two industries are materially weak and the pending bankruptcy of General Motors*, overall optimism is not warranted. Some positive outlook comes from productivity in the aerospace and industrial gas turbine markets. According to the US Department of Energy 7, Domestic and global potential markets for advanced turbines are large. At least half of all new power generating capacity added between now and 2010 is likely to use gas turbines. In addition, mid-sized turbines have tremendous potential for use as base-load, peaking, and standby/backup power in commercial and industrial settings. The above statement from the US Department of Energy generates sanguinity for engineered products and solutions with increased productivity and strong future demand for gas turbines. Packaging and Consumer On February 29, 2008, Alcoa completed the sale of its Packaging and Consumer businesses to Rank Group Limited. The Packaging and Consumer segment no longer contains any operations. The principal products in this segment included aluminum foil; plastic wraps and bags; plastic beverage and food closures; flexible packaging products; thermoformed plastic containers; and extruded plastic sheet and film. Consumer products were marketed under brands including Reynolds Wrap, Diamond, Baco, and Cut-Rite. *General Motors, as of June 1, 2009, have filed for bankruptcy. 10

11 GRAPH 2 Alcoa s 2008 Revenue by Segment / Geographic Region 11

12 Macroeconomic Conditions 8 Important macroeconomic factors significant to Alcoa s performance include: industrial production in important emerging market countries, economic growth domestically (GDP) and overall prices of aluminum on the LME (London Mercantile Exchange). Alcoa s primary business is cyclical in direct correlation to economic growth and current economic conditions. When there is economic uncertainty and a continuing recession, aluminum inventories will be high, thereby driving prices down directly and affecting Alcoa s ability to generate higher revenue. Another important factor for Alcoa as a multinational firm is fluctuation in currencies and the result this has on amount of P/L reported in their financial statements. Gross Domestic Product (GDP) The overall growth of a country is determined by their GDP growth. Developing GDP shows signs of a strong economy that would allow for development in building and construction. Currently the average GDP growth rate is decreasing at an annual rate of -6.1% in the first quarter of This does not favor well for Alcoa since Real GDP is decreasing; however, GDP cannot stay negative forever and when this number becomes positive, Alcoa will again start to grow relative to GDP. As projected by the OECD, by 2010 GDP should have positive growth and the price of aluminum should rise with GDP growth (Graph 3). 9 Appendix I Graph 11 displays a graphical representation that if the OECD economic indicators have bottomed the line will now start to trend upward. GRAPH 3- Real GDP Projection 12

13 Price of Aluminum traded on LME Since overall domestic growth is negative and international industrial production is at record lows it is within reason to see much cheaper prices for aluminum. Prolonged sustainable lows will not hold long term and with the eventual decrease in aluminum inventories which are at record high-levels, the price of aluminum will eventually rebound. Graph 1, where the 10 year price levels of aluminum are shown, in July 2006 aluminum was selling at a record highs of $1.50 (USD/lb) when inventories were low. Currently there is 5 times the amount of aluminum in the market that is not being turned over and is selling for $0.59 in comparison to the highs of As more aluminum is sold the inventory will start to decrease and as this graph starts to trend downward the price of aluminum will rise, allowing for better profit margins for Alcoa (Graph 4) 10. A graphical depiction of rate of change (ROC) in which aluminum is trading with eventual price reversion occurring and trending upward toward the mean (Graph 5) 11. GRAPH 4 Primary Aluminum Inventories vs. Days Inventory 13

14 GRAPH 5 10 Year London Metal Exchange Prices (Aluminum) *200 day exponential average in red. 200 day rate of change (ROC) green above. Currency Translation Alcoa generates 41% of its revenue overseas (Europe and Asia). With the US dollar trending downward relative to the Euro, income repatriation will return positive profits back to Alcoa. Due to the downturn in economic growth, the dollar has traded at historic lows over the past year $1.20/Euro and foreseeable increases are not in the near future. Another positive note for Alcoa s future is that commodity prices trade relatively higher in relation to a weak dollar. 14

