Alcoa – BrAAking Up: Unlocking Value, Creating Opportunity

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SEE LAST PAGE OF THIS REPORT FOR IMPORTANT DISCLOSURES

Graham Copley / Nick Lipinski

203.901.1629/203.989.0412

gcopley@/nlipinski@ssrllc.com

October 20th, 2015

BrAAking Up – Unlocking Value, Creating Opportunity

  • Assuming Alcoa can rebound to a return on capital consistent with historical trend the stock appears to have substantial “value”. The timing of this, of course, is uncertain but the split of the company into the commodity and value-added portions should be the catalyst for greater visibility into the potential.
  • The split into two companies could result in as much as $20/share for current AA stock based on some simplistic comparables – without a recovery in aluminum pricing.
    • We use CENX as a proxy for the “upstream” company – differing debt loads partially explain the current valuation gap, but it was indicated on the Q3 call that the value added company would take on AA’s debt.
    • Recently acquired Precision Castparts (PCP) has significant product overlap with the “value added” portion of Alcoa, and even applying a haircut to the multiple paid for PCP we arrive at an EV for that business that is greater than the entirety of AA currently
  • Results support AA’s capacity curtailments and move towards value-added products.
    • The last time aluminum pricing was as low as the Q3 ’15 average (Q2 ’09) AA took sizable losses as excess capacity cut deeply into earnings.
  • Demand growth is contributing to more balanced alumina/aluminum markets.
    • Alumina expected to be balanced in 2016, aluminum in deficit – AA has a history of being conservative in these estimates.
    • LME aluminum inventories are more than 40% off peak levels.
  • China remains a wild-card concern.
    • Chinese exports are down from the highs earlier in the year but remain at elevated levels.
    • Relative pricing (aluminum/coal) suggests there is room for further price weakness if China continues to respond to global rationalizations with increased output of its own.

Exhibit 1

Valuation – Framing the Upside for Upstream, Value Added Companies

Alcoa continues to screen as attractively as it ever has on our valuation work. The stock is approaching a level that proved to be an inflection point the last time the stock dipped, just a few years ago.

Exhibit 2

Source: Capital IQ, SSR Analysis

Looking beyond the opportunity in absolute terms, it appears the two companies that will emerge from the current Alcoa both have significant valuation upside opportunities.

For the upstream portion of the business, we look to Century Aluminum (CENX) as a proxy for a pure play metals company. The market is currently valuing CENX at 9.5 times forward EBITDA, roughly two and a half points higher than AA (currently at 6.9x) despite the fact that CENX does not have the strong downstream presence that AA has. Alcoa’s significantly higher debt burden and lower total return on capital are obvious contributors to this gap, but we note AA’s superior return on assets within its own primary metals business. Regarding the debt load, CEO Klaus Kleinfeld indicated on the Q3 call that the value added company would take on AA’s debt.

Exhibit 3

Source: Capital IQ, SSR Analysis

The prospective downstream company is said to have a product portfolio “60% in full overlap” with that of Precision Castparts (PCP), the newest addition to Berkshire Hathaway’s own portfolio. PCP was acquired at 13x forward EBITDA. If we take a haircut and assign 10x to the annualized Q3 EBITDA generated by AA’s “valued added” businesses, we arrive at an enterprise value that is nearly equal to the entirety of Alcoa today – Exhibit 4. It is reasonable to put a higher multiple here because we expect EBITDA to grow quickly as Alcoa drives synergies from the recent acquisitions. We annualize the Q3 figures simply because Alcoa has only reported EBITDA for its segments since the announcement of the split. Historically there does not appear to be any excessive seasonality to these businesses, on either a revenue or operating income basis – Exhibit 5. Combining this valuation with a slightly more positive view of the upstream business, abased on the Century comparison, we can conservatively get 50-100% upside for AA without a recovery in Aluminum prices.

Exhibit 4

Source: Capital IQ, SSR Analysis

Exhibit 5

Source: Capital IQ, SSR Analysis

Capacity Cuts, Move Downstream Helping Results

We have previously noted how AA’s results have begun to disconnect from their historical relationship with aluminum pricing. For perspective, the last time aluminum prices were as low as they were in Q3 ’15, AA posted sizable losses as costs were higher and AA overcapacity was greater.

Exhibit 6

Source: Capital IQ, SSR Analysis

Exhibit 7

Source: Capital IQ, SSR Analysis

Exhibit 8

Source: Capital IQ, SSR Analysis

Balanced Alumina, Deficit Aluminum Expected in ’16 – And AA Has Been Conservative Here

The initial 2016 market outlook provided by Alcoa in their Q3 earnings report calls for a balanced alumina market and a deficit for aluminum. Recent history suggests Alcoa has stuck to the conservative end of the range in their supply/demand forecasts.

Alcoa began 2014 with the expectation that the alumina market would be in surplus and the aluminum market more or less balanced – Exhibit 9. This proved a conservative forecast as alumina ended ’14 with a significantly lower surplus while aluminum actually moved to deficit for the year.

The company’s 2015 forecast has fluctuated mildly for aluminum, but the anticipated alumina surplus has been steadily taken down – Exhibit 10.

Exhibit 9

Source: Company Presentations, SSR Analysis

Exhibit 10

Source: Company Presentations, SSR Analysis

One of the drags on Aluminum pricing this year, in addition to China costs falling, has been the drawdown of speculative inventories – throwing more material onto the market and giving the impression of greater oversupply. We could have another year of these drawdowns, though any sign of recovery in Aluminum pricing could cause inventories to swing the other way quickly. Aluminum inventories have declined steadily from the 2014 peak (Exhibit 11), now off more than 40% from those levels. The World Bureau of Metal Statstics tracks monthly production and consumption of aluminum and by their measures, and based on their numbers, absent the inventory draw, the world should have been short of aluminum for much of 2015 – Exhibit 12.

Exhibit 11

Source: Bloomberg, SSR Analysis

Exhibit 12

Source: Bloomberg, SSR Analysis

The Chinese Wild Card – “Fake Semis”

“While the rest of the world remains in a deficit, the new supply from China in the form of fake semis has filled an increasing share of that deficit, which has placed the rest of the world total price under pressure.” – Alcoa Q2 Earnings Call July 8, 2015

“With lower all-in metal prices, the attractiveness of exporting fake semis has declined, which we saw reflected in the 21% drop in Chinese semi exports from the second quarter to the third quarter” – Alcoa Q3 Earnings Call October 8, 2015

Alcoa has in the past shed light on this apparent global deficit, which does not suggest we should be seeing the pricing weakness we are. “Fake semis” refers to aluminum products (essentially primary aluminum) altered just enough to avoid paying the 15% Chinese export duty on primary metals. These are included in Exhibit 13. Contemplating how the Chinese authorities will balance their many mandates and policy goals moving forward is largely a useless endeavor, but for context, we again note that it appears China has the ability to endure lower prices still, based on relative pricing histories.

Exhibit 13

Source: Capital IQ, SSR Analysis

Exhibit 14

Source: Capital IQ, SSR Analysis

©2015, SSR LLC, 1055 Washington Blvd, Stamford, CT 06901. All rights reserved. The information contained in this report has been obtained from sources believed to be reliable, and its accuracy and completeness is not guaranteed. No representation or warranty, express or implied, is made as to the fairness, accuracy, completeness or correctness of the information and opinions contained herein.  The views and other information provided are subject to change without notice.  This report is issued without regard to the specific investment objectives, financial situation or particular needs of any specific recipient and is not construed as a solicitation or an offer to buy or sell any securities or related financial instruments. Past performance is not necessarily a guide to future results.

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