Alcoa Corp. (NYSE: AA) Materials. Key Investment Highlights. Krause Fund Research Spring Recommendation: BUY. April 16, 2018

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1 Krause Fund Research Spring 2018 Materials Recommendation: BUY Analysts Xincheng Guo Yuxuan Huang Company Overview Alcoa is a vertically integrated aluminum company, comprised of technology, mining, refining, smelting, fabricating and recycling. This complete system helped the corporation to have high production efficiency among its competitors. Alcoa also has the advance alumina refining technology which improves the purity process of alumina. The main products of Alcoa are Bauxite, Alumina, Aluminum, cast product, rolled product and energy. Alcoa is the sixth largest aluminum corporation in the world. The corporation is located in Pittsburgh, although their business covered in ten countries, the primary market is still in the United States, and the sale is more than 50% in the United States. Stock Performance Highlights 52 week High week Low Beta Value 0.89 Average Daily Volume 4.21 m Share Highlights Market Capitalization B Shares Outstanding m Book Value per share EPS 1.18 P/E Ratio Dividend Yield Dividend Payout Ratio Alcoa did not pay dividends in 2017 or in 2016 (10K) Alcoa Corp. (NYSE: AA) Key Investment Highlights April 16, 2018 Current Price $55.03 Target Price $ Government Policy: In 2018, President Trump raised tariffs on Chinese aluminum imports and announced sanctioned by Russia aluminum industry. Under this economic condition, U. S. local aluminum company can gain benefit from it in terms of both demand and price. Aluminum demand increase: Accompany the technology development; most people would pay more attention to aluminum materials, because aluminum is lighter than steel, so it used in aerospace, automobile production, and many other industries. The ever-increasing demand for cars and airplanes made it possible for Alcoa to increase their aluminum supply in the short term. Market price increase: The price of Aluminum reach the peak price over five years, it is 2300 USD/t, which is 15% higher than According to our data and forecast of the market environment, we believe the price will continue to grow in the short run until the end of Expanding mining sites: Material corporations deeply rely on the material price and mining sites. Alcoa expanding its businesses and mining sites overseas makes it possible to be more competitive in the market, and more enduring for the price change. One Year Stock Performance Company Performance Highlights ROA 3.2% ROE 3.19% Sales $ 9.32 B Financial Ratios Current Ratio 1.30 Debt to Equity 21% Source: Yahoo Finance Important disclosures appear on the last page of this report. 1

2 S&P Metals & Mining Select Industry Index ECONOMIC ANALYSIS GROSS DOMESTIC PRODUCT Gross domestic product (GDP) is the total value of all the finished goods and services produced in a specific region and period. GDP can measure the economic activity of a particular area in a selected period. GDP can reflect the broad health condition of the United States. The health condition of U.S may also affect the Material section. The chart shown below is the Real GDP growth of the United States from 1990 to The Real GDP growth is adjusted and take the U.S. dollar value of 2009 as standard. Before the financial crises, the 8 year average real GDP growth from 1992 to 1999 is 3.81%. The 8 year average real GDP growth from 2000 to 2007 drop to 2.66%, with a high of 4.1% and a low of 1%. After the financial crises. The eight-year average real GDP growth from 2010 to %, with a high of 2.9% and a low of 1.5%, which below the average figure before the financial crises. S&P 500 Source: spindices@2018 INTEREST RATES Source: spindices@2018 Metals & Mining Industrial are also fear of the hiking interest rate. For a capital-intensive company like Alcoa Corporation. A significant portion of the company capital expenditure is Mining machine. Doesn t like buildings, mining machine requires not only a massive capital expenditure but also a considerable amount of depreciation each year. The company need debt and financing more than most other industries. source: S&P Aluminum Index and Metals & Mining Index are both not highly correlated with the S&P 500 for the past ten years, and S&P Metals & Mining Select Industry didn t outperform the economy as a whole during 2015 and However, With the stable real GDP growth, we expect that the aluminum sector can gain benefit from the continuous growth of the economy, and the aluminum price and demand will increase in the next two years. The real GDP growth for the past eight years has a lower growth rate compared to 2000 to 2007, we expect the U.S real GDP and Metals & Mining Industry to keep the current growth rate for the next two years, and we believe U.S. has a healthy condition of current real GDP growth rate. When interest rate decrease, the market will gain more money to spend and increased spending throughout the economy. With lower interest rates, people have more opportunities to do or start new businesses due to the low cost of borrowing. In this case, cost of debt and WACC are two prominent figures for the market as a whole, and for the most of time, the economy prefers lower interest rate. At the same time, mining industry can also benefit from the lower interest rate, with a lower cost of debt. We believe both in short-term ( 6 months) and long-term, the 30 Yr Yield will be stable at 3.00% while the economy continued to grow. Material and Mining industry is fear of the hiking interest rate. We believe this industry will not gain benefit from the increasing interest rate. However, even 3.00% isn t the best yield for Mining industry according to recent years industry. It will not hurt the industry as long as the government keeps the current yield. The current yield is 3.03%. We do not see any harmful impact for Alcoa in the future since the expected yield is still 3.00% and Important disclosures appear on the last page of this report. 2