15 Legal Proceedings 12 As previously reported, in November 2006, in Curtis v. Alcoa Inc., Civil Action No. 3:06cv448 (E.D. Tenn.), a class action was filed by plaintiffs representing approximately 13,000 retired former employees of Alcoa or Reynolds 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. Plaintiffs allege these changes to their retiree health care plans violate their rights to vested health care benefits. Plaintiffs additionally allege that Alcoa has breached its fiduciary duty to plaintiffs under ERISA by misrepresenting to them that their health benefits would never change. Plaintiffs seek injunctive and declaratory relief, back payment of benefits and attorneys fees. In August 2008, the court set a new trial date of March 24, 2009 and in January 2009 moved it to September 22, Alcoa estimates that, in the event of an unfavorable outcome, the maximum exposure would be an additional post-retirement benefit liability of approximately $300 million and approximately $40 million of expense (includes an interest cost component) annually, on average, for the next 11 years. Alcoa believes that it has valid defenses and intends to defend this matter vigorously. However, at this stage of the proceeding, the company is unable predict the outcome. This could cause issues for Alcoa moving forward. They are already facing liquidity issues; if they are found guilty and forced to pay $300 million, this would further impact Alcoa s liquidity. (Refer to Risks and Concerns to Investment Thesis for further explanation). 15

16 Regulatory Framework 13 Energy prices are a significant input in a number of Alcoa s operations. There is growing recognition that energy consumption is a contributor to global warming, greenhouse effects and potential climate change. A number of governments have recognized the needs for regulatory change in response to the potential impacts of climate change. There is current and emerging regulation, such as the mandatory renewable energy target in Australia, or potential carbon trading regimes that will affect energy prices. This impacts Alcoa because they have two smelters in Australia, so that alterations in energy prices could affect their profitability. Alcoa will likely see changes in the margins of greenhouse gas-intensive assets and energyintensive assets as a result of regulatory impacts in those countries in which the company operates. Assessments of the potential impact of future climate change regulation are uncertain, given the wide scope of potential regulatory change in countries in which Alcoa operates. The potential physical impacts of climate change on the company s operations are highly uncertain, and will be unique to the geographic circumstances. These may include changes in rainfall patterns, water shortages, sea levels, storm patterns and intensities and temperature levels. These effects may adversely impact the cost, production and financial performance of Alcoa s operations. 16

17 Industry Analysis The materials sector in the S&P 500 is highly cyclical. Alcoa operates in a very mature industry with over 100 years of experience. There is still countless room for growth in this industry, especially with the development of emerging market countries. Alcoa s business moves directly with the economy in the United States and with the S&P 500. When the economy is booming and there is tremendous growth the price of aluminum soars producing higher profit and positive EPS for Alcoa. In the case of economic turmoil and a bleak outlook on future growth and earnings, Alcoa is drastically hurt by negative economic growth and Real GDP. It is my opinion that our economy is in the recovery stage where there is cyclical growth and eventual cyclical value (Figure 2) 14. The problem in writing this thesis is the profound economic uncertainty that we are facing as a nation. With the Federal Reserve moving in the shadows of the financial system, no one in the general public truly knows what the future holds. Based on my personal optimism that we live in a country that will not become socialist and the conviction that our politicians believe in the free market system; growth for the materials sector will begin in the later part of this year and into The beta of Alcoa is 1.97, which is almost double the market beta of 1.0. FIGURE 2 Merrill Lynch Investment Clock 17

18 Materials Sector Valuation It is important to understand how the Materials sector and the S&P 500 are correlated with the metals and mining industry (aluminum). Two of Porter s 5 forces are important here when analyzing the sector and specifically aluminum. The first is the customer s / high, especially in the auto industry where Alcoa sells aluminum alloy to car manufacturers. The second is rivalry / high where global competition exists and there are cheap imports. These mature companies in the materials sector are constantly fighting for market share as was seen when Alcoa tried a hostile takeover of Alcan. With the exception of the dot-com bubble in , the materials sector is cyclical and grows in direct relation to the S&P 500. As Real GDP grows in the future and there is eventual global economic growth, especially in emerging market countries, the materials sector will increase as will the overall growth of the S&P 500. A regression was run to show how closely related the stock price of aluminum was related to the Materials sector (SPBMS) and the relationship of the Materials sector with the S&P 500 (SPX) (Graph 6) 15. GRAPH 6 Materials Sector vs. S&P 500 The data from 1998 to 2002 was removed for the regression analysis because of the Dot Com bubble that did not affect the Materials Sector. 18

19 Regression Statistics Multiple R R Square Adjusted R Square Standard Error Observations 122 TABLE 1 Materials Sector vs. Aluminum (US Cents/Pound) Regression Analysis Materials Sector vs. Aluminum (US Cents/Pound) ANOVA df SS MS F Significance F Regression E 48 Residual Total Coefficients Standard Error t Stat P value Lower 95% Upper 95% Lower 95.0% Upper 95.0% Intercept E X Variable E Regression Statistics Multiple R R Square Adjusted R Square Standard Error Observations 77 TABLE 2 Materials Sector vs. S&P 500 Regression Analysis Materials Sector vs. S&P 500 (data from 2003 to present to eliminate the Dot Com Bubble, ) ANOVA df SS MS F Significance F Regression E 30 Residual Total Coefficients Standard Error t Stat P value Lower 95% Upper 95% Lower 95.0% Upper 95.0% Intercept E X Variable E

20 Competitive Advantages / Disadvantages 16 There are several drivers of growth that will positively affect Alcoa over the long-term and give them competitive advantage. However, there are also some negative catalysts that will affect Alcoa in the future. Advantages Portfolio Reshuffling Alcoa moved to reinforce their strategic fundamental: producing aluminum. When they addressed their largest input cost, Alcoa successfully guaranteed that 80% of smelting power would be either selfgenerated or covered by long-term power contracts through In 2008, Alcoa removed the Packaging and Consumer business to create more profit. They also obtained two high growth fastener businesses and agreed on a cashless asset swap with their joint venture partner, Orkla. With the swap between Orkla and Alcoa, they were able to exit the non-core business of producing soft alloy extrusions. With Alcoa in full control of two smelters in Norway, this again made them the largest aluminum producer in the world. The potential of their downstream business in Engineered Products and Solutions had a record year with a 23% increase in profitability, so as projections are made long-term, it might be possible that Engineered Products and Solutions move to an upstream line of business. Infrastructure Development Another very important aspect of Alcoa s business is growth in global infrastructure. With the current government infrastructure stimulus programs in the US and Europe and the remarkable growth of cities in developing countries, the demand for aluminum in construction and mass transit will increase exponentially. Growth in the BRIC countries (Brazil, Russia, India and China) potentially will have the largest impact on Alcoa over the long haul (Appendix I Graph 11). In the global aerospace and defense markets, aluminum will continue to be vital. Alcoa created 90% of the advanced alloys required by Airbus and Boeing aircraft. Alcoa is also developing new partnerships among the community of defense contractors building the next generation of military aircraft and ships. China s new civil aircraft industry chose Alcoa-developed high-performance alloys and products for China s first regional jet, the ARJ In addition, it is possible that aluminum can be used as a substitute metal. Next to steel, aluminum is one of the cheapest metals and can be used as a substitute for other more expensive metals like copper and nickel (Graph 7)

21 GRAPH 7 Metal Prices of Steel, Aluminum, Copper, Nickel index Steel Aluminum Copper Nickel Relative Metal Prices Disadvantages Automotive Industry With Chrysler being sold to Fiat and General Motor s* on the verge of bankruptcy, Alcoa will face immediate issues until GM is restructured and can start manufacturing more automobiles. Another problem in the auto industry is the negative stigma that now surrounds General Motors. Even when the smoke clears after GM files for bankruptcy, the crucial question is whether consumers will buy GM, which directly affects Alcoa. Rising Energy Costs Alcoa s operations use a considerable amount of energy. The profitability of the company may be directly affected with increased energy prices or the interruption of energy supplies. This includes increases in natural gas prices and electricity costs and the inability to extend energy contracts. Leverage Once the financial crisis engulfed the markets, Alcoa obtained a $1.9 billion credit line before the cost of credit sky-rocketed. This increased by 60% their short-term debt capacity. A total of $5.2 billion of revolving credit facilities gave them valuable flexibility and staying power to cope with the continuing crisis, especially since they were facing liquidity issues. Although some may consider the fact that they were able to buy debt when it was cheap as a positive, this can also be viewed as a negative for any company needing so much credit. This is also reflected in their debt-to-equity ratio and how much it rose from 2007 to 2008 (Table 4). *General Motors, as of June 1, 2009, have filed for bankruptcy. 21