3 this is considered as a reasonable and low figure for the current economic status. U.S Treasury Bond Interest Rate as of April 2018 Both federal and local Government regulation may affect Mining corporations. City government like Boonville publish a new law in 2017 which limit the expansion of Alcoa Corporation s Coal mining in that area. Coal mining and other material mining process require explosion, vast land, and giant mining machine. All these factors affect the local environment around the mining site. A single regulation published by city or federal government will have a substantial effect on how the mining site will perform. 4 Government Changes in other countries and global impacts China joined WTO in 2001 its aluminum production raise from 14% to 54% of the total production globally, however since 2015, Chinese government restrained aluminum producing pace due to overcapacity. This supply reduction makes the global aluminum price rise 20% in the past year Source: U.S. DEPARTMENT OF THE GOVERNMENT CHANGES Trump administration s Policy 8% will oversupply overcapacity of aluminum in China in 2020 predicted by Bank of America Merrill Lynch. The amount of oversupply will have a possibility of flooding the Aluminum price and harm Alcoa in the Long run. 5 However, we still believe the price of the aluminum sub-sector will be rise around 30-40%, until the supply and demand close to being balanced in Trump administration withdrew from Trans-Pacific Partnership (TPP) on January 23, (Presidential Memorandum Regarding) TPP is a regional trade agreement between U.S. and 11 Asian-Pacific countries that together comprise about 40% of global economic output. CFRA researcher expected to affect 30% of imported steels come from TPP countries. (Miller) The influence is partially limited because most U.S. metal trade was made with Canada and Mexico which are also involved in the North American Free Trade Agreement (NAFTA). However, some other materials still face foreign competition. 1 Since metals and mining industry is sensitive to the GDP growth, especially aluminum as a consumer-driven sub-sector, the U.S. domestic demand growth will follow the expected GDP growth rate around 2-3% in the long run ( 2-3 years). President Trump signed Buy American, Hire American executive order on April 18, (Presidential Executive Order) The order will promote domestic metals & mining market and domestically manufactured steel and aluminum products. 2 Source: London Metal Exchange@2018 LME, Aluminum Price Trump administration impose a tariff on aluminum import (Lloyd-Smith), as well as increasing amount of antidumping suits of aluminum, the price of aluminum is expected to continue to rise. One example is Russian stocks crashed on April 15th, while aluminum prices increase after the United States add tax for aluminum against Russia. Local Mining corporations like Alcoa can gain huge benefit from tariff imposed on foreign countries while the price of Aluminum will increase and demand Alcoa will also be increasing. 3 Government regulation EXCHANGE RATES Alcoa corporation is one of the leaders of the global production of Bauxite, Alumina and Aluminum products. And it also has One of the most significant bauxite mining portfolios worldwide. As a company buy and sell products globally, it faces a risk of change in exchange rates. 7 If U.S. dollar appreciates among target customer regions, Alcoa s profit will boost in the short term before target region s Important disclosures appear on the last page of this report. 3

4 demand shift to other suppliers, which leads to a drop in sales in the end. For this reason, Mining and Material industries prefer fix or slightly lower exchange rates in the long run. However, dollar appreciation can help Alcoa purchase more raw materials or machines overseas with less U.S dollar. Thus no matter exchange rates increase or decrease; it has both benefit and side effect for Alcoa. Nearly 50% of Alcoa s global sales are from Spain and Australia. Take the significant customer Australia as an example; we believe AUD will slightly appreciate towards USD. Currently, AUD/USD is We expect it will be stable at between 0.78 and Minor change in exchange rates will not hurt Alcoa. We believe in the short term, USD will depreciate due to the trade war fear and other reasons. But the U.S exchange rate will not be volatile and hurt Alcoa in the long run (one to two years). The government policy play as an essential role as for how Alcoa will perform in the short run, such as Buy American, Hire American and trade war - impose a tariff on aluminum import all benefit Alcoa. We also believe Alcoa will outperform the market in the long run due to the continuously increasing demand for Materials, such as the construction need in the U.S and even globally. INDUSTRY ANALYSIS ALUMINUM INDUSTRY OVERVIEW Metals and Mining supply for various sectors such as construction, automotive, aerospace, and telecommunications. Alcoa is the leading Aluminum Corporation in this industry. While extraction is becoming more difficult, companies put a significant portion of funds on advanced technology. This industry has high demand from western countries and the everincreasing demand from developing countries. Increasing middle-class demand more commodities, expanding infrastructures all require the aluminum products. Alcoa has one of the largest bauxite mining portfolios among other competitors. Bauxite is the primary commercial ore of aluminum. Thus Alcoa is also one of the largest Aluminum producers globally. Alcoa has customers for a variety of products produced from Bauxite, 14% of Bauxite sold to the third party. Alumina was smelting from Bauxite and 67% sold to the third party. Aluminum was purifying from Alumina, and 100% was sold to third party. 8 Source: statista@2017 Breakdown of Alcoa's global sales in FY 2017, by region Holding the largest mining portfolios in the world, the cost of producing Aluminum still consist less than 40% of the total cost. The Alumina refining and Aluminum smelting process need a huge amount of cost including energy, machining, and other materials. MARKET OUTLOOK We believe Metals & Mining industry in the U.S is in a good shape and we recommend our client to invest Alcoa Corporation. As mentioned, from the perspective of U.S. economy, the U.S real GDP is continuously growing, and this trend increase the overall consuming and spending in the country, thus benefit most industries. Aluminum as a consumerdriven sub-sector can even outperform the market with GDP growth. On top of that, Stock market (S&P 500) even reach the all-time high this January In the short run (less than one year), we see a possibility of a slight increase in the interest rate, higher cost of debt or even the risk of changing exchange rates. While these only have a minor effect on Metals & Mining industry since we expect a low rate of change. Important disclosures appear on the last page of this report. 4