22 Financial Analysis / DuPont Analysis 18 Financial Analysis TABLE 3 Profitability / Liquidity Ratios Alcoa Profitability / Liquidity Ratios 12/31/ /31/ /31/ /31/ /31/2008 Return on Assets (ROA) Return on Equity (ROE) Return on Investment (ROI) See DuPont Analysis See DuPont Analysis EBITDA Margin % 14.91% 8.34% 16.04% 19.38% 8.39% Quick Ratio Current Ratio Return on Assets (ROA Net Income/Assets) indicates each dollar in income earned by the firm on its assets. This ratio measures the rate of return on total assets and how profitable it is in relation to their total assets. Alcoa management became more efficient at generating revenues using their assets from 2004 to 2007; however, because of the financial crisis, numbers in 2008 are going to be completely beaten down and skewed from historical numbers. EBITDA Margin (EBITDA / Total Revenue) is the earnings before interest, tax, depreciation and amortization as a percentage of sales. This calculation is more useful than operating margin because it excludes non-cash items like depreciation and is a good means of comparing the company s revenue to their earnings. Based on this margin, Alcoa has gradually become more efficient at generating revenue, exception for If the percentage reverts back to the mean, Alcoa will definitely see future growth. Quick Ratio ((Current Assets Inventory)/Current Liabilities) compares a company's cash and short-term investments to the financial liabilities the company is expected to incur within a year's time. Alcoa would be able to cover 46% of the upcoming year s liabilities. Current Ratio (Current Assets/Current Liabilities) explains the company s ability to pay back their ST liabilities (payables and debt) with their ST assets (cash and inventory). A quick way of assessing whether a company is able to pay back their debts is if they have a ratio that is above 1. In the case of Alcoa, they have a ratio that has remained constant above one for the past five years. 22

23 TABLE 4 Asset Management / Leverage Ratios Alcoa Asset Management / Leverage Ratios 12/31/ /31/ /31/ /31/ /31/2008 Receivables Turnover Inventory Turnover Total Asset Turnover See DuPont Analysis Accounts Payable Turnover Accrued Expenses Turnover Property Plant & Equip Turnover Cash & Equivalents Turnover Cash Flowper Share Total Debt to Equity Total Debt-to-Equity (Debt/Equity) measures how aggressive a company is with financing its growth with debt. From 2004 to 2007, Alcoa s debt-to-equity ratio remained nearly unchanged; in 2008 they had to take on more debt to satisfy their obligations and generate higher revenue with acquisitions. Inventory Turnover is how much the company s inventory is sold and replaced over a period of time. The ratio has remained steady since In the future one would hope that Alcoa would be able to sell more aluminum and keep inventory for shorter periods of time. Cash Flow per Share (Operating Cash Flow Preferred Dividends / Common Shares Outstanding) is a measure of the firm s financial strength. This calculation can be more important than EPS because of how easily it can be manipulated by management. Cash on the other hand is very difficult to falsify and shows the sustainability the company s business model. Alcoa had very strong cash flow per share until 2008 when they were dramatically affected by the financial crisis however it is my strong believe that over the next 5 years their cash flow per share will be back near