5 Source: After we discussed the impact of technology on the mining industry, we should move on the aluminum market. The above picture shows the price from 2017 Oct. 2 to 2018 Mar. 23. In the beginning, the price of aluminum was 2075 USD/T, but by March 23, 2018, the price fell by 1975 USD/T. This trend may make investor depressed, but we have to think the reason behind the price. Industry Trend Mining Industry with new technology Source: investors.alcoa. If we look at the previous data of mining industry, we find the stock price is volatile, because the economic situation changes every year, and the corresponding trend will affect the entire industry. However, we think 2018 will be a good year for the whole mining industry. According to the current events, we know that the U.S. government announced that it would stop importing China s aluminum at the end of March. This event will explain why aluminum prices have plummeted. Customers do not purchase a large number of aluminum mines, this will make the price fell straightly. However, this phenomenon is only temporary because stopping imports means U. S. local mining companies earn more opportunities; this will be a great opportunity for Alcoa to expand its company. As we continually look at the chart, we will find that the price of aluminum reached its peak in April 2018, reaching 2250 USD/T. This will prove that our forecast is correct. Aluminum price in 2018 First, in 2018, the mining industry will go into the digital mine, just as Deloitte Global s 10th annual report says: Tracking the trends 2018, which explores the key trends facing the modern mining industry as more and more mining organizations turn towards the digital mine. 9 In the future, most people will look forward to mining industry reforming, because the digital mine will solve people s misunderstanding of the mining industry, and accompany the data updating, the manager can easily control the pollution that from the mining process. Source: statista Aluminum market in the whole world Important disclosures appear on the last page of this report. 5

6 The U. S. Aluminum s profitability is through increasing its own company s production, but what is the situation in the aluminum mining industry in the world? According to the data from Statista website, we found the general demand for aluminum in the world comes from China. The chart below represents the data from , so if we want to forecast industry trend of aluminum, we have to analysis aluminum policy in China, because Chinese decision-making will affect the aluminum market throughout the world. There have been policy announcements regarding construction projects that will increase demand for raw materials in The most publicized policy is China's One Belt One Road project. (Maximilian Court) This shows that the current aluminum industry is a good shape. China, as a leader in the aluminum industry, not only produces large quantities of aluminum but also imports a significant amount of aluminum. China influences the global price a lot, and increase the rate for the past two years. Source: traderscommunity In 2017, the demand of aluminum grew by 5.8 percent 10, the growth of motor vehicle production exceeds the average level, because more automobile manufacturers will choose to use lighter materials to manufacture automobiles so that this industry will become the largest aluminum consumer. In addition, food packaging also grew in recent year because many countries are developing rapidly, most people are willing to pay more attention to their health. Packaging foods with aluminum foil can greatly reduce bacteria and increase thermal insulation. Therefore, compared with growth of 5.8% in 2017, we believed it would increase by 6-8%. COMPETITIVE ANALYSIS The following chart shows the key financial metrics of the leading Aluminum Corporations in the World. Aluminum Corporation Of China Limited (Chalco), world s second largest Alumina producer, with billion dollars revenue in 2017, only has 0.77% profit margin. Though Alcoa s profit margin 1.86% is significantly lower than other market leaders United Company RUSAL (Rusal) and Rio Tinto (Rio). United Company RUSAL Source: spglobal However Chinese development of the mining industry has also brought with it environment problems. The figures above are the 2017 China Air index, at the end of the year, the air quality is bad, the Chinese government also recognize this problem. So in the 2017 winter government limited the development of the mining industry. This policy also reflects why the aluminum price had significantly reduced at the end of But at the same time. We believe that also will be an opportunity for the U. S. mining industry. U. S. mining companies can produce more mines to fill up the gaps and generate higher profits. Demand of Aluminum After analyzing the market, we will discuss the aluminum demand in of many other industries. Rusal was shut out of the western market and its stock price drop from 4.64 HKD on April 10th to 1.43 HKD today, the recent price is only 30.8% of the price one week ago. At the same time, Aluminum Hits Highest Since 2011 because Rusal was forced to cut production. This also indicates how buyer power defined by Porter s 5-Forces can affect corporation performance. 11 Revenue 9.97B B MKT CAP 21.57B B Profit Margin 12.26% % B 11.65B 9.05B B 0.77% 1.86% Important disclosures appear on the last page of this report. 6