24 DuPont Analysis See the chart below for the complete five year DuPont analysis of Alcoa s financial statements. TABLE 5 DuPont Analysis DuPont Ratios Profit M argin % (EBIT / Sales) 18.78% 14.78% 22.59% 29.21% 5.89% Asset Turnover (Sales / Assets) Return on Investment (ROI) 10.16% 7.77% 16.29% 11.81% 3.41% Leverage Multiplier (Assets / Equity) Return on Equity Adjusted (ROE) 10.30% 9.25% 16.05% 16.73% -0.53% Profit Margin (EBIT/Sales) is a way to measure of performance of the company s management. When the ratio is rising and positive this means the company is selling aluminum and reducing their costs. The outlier year is 2008 when the economy went into recession. In 2007 the profit margin nearly doubled from the previous 2 years and then in the course of one year fell 75%. Asset Turnover (Sales/Assets) measures the amount of sales that are produced for every dollar worth of assets. Since 2004 the ratio was gradually rising and has now reverted back to its level of 5 years ago. The importance of this ratio is that the company is producing more sales from efficiently using their assets. Return on Investment or ROI (Profit Margin*Asset Turnover) measures the profitability of assets that are being used by the company. ROI strategy either strives for higher profit and low turnover or lower profit and high turnover. Alcoa s business segments are composed of this previous strategy because some of their businesses produce higher profits while others strive for higher turnover. With the majority of these ratios 2008 is skewed because our economy is affected by dramatic economic conditions that have left the markets extremely unfavorable. Leverage Multiplier (Assets/Equity) is a representation of capital structure. This ratio should not be rising because an increase means that more debt is being used to finance the company. This was discussed in detail in the competitive disadvantages section. When a company becomes leveraged, they must make payments of principle and interest or else be potentially forced into bankruptcy which was the case with so many financial firms last year that were in a sense illiquid and could not satisfy their debt payments. If a company is over leveraged and has an increasing high leverage multiplier this signifies an unsatisfactory capital structure. 24

25 Return on Equity or ROE (ROI*Leverage Multiplier) is a measure of much profit a company is able to generate with the money invested by stakeholders. Every company, regardless of industry, should look to maximize ROE over the long-term. An adjusted multiplier since Alcoa has high leverage to better understand this ratio. Since the majority of ROE is produced by ROI, asset turnover and profit margin, I did not use the leverage multiplier for this analysis. DuPont Analysis Summary At the end of 2007, Alcoa was in very a strong financial position due to their growing ROE. However, with a current ROE of -0.53% it does not reflect well on the company moving forward. Alcoa is truly a cyclical company and their ROE is not going to be at 16% anytime in the near future; however over a long-term horizon, one could safely predict that their ROE will not be negative at the end of the year. In addition, one would also expect their leverage multiplier to trend back down near 2.5 within the next year. 25

26 Equity Valuation: Multiples 19 Several valuation methods were used to derive the true intrinsic value of Alcoa s stock price: absolute - relative valuation and a comparable valuation of other domestic aluminum companies. Absolute Valuation Alcoa is well above the median of the historical P/E multiple. The current P/E is 12x earnings, whereas the 10 year average is around 13x earnings. I think that the forward P/E based on my DCF analysis is close in line with historical averages and reversion to the mean will occur. Global demand for aluminum in emerging market countries will drive down the idle inventory of aluminum and force the price of aluminum to rise along with Alcoa s stock price. Absolute Valuation TABLE 6 Alcoa Absolute Valuation High Low Median Current #Your Target Multiple *Your Target E, S, B, etc/share Your Target Price (F x G) A. B. C. D. E. F. G. H. P/Forward E P/S P/B P/EBITDA N/A N/A N/A N/A N/A N/A N/A P/CF Comparable Analysis Alcoa only has two publically traded competitors that can be used in a relative comparison. A comparable analysis was conducted by comparing the top aluminum producers in the US: Century Aluminum Company (CENX) and Kaiser (KALU). Alcoa could not be compared to their largest global competitor Rio Tinto Alcan because they are a privately held company. After conducting the comparable analysis based on EPS and P/E basis, the findings are that the company is in line to outperform. Another problem in this comparison is that Alcoa is on a different magnitude than the other US aluminum producing companies. What stands out the most in the comparison of the other US companies is the 2010 growth estimate for Alcoa of 132% and positive EPS of $