7 The perform of Rusal gives Alcoa an opportunity to expand their market and gain higher revenue and profit margin with a high price in the short term. However, Rusal is only one significant competitor of Alcoa. Stock prices for Rio and Chalco also increase a lot for the previous week. And along with Porter s 5-Forces. Alcoa face risk from several different perspectives. Rio Tinto Rio is the word largest producer of bauxite, alumina, and aluminum. This includes the purchased Canadian company Alcan and Rio Tinto. As the largest bauxite producer in the world, Rio operates its mining sites for bauxite in Australia, Brazil, and Africa. They also refineries materials in Europe, North & South America, and Australia. Rio is one strong competitive profit margin, mining sites, refineries operations and overall production compare to Alcoa. 12 Aluminum Corporation Of China Limited Total Alumina production in the world in 2017 is million tons, consume million tons, increasing by 7.7%, and 6.6% compared to In China, production is million tons and consume million tons, increase by 16.8% and 12.56% according to Chinese Alumina production and consumption outperform the global market, produce and consume 53.8% and 55.6% of the global amount. Maximum Alumina price is 484 dollars per ton with an average of 354 dollars per ton. Increase by 39% for As Chinese Alumina market outperform the global market, Chalco did not harm by the previously reductions of production in Shanxi Province. 13 Chalco also continuously investing various types of mining sites and capitals overseas. Including the recent investment in Peru copper mine. 14 KEY FACTORS DRIVEN THE INDUSTRY Advanced Equipment The technology development of mining industry, such as the drilling technology is becoming more advanced in recent years. More advanced technology can help corporations reduce the cost and make mining process more efficient and outcompete its competitors. Raw Material and Final Product Corporations of Metals and Mining industry prefer to locate their mining operation closer to the target customers to lower the production and transportation cost. This is one of the reason Alcoa owns global mining sites and assets. As mentioned in the industry overview, Corporations in this industry prefer this producing model to achieve the upstream vertical integration state, and hence lower the cost since they mine and produce raw materials for their final product. Government Policy and Global Energy Price The mining industry is sensitive to the government policy. For example, the U.S. mining industry will go forward if the Chinese government would decrease the production of a particular mineral. And the recent tariff on foreign materials also benefits the U.S. mining industry. Nation s Economic Situation As a nation's economy grows, investments increase in the infrastructure sector and increasing the demand for mining metals. Company overview COMPANY ANALYSIS Alcoa is a global leader in the mining industry; its main business products are Bauxite, Alumina, and Aluminum. It has 40 operating firms in 10 countries. Then Alcoa has the largest bauxite mining portfolios worldwide, that will increase the speed and benefit from mining, they also have an advance global alumina refining, which will improve the purity of alumina. Also, Alcoa has its innovation in product casting and marketing network, a combination of various products will enhance the commercial and market value for Alcoa Company. Secondly, Alcoa main product is still the primary aluminum trade, the revenue from aluminum is $6,168M in , where the main market for Alcoa is the United States, followed by Spain, Australia, Brazil, and Canada. In the United States, Alcoa income reached $5,370M that was 50% of total revenue. Also, Alcoa s aluminum products are mainly sold to Construction, Transport and packing industry. Independent Company On November 1, 2016, Alcoa announced its separation from Arcoinc 60, and became an independent public company. After the establishment of Alcoa, it will hold the Arcoinc s bauxite, alumina, Aluminum products, and energy business; they also have the parent company rolling mill business in Warwick, Indiana, and Arcoinc in Saudi Arabia 25.1% equity. Financial Summary The current stock price of Alcoa is $54.96 is a relatively high price, and it is a sustainable increase. The chart above shows the 5-year stock price of Alcoa. We found that stock in the whole year of 2016 was between $20-$30. This Important disclosures appear on the last page of this report. 7