27 TABLE 7 Comparable Analysis of AA, CENX and KALU 20 Alcoa Inc. Jun 09 Sep 09 Dec 09 Dec 10 Earnings Est (EPS) Avg. Estimate Revenue Est Avg. Estimate 3.97B 4.15B 16.89B 19.55B Share Price $9.22 Market Cap 8.98B Forward P/E (FYE 12/31/2010) Price/Book 0.72 Enterprise Value/EBITDA Growth Estimate AA Industry Sector S&P 500 Current Quarter % % 80.90% 36.90% Next Quarter % N/A 66.40% 27.00% This Year % % 65.80% 12.50% Next Year % N/A % 30.10% Trailing P/E Century Aluminum Company Jun 09 Sep 09 Dec 09 Dec 10 Earnings Est (EPS) Avg. Estimate Revenue Est Avg. Estimate M M M 1.01B Share Price $6.01 Market Cap M Forward P/E (FYE 12/31/2010) N/A Price/Book 0.46 Enterprise Value/EBITDA Growth Estimate CENX Industry Sector S&P 500 Current Quarter % N/A N/A 36.90% Next Quarter % N/A N/A 27.00% This Year % N/A N/A 12.50% Next Year 80.20% N/A N/A 30.10% Trailing P/E Kaiser Aluminum Corporation Jun 09 Sep 09 Dec 09 Dec 10 Earnings Est (EPS) Avg. Estimate Revenue Est Avg. Estimate M M 1.02B 1.17B Share Price $31.08 Market Cap M Forward P/E (FYE 12/31/2010) Price/Book 0.77 Enterprise Value/EBITDA Growth Estimate KALU Industry Sector S&P 500 Current Quarter 49.50% % 80.90% 36.90% Next Quarter 45.50% N/A 66.60% 27.00% This Year 42.50% % 65.90% 12.50% Next Year 4.30% N/A % 30.10% Trailing P/E

28 Equity Valuation: Discounted Cash Flow (DCF) To better understand the intrinsic value of Alcoa, a DCF model was used to support the multiple valuation estimation. The DCF model produces an implied equity value per share of $ My price target is $18.25; however, over the next 5 years, I definitely believe that $29.90 is a reasonable price target. For further explanation I will clarify and outline the assumptions made in the DCF model. DCF Modeling Assumptions Revenue Forecast The revenue forecast was generated by calculating the revenue for each business segment of Alcoa: Alumina and Chemicals, Primary Metals, Flat-Rolled Products, Extruded and End Products, Engineered Products, Packaging and Consumer, and Other. Each segment s revenue was calculated based on a historical performance growth rate that would guardedly estimate total revenues. Total Revenues for were -6.35%, 3.16% and 10.63% respectively. In 2006, Alcoa was trading at their 52-week highs and their revenue was near 19% so gradually over the next three years I think that they will be recording revenues near their average as well as increase in aluminum prices will drive their revenue higher. As Alcoa reshuffles their portfolio and focuses more on their upstream bauxite mining and refinery business their revenue will growth even more. Income Statement Net Sales: Derived from the Segment sheet of the DCF Minority Interest: % of revenues COGS: % of gross margin Income Tax Expense: Assumed 30% tax rate According to Michael J. Mauboussin, Analysts frequently project growth (sales and margins) independent of investments. A simple way to check for this error is to add a ROI line in the model. 21 According to my DCF from , ROI increases from $724, $1,099 and $1,356 respectively (millions). 28

29 Balance Sheet Cash and cash equivalents: This was produced by taking the cash generated at the end of the year and adding it back to the cash made at the beginning of the year. Receivables: Total Sales * Days Receivable / 365 Inventories: % of total sales Goodwill: Calculated using historical levels Accounts Payable: % of total sales Due to difficulties in forecasting debt levels of Alcoa it was done so conservatively. Summary and Relative Outputs Operating margins of about 8.0% were used due to future sustainability. This is rational because Alcoa s margins were growing and I believe them to stay constant over the next decade. Terminal Discount Rate of 10.0% Terminal FCF Growth Rate of 3.0% Implied terminal P/E multiple of 12.2 which is in line with the historical median P/E of I was conservative in my growth rate however the long-term aluminum demand growth from The O Carroll Aluminum Bulletin is illustrated in Table 8. TABLE 8- LT Aluminum Demand Growth 22 29