8 shows the Alcoa was very depressed in 2016, but the situation has improved after Alcoa became an independent company. When we discussed industry trend, we already said that the beginning of 2018 and now would be a good time for the Alcoa. This is because the Chinese aluminum market production dropped in the winter, so at the beginning of 2018 and now, the stock price of Alcoa is in the peak, and there will be a continuous rise. Source: Yahoo Finance According to Alcoa s statement. In 2016, Alcoa s adjusted EBITADA was $1108M, but in 2017, EBITDA had risen to $2352M, EBITADA doubled within a year, this phenomenon not only indicates that Alcoa had a very good operation in 2017, that also represents the market condition for mining industry has an improvement. Products and Market Alcoa has 6 main operating products, they are 60 : 1. Bauxite 2. Alumina 3. Aluminum 4. Cast Products 5. Rolled products 6. Energy Among them, Bauxite, Alumina, and Aluminum is two major products of Alcoa. At first, we will focus on these three products. Bauxite Segment In 2017, the production of Bauxite was 45.8mdmt, which increased 20.5mdmt compared with This was mainly due to the increase of production in Brazil and Australia. Alcoa should have more Bauxite production in 2017, but due to drought and heavy rain, several mines was interrupted, and the boke mines suffered civil war, so the operation stoped 60. Bauxite third-party sales increased by $18M in 2016, because Alcoa expanded sales for the third-party, its total sale in 2017 increased by 17% compared to the The price adjustment also led to higher prices for Bauxite, the 2017 EBITDA increased by $52M over 201, because of rising market prices, reduced transportation costs and changes in the exchange rate with U. S. dollar. Finally, According to the official report from Alcoa, we believed that the output of Bauxite in 2018 would continue to increase because the production of the Huntly and Juruti mines will increase. Alumina Segment This segment is entire company refining system, the Bauxite will be processed into alumina, which will be sold to other chemical companies for Aluminum smelting, its main sales channels are third parties sales, and the residual alumina will be used by the company itself. By the way, this segment also contains 25.1% share of Saudi Arabia. According to the Alcoa 10-K statement, we found the alumina production in 2017 was decreased by 155kmt compare to 2016, But the EBITADA was increasing $991M in 2017, so the main reason is Point comfort refinery production decreased due to some reasons. In 2017, the price of bauxite decreased, and due to the adjustment of the exchange rate between US dollar and Australian dollar, it led to an increase of $911M in Finally, in 2018, we believe that the price of alumina will remain balanced, because the price of Bauxite will increase, even though, the price of alumina keep rise in 2018, but the cost and revenue will be a balance level. Aluminum Segment Alcoa s aluminum is mainly used for external sales, and just a few of aluminum was lost during the production process. The aluminum produced is used for Transportation, construction, packing and other manufacturing operations, by the way, this sector also contained 25.1% share of Saudi Arabia. According to the Alcoa 10-K statement 60, we found aluminum production in 2017 was decreased by 400,000 tons compared to The main problem was Australia production declined, so the manager had to stop a product line, but the situation was restored in mid Third-party sales increase by 23% during 2017, because the company expanded its business, and EBITADA in 2017 was $284M higher than 2016 because the aluminum prices have increased by the end of In 2018, we believe that will be the best opportunity for Alcoa because President Trump has stopped importing Chinese aluminum, and recently he imposed economic sanctions on Russia. Under this economic environment, the local aluminum company will earn more opportunity to expand their production, so we are very optimistic for the Alcoa in Cast product Alcoa cast product is a global leader 15, because they have advanced product development and research team. In 2016, Alcoa creates a SUSTANA product line; this new product line will reuse sustainability materials, so that will reduce environmental pollution and resources waste. Then, Alcoa cast product Important disclosures appear on the last page of this report. 8

9 includes aluminum billet, foundry ingot, rolling slab, rod, power, high purity and p1020, this product will improve the competition for this segment. In 2017, the revenue decreased 12% than 2016, so the reason is the cost of aluminum was increased, and then, we found the third-party sales also decline $1060M compare to 2016, so we think the company has reduced the size of this segment. So we predict that in 2018, the cast product revenue will continue to decline, but SUSTANA product line will be maturity in the future, so we expect sale will increase in the next three years. Energy Alcoa energy segment manages 4.5GW electricity power, and its electricity production capacity is about 1.7GW. These electricity power are using to company operating, and they will sell the excess power to get the revenue. In this segment, 61% of Alcoa s electricity production comes from hydropower, which will achieve Alcoa sustainable development goals. In 2017, Alcoa revenue through the electricity power was $331M; it decreased 20% compared This due to Alcoa expansion mining business and led to more internal consumption. Rolled-Product Rolled product segment is very important to Alcoa because accompany the technology development, more vehicles will need lighter materials, and aluminum sheets will match the times. These sheets are used for packing, automotive and aerospace. Therefore, in recent years, rolled-product segments will become Alcoa s second largest industry. In this industry, Alcoa has an advantage that is obtaining primary aluminum at a very low price. As we expected, in 2017, the total sale of Alcoa rolled product was $1170M, which was $101M more than However, there are more new materials influence the price, such as carbon fiber, so we also think in recent years, aluminum sheet price will lightly decline. Then, more industry like packing industry will recognize aluminum sheets are healthy, so in the future, the price will increase. S.W.O.T Strengths Alcoa is a global company with 40 operating point in 10 countries. This business model will allow company always have enough inventory, and they will meet most of demands that from every countries. In addition, Alcoa has an integrated aluminum industry chain. From the mining, smelting and processing of aluminum, this system will greatly reduce the cost. Then, as we mentioned above, Alcoa owns a SUSTANA product line. This product line will make sure that Alcoa recycle all waste materials, thus will maintain a sustainable development strategy. 60 Weakness The first disadvantage of Alcoa is that mineral resources are limited, and long-term mining will result in fewer mineral reserves, so recycling is the most critical problem for Alcoa. Alcoa will break the ecological balance; there have two aspects: first, Mining will destruct soil layer. Second, Mining machines will cause air pollution. The final problem is mining industry will depend on the policy, so their income will be uncertainty. Opportunity First, in 2018, President Trump s policy was very beneficial to Alcoa because he stopped importing aluminum mines from China, and also he imposed economic sanctions on Russia aluminum industry, so if Alcoa expands in 2018, they will earn a lot of money than before. Accompany technology development; more industry will need aluminum products, because its lightness and heat insulation, so in the long-run, this will be another opportunity for Alcoa company. Threat As we mentioned before, some Alcoa s mines are in countries with war, so aluminum output and safety of these mines are very uncertain. Then China is the first aluminum export and import countries so that Chinese market will affect the aluminum price. Finally, President Trump s economic policies on other countries may cause the exchange rate of the U. S. dollar to go down; this might cause loss of exchange rates. VALUATION ANALYSIS We recommend a BUY rating on Alcoa. For the DCF and EP model we built, the intrinsic value of Alcoa by the end of 2017 is $66.12, which indicate the Alcoa is undervalued by $ However, our DDM model shows the recent intrinsic value is $55.55, which is considered much lower than DCF and EP. Given by the Alcoa 10K, the company has no dividend paid either in 2017 or Thus the DDM model is not our key model. Revenue Decomposition Alcoa s revenue depends on six segments; they are Bauxite, Alumina, Aluminum, cast products, and energy. Therefore, if we want a deep understanding of the Alcoa company revenue, we have to analyze each segment, because each department growth rate will differ when the market environment change. Based on our previous analysis, we found that in 2017, the Alcoa total segment sale is $19244M 60, and it increased 29.92% compared to 2016, so we are very optimistic about the revenue growth in 2018, and the growth rate will reach 10.35% 60 Bauxite Important disclosures appear on the last page of this report. 9

10 According to our company analysis, we mentioned that Alcoa had expanded its third-party bauxite business. There has been a great increase in third-party sale in 2017, so we believe that expansion will continue, then, Some of Alcoa s mines are not reached the maximum output for some reason, but as the 10-K statement says 60, these mines will resume average production in 2018, Bauxite production will increase in Base on the above information, we believed Bauxite segment sale would reach $1376 in Alumina Alumina is a semi-finished product of Alcoa for smelting aluminum. The production of 2017 decreased 155KMT compared to , but EBITADA increased in 2017, the main reason is alumina price became high in So our group believes in this economic environment, all segment will increase their revenue in 2018, except energy segment. But when we look at growth rate between 2017 and 2016, we are surprised find the rate is 35.9%, but we think that growth rate is not stable because Alcoa just recovered their market in 2017, and even economic environment improves, it will not increase like 35.9%, we think Alumina segment will increase 26.31% in Aluminum Aluminum segment is a most important division of Alcoa, although, the production of Aluminum segment was decrease in early 2017, but it recovered in the mid-year. Secondly, Aluminum segment also expanded the scale of third-party, and the sales growth reached 23%. In 2018, we believe the growth will continue because of Trump trade policy, therefore, this segment of Alcoa will be the most profitable segment of Alcoa, because in 2017, the aluminum segment was increase 120% revenue compare to 2016, we think even though it will rise in 2018, but that will not too much, so we think the growth rate is 14.10% Cast product and Rolled product Because these two segments are not the primary segment, we decide to put them together to analysis. First of all, we found cast product and roll product segments are both have negative revenue growth rate in 2017 compare to 2016, we think the same reason is an aluminum price increase. Then we found the cast product segment reduce the size of third-party sales, so we believe the cast product segment profitability is low, we predict cast product segment growth rate will continue to below zero. Secondly, according our analysis in company analyze, we find rolled product segment have so many competitors, so we are not optimistic about the development of this department in recent years. For these two segment, we think that in 2018, cast product segment will decrease by 20% and rolled product will reduce by 14.09%. Energy Our team believes the growth rate of the energy segment will continue decrease, because the energy segment will support electricity for whole company, and the remaining electricity will be sold out. We can see in 2017, the income of the segment company of Alcoa increased by 29.92%, but the revenue growth rate of the energy segment has decreased. Therefore, the energy segment revenue decline means entire company s turnover increase, finally, we think the energy segment will continue to decline, and the rate of decline will be -17% in Cost of Goods Sold and SGA Firstly, both COGS and SGA are estimated by growth ratio of sales. We calculated the average growth rate of 5 years sales; it was 4.9%. However, this method suits the SGA because we found the COGS has grown too high. According to Alcoa official news, the manager already started reducing COGS spending in 2016, and we also found that the proportion of total COGS was decreased over the years, therefore, from 2017, we will cut our spending by 0.5% annually to complete our forecast of COGS. Weighted Average Cost of Capital First, we calculated the weight of equity and weight of debt according to Alcoa 10-k table, which was 82.92% and 17.08%. Then we use 21% marginal tax rate to calculate the pre-tax cost of debt is 4.05%, and use the CAMP formula to calculate the cost of equity. Finally, we use the WACC formula to calculate WACC equal to 5.90%. Cost of Equity & Cost of Debt When calculating the cost of equity, we used the capital asset pricing formula. First, we found Alcoa beta was 0.89 at Yahoo Finance. Then we predict future market risk premium is 4.18%; then we found 10 years treasury yield to use as the risk-free rate. Finally, we calculated the cost of Equity equals 6.46% by using CAPM formula. Yahoo finance While 30-year bond not found, so we looking for the Damodaran's Industry Cost of Debt. Apply it to the latest marginal tax rate 21%, we got after-tax cost of debt as 4.05%. 61 Discounted Cash Flow & Economic Profit & Dividend Discount Model The adjusted target price calculated by Both DCF and EP model is $66.12 as of 11/29/17, which is higher than the current price $ A large number of CV growth brings the higher intrinsic value. After adjusting the price, we target the price to $ Compare to the DDM model, DCF and EP model predicted to be $11.81 higher. We believe DCF and EP model to be a better prediction Important disclosures appear on the last page of this report. 10