30 CONCLUSION: BUY Alcoa is the largest aluminum producer in the United States and produces 30% of the world s aluminum. The company has revenues in 5 different segments: Q figures, Flat-rolled products (-4%), Primary Metals (-17%), Engineered Products and Solutions (8%), and Alumina (4%). With the current recession and the collapse of the market last fall, Alcoa s stock price lost nearly 90% of its value from its 52-week high of $ When Alcoa reported its first quarter earnings with a net loss of $497M compared to net income of $303M a year earlier, the market had already valued the bad news of their earnings into the current stock price. At the close of trading on April 7 th, 2009, after Alcoa reported their 1Q loss, Alcoa s share price rose 22 cents, to $8.01 after the official close of the NYSE. The global recession has increasingly reduced the demand for aluminum used in automobiles and appliances and the drop of the overall market over the past year has drastically hurt Alcoa s stock price. Coupled with all this bad news, aluminum prices on the LME have dropped 51 percent over the past year. However, to preserve cash, Alcoa cut their dividend for the first time in more than two decades and plan on selling stock, having pledged to cut costs by more than $2.4B annually. Over the next year, there may not be much room for growth in the aluminum industry due to lack of demand for the metal; however, by the end of 2010, Alcoa will be delivering positive EPS and the company will definitively start increasing profit and expanding their margins (Graph 8) 23. GRAPH 8 EPS and Future Growth 30

31 As aluminum supplies drop worldwide and the demand eventually starts to grow along with government stimulus programs like the one in China, this will definitely be a huge catalyst of growth for Alcoa. China is the world s largest aluminum consumer, and as China grows, so will the potential for Alcoa s growth. With a forecasted 7% drop in global aluminum demand this year, China will be the only market where the demand for aluminum grows and eventually as the demand increases in Europe and North America, the benefits can only drive the stock price of Alcoa higher. The GDP growth of China will also play an important role in the consumption of aluminum in China and the positive impact it will have on Alcoa. (Graph 9) 24 and (Graph 10). 25 GRAPH 9 China GDP GRAPH 10 Chinese Aluminum Consumption 13 China GDP Growth Chinese Aluminum Consumption mmt '99 '00 '01 '02 '03 '04 '05 '06 '07 '08 1 Based on my P/B price target of $17.57, I think that it is most reasonable to forecast a one year price target of $ Alcoa is a strong BUY based on a % upside to the company s stock price of $9.93. Alcoa has been producing aluminum for the past 100 years, have maintained a strong business model, and are part of a highly cyclical industry. After reaching their 52-week low of $4.97 last fall, they have gained nearly 50% since then even with negative 1Q earnings. Alcoa is not going to cease to exist anytime soon and the potential for future growth is boundless, especially in emerging market countries. My $18.25 target price reflects a 15x 2010E earnings and 8x EBITDA on a longer-term future aluminum price of $0.90/lb. 31

32 Risks and Concerns to Investment Thesis 26 The extent and relentlessness of the global economic downturn and disorder in the financial markets. Alcoa could be negatively affected by further declines in aluminum prices. Downgrades in Alcoa s credit ratings which will increase the cost at which they can borrow from the banks and have access to the capital markets. Alcoa consumes large amounts of energy and profitably could be affected with increasing energy costs. Alcoa may not be able to effectively realize its growth projects in Brazil due to lack of financing and increasing construction costs. Alcoa operates globally and are exposed to political and economic risks and events that are beyond its control. Any reduction in Chinese demand for aluminum may negatively impact Alcoa. Fluctuations in foreign currency exchange rates and interest rates as well as inflation impact Alcoa. Union disputes along with pending legal disputes and other employee relations issues could unfavorably affect Alcoa. Alcoa is subject to a broad range of health, safety and environmental laws and regulations in the jurisdictions in which it operates and may be exposed to substantial costs and liabilities associated 32

33 Appendix I Aluminum Moving Forward GRAPH 11 OECD Leading Economic Indicators 27 GRAPH 12 Future LT Growth of BRIC Countries 28 33

34 GRAPH 13 Escalation in Long Run Marginal Cost 29 Red line represents fit of future projected GDP growth GRAPH 14 LME Future Projection 30 Red line represents future projected LME 3 month US$/tone of aluminum 34

35 GRAPH 15 - Credit Suisse Future Financial Valuations 31 According to this future data projection by Credit Suisse analysts Davld Gagllano, Richard Garchltorena and Sean Wright, they estimate that Alcoa should be producing normal levels of EBITDA by 2010, along with positive EPS of $0.35 and relative P/E (%) estimate returning to positive levels over the next 2 years. In my DCF model, the EV/EBITDA for 2010E closely matches that of the Credit Suisse analysts, 6.46 and 4.50 respectively. 35

36 APPENDIX II TABLE Income Statement 36

37 TABLE Balance Sheet 37

38 TABLE Statement of Cash Flows 38

39 TABLE 12 DCF Valuation (ALCOA) DCF Valuation Ticker: AA Terminal Discount Rate = 10.0% Theo Constantinou Terminal FCF Growth = 3.0% Forecast Terminal Year 2009E 2010E 2011E 2012E 2013E 2014E 2015E 2016E 2017E 2018E 2019E Value Revenue 31,471 32,465 35,915 39,237 42,376 45,766 49,084 52,642 55,801 58,870 61,519 % Growth 3.16% 10.63% 9.25% 8.00% 8.00% 7.25% 7.25% 6.00% 5.50% 4.50% Operating Income 1,459 1,998 2,378 2,943 3,390 3,661 3,927 4,211 4,464 4,710 4,922 Operating Margin 4.64% 6.15% 6.62% 7.50% 8.00% 8.00% 8.00% 8.00% 8.00% 8.00% 8.00% Interest - net Interest % of Sales 0.35% 0.35% 0.35% 0.32% 0.30% 0.28% 0.26% 0.24% 0.23% 0.21% 0.20% Taxes ,025 1,102 1,185 1,258 1,329 1,391 Tax Rate 30.0% 30.0% 30.0% 29.0% 29.0% 29.0% 29.0% 29.0% 29.0% 29.0% 29.0% Minority Interest Net Income 724 1,099 1,356 2,220 2,537 2,730 2,918 3,121 3,300 3,474 3,625 % Growth 52% 23% 64% 14% 8% 7% 7% 6% 5% 4% Add Depreciation/Amort 1,220 1,461 1,562 1,668 1,780 1,876 1,963 2,053 2,176 2,237 2,276 % of Sales 3.88% 4.50% 4.35% 4.25% 4.20% 4.10% 4.00% 3.90% 3.90% 3.80% 3.70% Plus/(minus) Changes WC (1,702) (136) (472) (392) (424) (458) (491) (526) (558) (589) (615) % of Sales -5.41% -0.42% -1.31% -1.00% -1.00% -1.00% -1.00% -1.00% -1.00% -1.00% -1.00% Subtract Cap Ex 1,416 1,623 1,562 1,668 1,780 1,876 1,963 2,053 2,176 2,237 2,276 Capex % of sales 4.50% 5.00% 4.35% 4.25% 4.20% 4.10% 4.00% 3.90% 3.90% 3.80% 3.70% Free Cash Flow (1,174) ,828 2,114 2,272 2,428 2,594 2,742 2,886 3,010 YOY growth -168% 10% 107% 16% 8% 7% 7% 6% 5% 4% Terminal 44,284.4 Terminal Value 44,284 P/E 12.2 NPV of free cash flows 12,052 41% EV/EBITDA 6.46 NPV of terminal value 17,074 59% Free Cash Yield 6.80% Projected Equity Value 29,125 Free Cash Flow Yield -4.03% Shares Outstanding Current Price $ 9.95 Implied equity value/share $ Upside/(Downside) to DCF % Cash 762 Debt 2,946 39

40 TABLE 13 Sensitivity Analysis: Implied Equity Sensitivity Analysis- Implied Equity Value ($) Terminal Discount Rate Terminal FCF 10.00% 10.50% 11.00% 11.50% 12.00% 12.50% 13.00% 13.50% 14.00% 2.50% % % % % TABLE 14 Sensitivity Analysis: Up Side / Downside Sensitivity Analysis- Up Side/Downside (%) Terminal Discount Rate Terminal FCF 10.00% 10.50% 11.00% 11.50% 12.00% 12.50% 13.00% 13.50% 14.00% 2.50% 187.9% 167.7% 149.9% 134.2% 120.1% 107.4% 96.1% 85.7% 76.3% 3.00% 200.5% 178.3% 158.9% 141.8% 126.6% 113.1% 101.0% 90.1% 80.1% 3.50% 215.0% 190.4% 168.9% 150.4% 134.0% 119.4% 106.4% 94.8% 84.2% 4.00% 231.9% 204.2% 180.6% 160.1% 142.2% 126.4% 112.5% 100.0% 88.7% 4.50% 251.9% 220.4% 193.9% 171.2% 151.6% 134.4% 119.2% 105.8% 93.8% 40