11 because the calculation includes NOPLAT and IC, Invested Capital can help investors predict capital gain in the future rather than the dividend. SENSITIVITY ANALYSIS Risk Free Rate vs Risk Premium As mentioned before, when the risk premium increase, the price will decrease. We can see a clearly more change of price when we compare the risk premium with the risk free rate. This analysis yielded from $36.66 to $92.18 There are certain numbers of variables affect Alcoa stock price. We choose some of the key variables / assumptions to conduct different sets of sensitivity analysis to find how stock price react to the change of different sets of key assumptions. Beta vs. Risk Premium This comparison shows how stock price influence by Beta and risk premium. As we observe, Beta increase will led to stock price decrease. Under 4.65% risk premium, when beta increase 0.1 the price decrease $ And under 0.8 beta when risk premium increase 0.05%, the price just decrease $0.64. So compare beta and risk premium, beta changes will be more sensitive for the stock price. NOPLAT CV Growth vs. ROIC CV Both factors are represent asset of a company, and NOPLAT and ROIC increase will cause a lot of cash flow. So increase each one will lead to price increase. Under ROIC CV equal 11.67%, when NOPLAT increase 0.1%, the price will increase $0.96, and then under 0.69% NOPLAT CV Growth, when ROIC CV increase 1%, the price increase $0.66. So according to the compare, the NOPLAT CV Growth will more sensitive for the stock price, and keeping high NOPLAT CV Growth will more efficient than ROIC CV. Marginal Tax Rate vs. Risk Free Rate While the marginal tax rate has dropped to 21%, we believe it is important to analyze the Marginal Tax Rate. The drop in the tax rate would increase FCF. However, if we compare it with the Risk-Free Rate, the rising risk-free rate would increase the cost of equity. They have a reverse relationship. As we can see, the change of tax rate doesn t have as much power as the change of risk-free rate affecting the price. WACC vs. CV Growth rate In this comparison, we believe the WACC will more sensitive than CV Growth rate, because company leverage are rely on WACC, and when we look at our data table, we found the fact just same as our expect. Accompany WACC increase 1%, under CV Growth rate was 0.69%, the price will decrease $23.1. When the WACC equal 5.97%, CV Growth rate increase 0.1% will lead price increase $0.69. So WACC is more sensitive than CV Growth rate, thus when Alcoa want keep our maximum benefit, Alcoa should maintain the WACC at a low leverage. Important disclosures appear on the last page of this report. 11

12 Important Disclaimer This report was created by students enrolled in the Security Analysis (6F:112) class at the University of Iowa. The report was originally created to offer an internal investment recommendation for the University of Iowa Krause Fund and its advisory board. The report also provides potential employers and other interested parties an example of the students skills, knowledge and abilities. Members of the Krause Fund are not registered investment advisors, brokers or officially licensed financial professionals. The investment advice contained in this report does not represent an offer or solicitation to buy or sell any of the securities mentioned. Unless otherwise noted, facts and figures included in this report are from publicly available sources. This report is not a complete compilation of data, and its accuracy is not guaranteed. From time to time, the University of Iowa, its faculty, staff, students, or the Krause Fund may hold a financial interest in the companies mentioned in this report. References 1 Solís, M. (2017, May 10). Trump withdrawing from the Trans-Pacific Partnership. Retrieved April 17, 2018, from mp-withdrawing-from-the-trans-pacific-partnership/ 2 Buy American, Hire American. (n.d.). Retrieved April 17, 2018, from 3 Imbert, F. (2018, April 09). Russian stocks crash on new sanctions; aluminum prices soar on penalties to global producer Rusal. Retrieved April 17, 2018, from 4 Martin, J. (2017, December 14). Alcoa still plans smelter restart, but concerned about Boonville coal regulations. Retrieved April 17, 2018, from oa-still-plans-smelter-restart-but-concerned-boonville-coalregulations/ / 7 WHO WE ARE. (n.d.). Retrieved April 17, 2018, from Dale Benton. (2018, January 31). Predicting the disruptors of tomorrow's mining industry: Deloitte's tracking the trends Retrieved April 17, 2018, from 10 World Aluminum. (n.d.). Retrieved April 17, 2018, from 11 Aluminum Hits Highest Since 2011 With Rusal Supply Seen At Risk. (2018, April 16). Retrieved April 17, 2018, from f89355eb53f0/aluminum-hits-highest-since.html 12 (n.d.). Retrieved April 17, 2018, from _deal_070712/ ?hub=topstories pdf 14 Sanderson, H. (2017, April 05). Chinalco to ramp up investment in Peru copper mine. Retrieved April 17, 2018, from 15 (n.d.). Retrieved April 17, 2018, from Additional sources K 61 Yahoo Finance 5 How Chinese overcapacity hits American workers. (2017, June 15). Retrieved April 17, 2018, from /goldman-warns-trump-will-probably-slap-tariff-onaluminum-trade Important disclosures appear on the last page of this report. 12

13 Alcoa Corporation (AA) Key Assumptions of Valuation Model Ticker Symbol AA Current Share Price $55.03 Current Model Date 4/16/2018 FY End (month/day) Dec. 31 Pre-Tax Cost of Debt 7.80% Beta 0.89 Risk-Free Rate 2.48% Equity Risk Premium 5% CV Growth of NOPLAT 0.69% CV Growth of EPS 20.37% Current Dividend Yield 0.00% Marginal Tax Rate 21% Effective Tax Rate 31.80% wacc 5.97% CV ROIC 11.76% Dividend Payout Ratio N.A Forward P/E

14 Alcoa Corporation (AA) Revenue Decomposition Fiscal Years Ending Dec E 2019E 2020E 2021E 2022E 2023E Bauxite: Bauxite production (million bone dry metric tons) Third-party sales Intersegment sales Depreciation, depletion, and amortization Third Party Shipments (mdbmt) Third Party Sale Price (per mbdmt) Total Bauxite revenue Bauxite segment growth % 13.85% 22.17% 18.45% 5.71% 6.38% -2.10% 3.37% Alumina: Alumina production (million bone dry metric tons) Third-party sales Intersegment sales Depreciation, depletion, and amortization Third Party Shipments (kmt) Third Party Sale Price per metric ton Total Alumina revenue Alumina segment growth % 35.90% 26.31% 17.14% 7.81% 8.54% 4.67% 3.61% Aluminum Total Aluminum Sales Aluminum production (million bone dry metric tons) Third-party sales Intersegment sales Depreciation, depletion, and amortization Aluminum Production (mt) Aluminum Sale price per metric ton Total Aluminum revenue Aluminum segment growth % % 14.10% 6.50% 1.70% -0.60% 1.07% 2.25% Cast product: Third-party Alumiunm shipments(kmt) Third-party sales Intersegment sales Depreciation, depletion, and amortization Aluminum Shipments (kmt) Cast products price per metric ton Total Cast product revenue Cast product segment growth % % -9.70% 1.70% 1.10% -2.10% 2.30% 3.10% Energy*: Third-party sales(gwh) Third-party sales Intersegment sales Depreciation, depletion, and amortization Energy Production (GWh) Third-Party Sales price per GWh Total energy revenue Engergy segment growth % % % % 5.20% 5.67% 5.74% 4.91% Rolled product: Total sales Third-party Alumiunm shipments(kmt) Third-party sales Depreciation, depletion, and amortization Aluminum Shipments (kmt) Rolled Products Price per metric ton Rolled product segment growth % % -7.07% -3.54% 2.12% 3.14% 1.14% 2.56% Total segment sales Sales Growth % 29.92% 10.35% 8.47% 3.75% 2.71% 2.26% 2.96% * Energy is defined by Alcoa as one major product.

15 Alcoa Corporation (AA) Balance Sheet Fiscal Years Ending Dec E 2019E 2020E 2021E 2022E 2023E Assets Current Assets Cash & cash equivalents Receivables from customers Other receivables Inventories Prepaid expenses & other current assets Total current assets Properties, plants, & equipment, gross Less: accumulated depreciation, depletion, & amortization Properties, plants, & equipment, net Goodwill Investments Deferred income taxes Fair value of derivative contracts Other noncurrent assets Total assets Liabilities Current Liabilities Accounts payable, trade Accrued compensation & retirement costs Taxes, including income taxes Other current liabilities Long-term debt due within one year Total current liabilities Long-term debt, less amount due within one year Accrued pension benefits Accrued other postretirement benefits Asset retirement obligations Environmental remediation Noncurrent income taxes Other noncurrent liabilities & deferred credits Total liabilities Equity Parent company net investment & Common equity Retained deficit Accumulated other comprehensive income (loss) Total net parent investment and other comprehensive loss Noncontrolling interests Total equity Total liabilities and equity